Competitiveness and Growth

COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND road GROWTH COMPETITIVENESS AND GROWTHeconomic COMPETITIVENESS convergence AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS ANDGovernor GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT The to sustainable György Matolcsy Hungary’s economic convergence onlyCOMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND can GROWTH be achieved through improving competitiveness, COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT whichAND calls for continued structural reforms. Strong and political COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND institutions GROWTH COMPETITIVENESS AND stability GROWTH COMPETITIVENESS AND GROWT are vital for this. COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT One of the statutory tasks theCOMPETITIVENESS Magyar Nemzeti Bank is toAND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS ANDofGROWTH AND GROWTH COMPETITIVENESS COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT Dániel Palotai COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESSDeputy AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT Governor Márton Nagy Barnabás Virág policy primarily contributes COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESSMonetary AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT to convergence by maintaining price stability COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND COMPETITIVENESS GROWTH COMPETITIVENESS AND GROWT andGROWTH activating domestic AND sources of funding. AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS ANDAND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT Deputy Governor László Windisch COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESSGROWTH AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT The basic precondition for balanced economic financial stability. COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS ANDgrowth GROWTHisCOMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS 4900 AND Ft GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT Deputy Governor Ferenc AND Gerhardt COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS GROWTH COMPETITIVENESS AND GROWT In addition to structural and financial reforms, COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT HungaryAND needs a mental and spiritual renewal in order to enter on a new convergence path. COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWTH COMPETITIVENESS AND GROWT

COMPETITIVENESS AND GROWTH

Dániel Palotai – Barnabás Virág

COMPETITIVENESS AND GROWTH

Competitiveness and Growth The road to sustainable economic convergence

Competitiveness and Growth The

road To susTainable economic convergence

MAGYAR NEMZETI BANK, 2016

COMPETITIVENESS AND GROWTH The road to sustainable economic convergence A series of books published by the Magyar Nemzeti Bank © Magyar Nemzeti Bank, 2016 With the participation of: Directorate Economic Strategy Directorate for Fiscal and Competitiveness Analysis Directorate Economic Forecast and Analysis Research Directorate Directorate Monetary Policy and Financial Market Analysis Directorate Financial System Analysis Editors: Dániel Palotai, Barnabás Virág The editors would like to express their gratitude to Governor György Matolcsy and Deputy Governor Márton Nagy for their insightful comments. Published by: Magyar Nemzeti Bank 1054. Budapest, Szabadság tér 9. www.mnb.hu All rights reserved. Prepared for printing and printed by: SPL – Prospektus Nyomda Konzorcium ISBN 978-615-5318-07-8 ISSN 2416-3503

2016

Contents

Foreword

Introduction

Summary of the most important conclusions

Part I: International and national experiences in economic convergence A. The theory and practice of economic convergence

1. A brief summary of economic convergence theories

2. Successful international experiences

B. Financing economic convergence

137

3. Financing models from a macro perspective

139

4. The role of financial intermediation in growth

186

5. The fiscal policy of successfully converging countries

212

C. The current Hungarian situation

259

6. Convergence and equilibrium in Hungary since the political changeover

261

7. Regional differences in economic growth in Hungary

321

8. Hungary’s position in terms of the determinants of growth potential – demographics and the labour market

—5—

381

9. Hungary’s position in terms of the determinants of growth potential – investments

466

10. Hungary’s position in terms of the determinants of growth potential – productivity

486

11. Present situation and outlook for the banking system in Hungary

529

12. The impact of fiscal policy on economic performance

570

Part II: Competitiveness reforms Overview of draft reforms on competitiveness

619

13. Labour market competitiveness

625

14. Corporate competitiveness

641

15. State competitiveness

683

16. The competitiveness of human resources

699

17. The role of European Union funding in enhancing competitiveness and growth

738

18. Special topics

781

19. The banking system scheme

791

Acknowledgements

808

List of acronyms

809

List of charts and tables

815

—6—

Foreword In October 1989, Hungary joined the camp of democratic countries harbouring hopes of economic progress and full convergence. Looking back 25 years later, it is clear that Hungary’s hopes for economic development were not realised. Over the last quarter century, the growth rate of the Hungarian economy was among the lowest overall in the region, and Hungary only managed to achieve sound and sustainable growth for brief periods. The economic policy detours of past decades failed to set the country on a successful convergence path, as the period was characterised by economic growth at times (albeit not sustainable), and the search for economic balance at other times. In 2015, Hungary arrived at a new historic moment. After many decades the stabilisation policy in recent years and implementation of the structural reform programme known as the Széll Kálmán Plan finally established harmony between the two fundamental criteria for longterm economic convergence: equilibrium and growth. This provides an exceptional opportunity to strengthen the last weak pillar which is crucial for the economy’s dynamic convergence: competitiveness. We can legitimately be confident that, equipped with the appropriate knowledge and willpower, the next 25 years will bring far more success for Hungary than the previous quarter century. However, this calls for new structural reforms which are geared towards boosting the competitiveness of the economy, as a continuation of the Széll Kálmán Plan. The management of the Magyar Nemzeti Bank has accepted the Government’s request to contribute to Hungary’s competitiveness with its professional expertise and knowledge. It is the central bank’s statutory function to support the government’s economic policy with its available tools, without jeopardising its primary objective of achieving and maintaining price stability. The publication of this volume and the formulation of a competitiveness-based strategy laying the groundwork —7—

Foreword

for sustainable convergence serves this statutory function of the Magyar Nemzeti Bank. Based on the analytical traditions of Hungarian economics, this book also aims to provide an in-depth overview of the economic policy experiences of successfully converging countries, to analyse the current situation in Hungary, and finally – building on these findings – to formulate recommendations in various domains for improving Hungarian competitiveness and the economy’s long-term growth potential which can be incorporated into a new Széll Kálmán Plan.

György Matolcsy, Márton Nagy, László Windisch, Ferenc Gerhardt

—8—

Introduction The topic of economic growth and convergence are among the most analysed and researched areas of economics, and are also the two key objectives that economic policy-makers seek to achieve. Rapid economic growth, however, is not an objective in and of itself: it paves the way for individual and social development. History shows that sustained growth and economic convergence can generate the resources necessary for education, healthcare and the development of infrastructure, may reduce poverty and generally contribute to a rise in social welfare, while the absence of growth may push countries towards social and political instability. Accordingly, understanding the nature of growth and more importantly, its fundamental determinants has long since been the main focus of economic researchers and policy-makers. In the aftermath of the economic crisis that began in 2007 and took on global proportions in 2008, the issue of growth and convergence has become more important than ever. In the seven years since the collapse of Lehman Brothers, the prospects for the global economy have been significantly gloomier than in the previous decades. Many advanced economies still operate at below pre-crisis output levels. Due to this very slow recovery, Europe is still burdened by a nearly double-digit unemployment rate, which even exceeds 20 per cent among the younger generations. In view of the sluggish growth in emerging countries, we can say with increasing certainty that the crisis has had an adverse impact on the global economyâ&#x20AC;&#x2122;s long-term growth potential. In light of the persistently low inflation and moderate growth, coupled with inadequate economic policy responses, many prominent contemporary economists predict a prolonged period of stagnation. Sustainability has gained even more importance in light of the lessons drawn from the crisis. The slow recovery and the protracted decumulation of debts underlined the importance of the funding

â&#x20AC;&#x201D;9â&#x20AC;&#x201D;

Introduction

for growth, while climate change and increasingly frequent natural catastrophes acted as a reminder of the environmental impacts of economic development. The subject of growth has become more complex than ever. Alongside the quantitative and qualitative determinants of development – such as geographic attributes, demographic changes, the institutional environments and social values – funding and environmental impacts are becoming increasingly important from a sustainability perspective. Although the Hungarian economy turned into a market economy after the political transition in hopes of achieving full convergence, 25 years later, we can declare without any doubt that these hopes have not been fulfilled. Hungary has failed to make the most of the historic opportunities afforded by the political transition and its subsequent accession to the European Union, and was unable to rise out of the group of middle-income countries. In the wake of the crisis, Hungary was compelled to completely revise its growth model in terms of both structural factors and the funding side. The economic policy measures taken since 2010, including the structural reforms of the Széll Kálmán Plan, managed to stabilise the finances of the economy, substantially reducing its vulnerability. In addition to equilibrium indicators, more and more signs of a turnaround have also been seen in the real economic indicators in recent years, while targeted measures have resulted in substantial improvements in the labour market, the factor restraining the Hungarian economy’s growth potential to the greatest degree. By 2015 the period of stabilisation had ended and the resilience of the Hungarian economy had substantially improved. At the same time, in order to achieve the growth potential that could drive successful convergence, additional sources of growth must be found. The groundwork for this must be laid with a new strategy focusing on boosting economic competitiveness, a third Széll Kálmán Plan.

— 10 —

Introduction

Analysing sustainable growth is a priority for the Magyar Nemzeti Bank. According to the central bank act, the primary objective of monetary policy is to achieve and maintain price stability and to ensure financial stability. It is important to emphasise that these criteria are informed by the need for sustainable growth. Sustainable convergence can only be achieved in a predictable pricing environment and with a sound financial system. Accordingly, the central bankâ&#x20AC;&#x2122;s measures fostering price stability and financial stability also support sustainable growth. At the same time, in the post-crisis economic environment, supporting the real economy has emerged as an even more direct objective for central banks. This is because the link between stability and growth also grew stronger in the reverse direction. Instead of alarmingly low inflation rates, acceleration in economic growth may represent the solution to once again achieving price stability and bolstering the banking system, which is essentially frozen at present. With this book, the Magyar Nemzeti Bank wishes to contribute to the discourse on sustainable economic growth. Our objective is to review Hungarian and international experiences to provide a comprehensive picture of the most important determinants of economic convergence. The chapters of this book are closely interlinked, but also contain valuable information as individual studies for those interested in a specific topic. The first half of the book provides an overview of successful international experiences and then evaluates the current situation of the Hungarian economy in light of these. We then attempt to identify the areas requiring improvement and formulate recommendations for reforms that may contribute to boosting competitiveness. It is important to stress that there is no one-size-fits-all solution for successful convergence. No model of a single successfully converging country can be used to forecast the future of less developed economies. Every country must devise its own convergence strategy, building on its own creative energies and initial situation and attributes, while objectively assessing current trends of the global economy. In addition â&#x20AC;&#x201D; 11 â&#x20AC;&#x201D;

Introduction

to the short-term fluctuations of business cycles, such an economic policy must closely monitor the determinants of the economy’s growth potential over the medium and long term. To devise such a strategy, input from all stakeholders, including the government, the central bank, academic circles, the business world and civil groups is necessary, which may be harmonised in an institutionalised form, for example by a Competitiveness Council. To ensure that the next 25 years are not another example of wasted opportunity, this volume highlights the most important areas for a convergence plan promising a successful future.

Dániel Palotai, Barnabás Virág

The papers and our recommendations are based on the data available on 15 January 2016.

— 12 —

Summary of the most important conclusions There are significant, lasting differences between the development of economies. Many countries can achieve rapid growth for some years or even for a decade, but only a handful of countries showed development and economic convergence spanning several decades. This also demonstrates that economic development is an extremely difficult and complicated task. The convergence of less developed economies does not happen automatically. It can only be achieved with thoughtful, consistent economic policy and a stable institutional background. Countries that have converged successfully form a fairly heterogeneous group: they have different natural resources as well as institutions and political systems. Accordingly, there is no generally applicable recipe for all countries to achieve steadily high growth and economic convergence. Thus, economies that have successfully converged are not models for currently underdeveloped countries. Nevertheless, several key factors can be identified which contributed to their success, and evaluating the experiences from economic history may enable todayâ&#x20AC;&#x2122;s economic policymakers to formulate the right questions. Still, in the quest for answers no nation can forego utilising its own creative energy. The staff of the MNB has compiled these studies for two reasons: first, we would like to support economic policy and thus assist the professional public in identifying the right questions and the key areas with respect to successful convergence by analysing a wide variety of international and Hungarian data. We also wish to present a detailed picture of the current state of the Hungarian economy through a deeper analysis of the characteristics of the growth patterns employed by Hungary before and after the crisis, which may be a good starting point for formulating a new, long-term convergence strategy. â&#x20AC;&#x201D; 13 â&#x20AC;&#x201D;

Summary of the most important conclusions

An effective growth strategy also takes into account issues related to short, medium and long-term growth. Short-term measures mainly aim to smooth cyclical fluctuations in the economy, while medium and longer-term programmes focus on the structural characteristics of the economy and its competitiveness. We would like to emphasise that the analyses in this book principally concentrate on the latter, and do not (or only briefly) cover aspects related to the short-term growth management.

What do international experiences show? From the second half of the 20th century, globalisation and the increasing openness and integration of the global economy created a new opportunity for emerging economies. The freer movement of capital enabled swifter adoption of new ideas and the acquisition of know-how from foreign companies through capital investment. The freer movement of labour and the spread of foreign educational opportunities facilitated faster accumulation of human capital. In addition, a high level of specialisation became possible for smaller economies as well, since the market for their companiesâ&#x20AC;&#x2122; products was not only restricted to their own national economy, but extended to include the entire global economy. The increasing openness of the world economy resulted in many opportunities and new features. In the global economy, companies form an expanding and increasingly complex value chain, i.e. from the point view of individual economies the focus is not only on the type of industries present in a country, but also on the work phases in which the companies are involved and the level of the value chain where they can enter production. On the expanding market, competition has increased as well, and only companies which are able to constantly and swiftly adapt can be successful. These tendencies presented new challenges to national economic policies. In addition to economic stimulus measures focusing on specific industries, promoting â&#x20AC;&#x201D; 14 â&#x20AC;&#x201D;

Summary of the most important conclusions

innovation and human capital accumulation as well as enhancing the adaptive capabilities of individuals and companies have received priority. Fiscal responsibility with respect to the fiscal deficit and government debt is imperative in order to guarantee the stability of the economy: there can be no sustained convergence without this. The structure of the budget can also contribute to more rapid growth in various ways. Increasing the weight of expenditure aimed at strengthening the physical infrastructure and human capital, and promoting less distortionary taxation can significantly improve a countryâ&#x20AC;&#x2122;s competitiveness. An economic policy facilitating convergence cannot be implemented without well-prepared, open, motivated and accomplished experts and decision-makers. The common prerequisite for successful convergence is the rapid pace and correct structure of capital accumulation. In some areas, especially with respect to government services, the development of infrastructure and the promotion of innovation, the state may directly play an important role, which may also boost private investment. The quality of productive private investment is first and foremost determined by corporate management skills, but in this case government regulation and incentives may also help to focus investments on projects that raise the output of the economy even over the longer term. The high investment rate necessary for dynamic economic growth also raises the question of financing investments. Experience shows that domestic savings need to play a central role in this. As demonstrated by the latest global economic crisis, over-reliance on external funding makes an economy vulnerable, which casts doubt on the sustainability of convergence over the long term. However, external funding through direct capital investment is crucial from the perspective of both stability and knowledge transfer. Moreover, in the European Union the availability of financing from investment and structural funds is exceptional. Taking into account the magnitude of these funds and â&#x20AC;&#x201D; 15 â&#x20AC;&#x201D;

Summary of the most important conclusions

the fact that the government plays a vital role in their allocation, it is important to maintain a disbursement system which ensures that investments contribute to economic growth over the longer term as well. The financial sector, and especially credit institutions, play a decisive role in satisfying the funding needs arising during convergence and in the appropriate allocation of available funds, particularly in the case of middle-income economies. There can be no sustained convergence without a stable banking sector which is able to support growth. The quality of the regulatory environment, the structure and efficiency of the banking system and the state of capital markets fundamentally influence credit institutions’ ability to support convergence. While the state has a vital function in developing an environment conducive to economic growth, over the longer term, a competitive, efficient and continuously expanding private sector is the driving force behind successful convergence. For this, an adequate amount and quality of resources is indispensable. Successfully converging countries have generally spent a substantial amount on raising the standard of education. It is worth noting that the majority of operative decisions necessary for successful convergence are taken at the level of companies rather than the government. Accordingly, the creative, innovative trendsetters with leadership qualities who are able to establish new companies and to head and expand existing ones are essential in this process. To an extent, these skills can be improved, and thus training and educational policies need to focus on this as well. In addition to qualifications, the efficiency of the labour force is fundamentally influenced by employees’ general health condition. Although developing an efficient, high-quality healthcare system can pose considerable challenges even to developed countries, it can significantly contribute to sustained convergence.

— 16 —

Summary of the most important conclusions

Chart 1: Key areas in successful economic convergence Economic openness Access to global markets

Macroeconomic stability Future orientation

Knowledge import

High domestic saving..., Low level of debt

and investment rate

Stable exchange rate

Leadership and governance Credible commitment Pragmatic decisions Clear communication Effective administration

Source: based on Growth Report: Strategies for Sustained Growth and Inclusive Development

The Hungarian situation Over the past 25 years, the Hungarian economy was unable to take advantage of the historic opportunity that presented itself as a result of the transition to the market economy and accession to the European Union. Since the political transition, Hungary has converged towards the average level of development of the euro area, but this convergence was only financed in a sustainable manner for short periods in the past 25 years. Thus from time to time, Hungary was faced with the need for consolidation due to over-indebtedness and the consequences of the resulting sluggish growth. The growth models observed in the individual periods were in close correlation with the value choices of the governments in power as regards economic policy. The global economic crisis forced the Hungarian economy to completely rethink the growth model it had employed until then. Instead of the growth model built on increasing indebtedness that characterised the period before the crisis, the restoration of macroeconomic stability as well as the development of a new, sustainable growth model came to the forefront. The first results of â&#x20AC;&#x201D; 17 â&#x20AC;&#x201D;

Summary of the most important conclusions

the process have gradually emerged in recent years. The positive change observed in the current account balance was outstanding even in international comparison, contributing to the downward trend in Hungary’s net external debt, which was one of the most significant vulnerabilities during the crisis. The rapid adjustment of the financing model, which was previously based primarily on the accumulation of external debt, was due to the improving financing capacity of households and the corporate sector on the one hand, and the sharp fall in the borrowing requirement of the general government on the other hand. As a result of the fiscal turnaround facilitated by the Széll Kálmán Plan launched in 2010 and the structural reforms of 2011– 2012, Hungary was removed from the excessive deficit procedure in 2013, for the first time during its EU membership. The conversion of foreign currency-based mortgage and car loans eliminated a systemic risk, and this decision also stimulated the process of debt reduction for over-indebted households. With the help of the increasingly accommodative monetary policy, 2013 marked a turning point in growth and investment as well. The convergence of the Hungarian economy that faltered in 2006 resumed, while the investment rate rose above 21 per cent by 2014. In parallel with the recovering growth, the unemployment rate fell from above 11 per cent to below 7 per cent, while the labour force participation rate rose by 5 percentage points since 2010. Moreover, household consumption also began to increase in 2014. The growth that resumed after 2013 exhibited a more balanced structure than previously, which entailed the possibility of sustained, balanced economic growth. In order to maintain the dynamic convergence that characterised recent years over the long term, economic policy needs to face several further challenges. In addition to the quantitative conditions of growth, qualitative and economic-psychological factors also have to be given priority. The Hungarian economy continues to be characterised by a considerable duality. There are extreme differences in productivity between large and smaller companies. Foreign-owned, export-oriented — 18 —

Summary of the most important conclusions

companies have formed few ties with suppliers so far, and therefore they have not driven the convergence of Hungarian small and medium-sized enterprises to a sufficient degree. Furthermore, there is also room for improvement as regards the direct export market presence of Hungarian SMEs. The small average size of Hungarian SMEs also constrains the strengthening of supplier networks and export capacities, and accordingly improving economies of scale represents a growth potential in both areas. The regional disparities regarding the level of development are also relatively large, which may also stifle growth over the long term. Looking ahead, demographic developments may pose enormous challenges. Due to the labour market reforms and targeted measures implemented after the crisis, the participation rate has increased considerably in recent years. Yet in international comparison it can still be considered low, therefore the focused expansion of labour supply should still remain a priority. In order to improve competitiveness, we have made proposals for reforms in a few areas that may help to mobilise potential resources, and that may form part of a new Széll Kálmán Plan focusing on competitiveness. These proposals cover the labour market, the tax system, the operation of the state, human capital, innovation capacities, the banking system and the utilisation of EU funds. It may contribute to the expansion of employment if taxes on labour continue to decrease in line with the measures of recent years, and the employment situation can be improved in a targeted manner through the expansion of the Job Protection Action Plan, the development of the public work system and the stimulation of atypical forms of employment in the groups that have looser ties to the labour market. The competitiveness of the state’s operation could also be enhanced, for example by improving the speed and quality of state services, reviewing the structure of state institutions, making the wage system — 19 —

Summary of the most important conclusions

more efficient and motivating, and expanding e-governance and the scope of satisfaction surveys as regards services. The state can also contribute to the improvement of the corporate sector’s competitiveness through appropriate regulation and incentives, although this is primarily determined by accumulated knowledge and corporate management skills. In this respect, the simplification of the tax system and the strengthening of its investmentsupporting characteristics, the reduction of tax avoidance as well as the promotion of research and development through direct and indirect instruments may be possible areas for progress. According to international experiences, one of the main factors behind long-term convergence is the development of human capital. The state has ample leeway as regards human resources: this includes measures potentially influencing demographic developments, the potential reform of healthcare services as well as the steps that can be taken in the educational system. The latter may include the expansion of resources, the promotion of language skills and increasing the share of students of technology and natural sciences in tertiary education. The accessibility, amount and efficiency of resources available to the national economy from EU funds, the banking system and the stock exchange should be improved as well. As regards financing provided by the European Union, the primary objective is to spend a larger share of the funds on economic development than previously. In addition, it would be favourable if the government’s efforts to speed up disbursement and lower the financial and administrative costs linked to accessing the funds were realised. The MNB has taken several steps in recent years in order to create a banking system that functions well, funds the economy and avoids excessive volatility. However, the desirable pace of corporate lending and the adequate profitability of the banking system still need to be achieved. The other main source of corporate finance is the stock exchange, which however has not fulfilled its potential role in the recent period. It may contribute to the renewal — 20 —

Summary of the most important conclusions

of the stock exchange on the supply side if more companies (stateowned and SMEs) were listed, while demand-side factors include brand building, the expansion of financial literacy and the development of a motivating regulatory system. A large share of the measures boosting competitiveness influence the budget, but during implementation one needs to take into account short-term equilibrium as well. Assessing which structural reforms can be implemented depending on the possibilities and preferences is within the competence of the government. In the long term, successful reforms have favourable effects on the budget, and they may also increase the room for manoeuvre with respect to other measures. As a result, the timing of the measures and the exploitation of the synergies is essential. According to international experiences, achieving the broadest possible consensus regarding the structural reforms is imperative; therefore, establishing a coordinating institution, for example a Competitiveness Council, which consolidates the knowledge of all the stakeholders, i.e. the Government, the MNB, companies, the banking system, the scientific world and civil society, can be expedient. This publication discusses the above-mentioned topics in the following structure: After an overview of the theoretical models of economic convergence, we present detailed case studies on successfully converging economies. We then explore the current state of the Hungarian economy, and – drawing on international experiences – identify the areas in which we need further progress in order to reach a sustained convergence path.

— 21 —

Part I

International and national experiences in economic convergence

The theory and practice of economic convergence

A brief summary of economic convergence theories Tamás Briglevics – Géza Rippel – Zoltán Szalai

Over the past decade, the convergence of Hungary’s real economy has come to a halt. This chapter examines models of economic growth that can help understand this process. Unfortunately, the well-known models of neoclassical and endogenous growth theory provide little help, as convergence in these models is either a consistent process (neoclassical models) or does not exist (endogenous growth models). There are extensions of these frameworks in which the convergence of certain economies becomes stuck at a lower income level, leading to what is referred to as convergence clubs. At the same time, the empirical literature has only been able to classify sharply differing countries or regions into different convergence clubs. Therefore, these studies provide little insight for useful economic policy recommendations. The latest growth models attempt to incorporate the work of Kuznets (1966) and emphasize the structural transformation process, during which less advanced economies first see an increase in the ratio of industry to the detriment of agricultural production, followed by a shift towards the service sector as the main driver of economic growth. Although the industrialisation process has significant growth potential, further action is needed to achieve a high income status. The required productivity growth can be achieved through a shift towards high-value added complex products and services, and domestic innovation instead of copying foreign technologies. An examination of the growth process of successfully converging countries reveals that they were able to sustain economic growth 3.8 percentage points — 27 —

Part I: International and national experiences in economic convergence

above the rate of growth in the United States for nearly a quarter of a century on average. From Hungary’s perspective, the fact that the majority of these countries fell into the middle-income trap but later managed to return to a growth path gives reason for hope.

1.1 Has convergence stalled? After the political changeover, the main motive for the shift towards a Western-style, market-oriented economy in Hungary was to achieve Western European standards of living. Chart 1-1 shows the results of this process, by comparing GDP per capita in the Central and Eastern European countries admitted to the European Union to the GDP per capita of the EU15 which had joined earlier. Chart 1-1: Central- and Eastern-European countries’ per capita GDP relative to EU15 90

Relative income (per cent)

POL CZR

HUN SVN

Note: EU15 = 100 per cent Source: Eurostat, MNB calculation

— 28 —

SVK EST

LTU LAT

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1. A brief summary of economic convergence theories

As shown by Chart 1-1, gross domestic product per capita in Hungary only approached the EU15 average at a very slow pace over the past 20 years, and the past decade saw the convergence process slow down or even stall. This book aims to investigate the possible determinants of this slow convergence. One might be tempted to attribute the recent halt in the convergence process to the financial crisis of 2008 and the ensuing European debt crises in 2010 and 2012. However, according to Chart 1-1, this is not a satisfactory explanation for two reasons. First, convergence had already stalled in 2004, well before the global economic crisis, and second, several other countries that had joined the EU along with Hungary in 2004 managed to remain on a convergence path during this period, even if the momentum of this process declined in most countries. It is important to stress that convergence is a long-term process spanning several decades. Examining the performance of an economy over such a horizon renders cyclical fluctuations unimportant, and the emphasis is on trend growth, determined by the economy’s production potential. In other words, successfully converging countries are able to increase their available factors of production (mainly physical and human capital) and to include them as efficiently and fully as possible in production.

1.2 Convergence from a different perspective Although the objective of this book is to analyse the current growth prospects of the Hungarian economy, it is also worth looking at other regions and historical periods. In terms of Hungary’s past performance, the work of Maddison (2010) provides data going back approximately 150 years on per capita income relative to a similar indicator for the most advanced economy of that period. Chart 1-2 shows that although there

— 29 —

Part I: International and national experiences in economic convergence

were several periods when the Hungarian economy started to catch up, each of these periods stalled at a relatively low level of convergence. Chart 1-2: Relative income per capita in Hungary 100

Relative income (per cent)

100

2010

2000

1990

1980

1970

1960

1950

1940

1930

1920

1910

1900

1890

1880

1870

Relative to the most developed country at the time Relative to Austria Source: Maddison Project, MNB calculation

With regard to countries around the world, the period of roughly the past half century features examples of both successful and failed convergence. Chapter 2, entitled Successful international experiences, takes a look at several of these examples. One of the key objectives of the European integration process is to foster the convergence of lagging regions. Thanks to this, several formerly moderately advanced Western European countries managed to achieve the status of advanced economies (for instance Ireland). At the same time, European development policy does not only consist of success stories: some countries have been unable to achieve Western European income levels over many decades (such as Portugal or Greece).

â&#x20AC;&#x201D; 30 â&#x20AC;&#x201D;

1. A brief summary of economic convergence theories

Most cases of successful convergence outside of Europe can be found in eastern Asia, such as Singapore, Hong Kong, Taiwan, and South Korea, as these countries have managed to go from poor to advanced status in two generations. Chart 1-3 shows per capita output for each country in 1970 and 2011, as a proportion of per capita output measured in the United States. Most of the observations are scattered along a 45-degree straight line, meaning that no salient change occurred in the relative development for most countries over the course of four decades. The performance of Ireland and the Four Asian Tigers is clearly exceptional. Chart 1-3: Changes in GDP per capita between 1970 and 2011

GDP/capita relative to USA (2011, per cent)

160 SG

140 120

100

40 20 0 0

100

120

140

160

GDP/capita relativte to USA (1970, per cent) Source: Penn World Table 8.1

Before presenting these international examples in depth and analysing the current state of the Hungarian economy, we will define a few key concepts addressed several times in this work. The remaining part of this chapter therefore provides a brief, selective overview of attempts

â&#x20AC;&#x201D; 31 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

by economic theories to describe and explain economic growth and the convergence process.

1.3 Growth theory1 Although the source of economic growth is a fundamental question, as old as the discipline of economics itself, our short literature review focuses on the growth theory that emerged in the second half of the 20th century. This is worth emphasising because the theories developed during this period differed fundamentally from the Keynesian growth theory of the preceding era, the most widely known versions of which appear in the Harrod (1939) and the Domar (1946) studies. The main message of Keynesian growth theory is that because there are no selfregulating automatisms to keep economies on a balanced growth path, “effective” demand and “potential output” may diverge in the long run, giving rise to sustained underemployment. In the aftermath of the 1929 global economic crisis, this view easily gained popularity, but by the 1950s, the experience of the crisis was replaced by balanced growth. Accordingly, the validity of this way of thinking was questioned, and the neoclassical growth theory emerged. During this period, Káldor (1963) summarised the stylised facts of the process of economic growth based on the data available at the time, which are: 1. Per capita output increases and the rate of growth does not decrease. 2. The stock of physical capital increases over time. 3. The rate of return on physical capital is roughly constant. 4. The ratio of physical capital and national income is roughly constant. 5. The share of national income received by labour and capital is roughly constant. 1

This chapter follows the train of thought proposed by Barro and Sala–i–Martin (2004).

— 32 —

1. A brief summary of economic convergence theories

6. The growth rate of per capita output varies significantly between countries. The observations focus on the link between the factors of production and the output of economies, which became the central topic of neoclassical growth theory.

1.3.1 The neoclassical production function

Production potential and the factors shaping it are thus the focal points of the theories that emerged in the second half of the 20th century, with aggregate demand not playing an important role. Neoclassical growth theory adapted the concept of the production function used to model the production of individual corporations in microeconomics to describe the production potential of the whole economy. It shows the amount of output that can be achieved through various combinations of the factors of production (including labour, capital, land, energy). The simplest models primarily focus on three factors of production: labour, L(t); capital, K(t); and the level of technological development, A(t); and define the highest achievable output during a given period (for instance the period defined by t) as: Q(t) = A(t)∙f (K(t), L(t)). Two things are worth noting in this equation. One is that the role of technology is different than that of other factors of production. While capital and labour are so-called rival factors of production (because one person can only work in one place at any given moment), the level of technology is available to everyone, and may be used simultaneously by multiple entities. The other is that the characteristics of the f(.,.) function primarily influence the conclusions drawn from the model. Neoclassical theories include the models where the production function features certain characteristics. — 33 —

Part I: International and national experiences in economic convergence

To present these characteristics, for the sake of simplicity, we will use the Cobb-Douglas production function, a frequently employed and very tractable function form: Q(t) = A(t) L(t)α K(t)1- α. The main difference compared, for instance, to the production function used in the Harrod–Domar model is that here, a given level of output can be achieved with various combinations of the factors of production. As a result, the economy, in contrast to the Keynesian approach, is able to respond to changes in the availability of factors (such as a shrinking labour force in the wake of demographic developments), and sustained imbalances do not emerge. An important characteristic of the neoclassical production function is that if we only increase one rival factor, output does not increase proportionately (diminishing marginal product), however if we increase all rival factors by the same degree, the growth rate of output does not decrease (constant returns to scale). Regarding the special role of technology, it is apparent that as it increases, while the other factors of production are left unchanged, output increases proportionately.

1.3.2 The role of physical capital

Based on Káldor’s observations, it comes as no surprise that the capital accumulation process is the central element of neoclassical growth models.2 Solow (1956) and Swan (1956) present a model in which the marginal product of capital is higher in less advanced economies compared to advanced economies; therefore, assuming that economies use the same portion of their generated income for capital accumulation, less advanced economies can grow at a faster rate and catch up with advanced economies. 2

These models are referred to as neoclassical growth models due to the hypothetical characteristics of the production function.

— 34 —

1. A brief summary of economic convergence theories

The model of Ramsey (1928) – Cass (1965) – Koopmans (1965) supplements this with the fact that economies do not always allocate the same portion of their income to capital accumulation as in the Solow model, but do so as a function of the return on investments, which is closely linked to the characteristics of the production function, and make rational decisions on the amount of capital accumulation. The model’s final conclusion, however, is similar: less advanced countries are able to catch up with their more advanced peers. In these models, however, the growth rate of economies cannot be sustained purely on the basis of capital accumulation: the marginal product of capital decreases as per capita capital increases. Thus, in order for them to reproduce the two initial points of Káldor’s observations, some other external process (population growth, technological growth) is needed. Solow (1957) presented a simple procedure based on the production function to break down the growth observed in economies into the contribution of various factors of production. By rewriting the Cobb– Douglas production function to growth rates (indicated by lowercase letters, with a representing productivity, q output, l labour and k the capital stock growth rate, while α represents the ratio of labor income and output), we obtain a = q – (α*l + (1- α)*k). Assuming that the growth rate of output, labour and the capital stock is measurable (see Box 1-1), and that the parameter α can be calculated from the constant factor income ratios observed by Káldor (fourth observation), the above equation yields a simple formula for calculating technological progress (total factor productivity, TFP). This is the so-called Solow residual: the portion of output growth that cannot be explained by an increase in capital and labour inputs taking the parameter α as given.

— 35 —

Part I: International and national experiences in economic convergence

On this basis, empirical research revealed rather quickly that on its own capital accumulation only accounts for a relatively small portion of economic growth, with technological progress being the key determinant. Solow (1957), for instance, still estimated technology’s contribution to growth at 80 per cent. These models, however, make no mention of the source of this process. 1-1. Box Some theoretical problems related to the production function

Despite the central role of the production function, modern presentations barely address the issues that were hotly debated in journals at the time when the function was being developed and incorporated into the mainstream framework. The issues can be grouped around two main topics: one is aggregation, also known as the “index number problem”, while the other is the “well-behaving” nature of the capital and labour demand predicted by the production function. The issue of aggregation involves one of the most fundamental questions of macroeconomics: what unit of measure should be used in measuring the output, and how can we compare the economic performance of two periods. The most common response in modern economics is the application of “baskets of goods of fixed composition”: if the output during the two periods includes the same quantity of every type of goods, then the outputs are identical, while if the later period’s output contains at least the amount of every type of good as the earlier period, but at least one or possibly more of some types of products, then output has increased.3 This solution is intuitive but can only be applied with strict limitations.

We assume that a clearly “bigger” basket of goods is “more useful”. The method described is referred to as Pareto comparison, and the ranking of baskets by utility does not depend on individual preferences. When we compare two baskets of goods that are not identical, then the ranking is not clear in the Paretian sense: if we leave out two bottles of beer but put in one bottle of wine, then the utility of the change to the basket depends on individual consumer preferences, while if we just add a bottle of wine to the basket, it will be more useful (although the degree of usefulness may vary individually).

— 36 —

1. A brief summary of economic convergence theories

The greater the amount of time that has elapsed between the two dates, the more difficult it is to ensure comparability, as products change and the degree of similarity of a product with new products is not trivial.4 Changes in the product basket that involve the introduction of new products and the discontinuation of old ones create further difficulties. One of the most difficult tasks for statistical offices is to create the right price indexes that best ensure the comparability of various baskets of goods and services (aggregates). Even the most circumspect procedure only allows partial comparison, and the limits on comparison only grow as the time difference increases. They are hard to interpret without supplementary historical knowledge and descriptions. The issue of aggregation also applies to the production function, but this requires another comparison as well: comparing the size of capital and output. With the exception of the assumption of an economy consisting of a single product,5 different baskets of goods must be compared here as well, as capital goods differ from the goods produced by them in modern economies. The composition of output is also not constant: it may contain different ratios of investment and consumer goods, to mention just the simplest distinction. The comparison is already far from simple in the case

Nordhaus, taking an approach from the utilisation side, used the candle as a comparator to modern light sources based on the light emitted by them, making the measurement in the unit of measure used for light (lux). This allowed him to compile a long historical time series on the relative price of “light”, linking periods when only candle lighting and similar light sources were known to the modern era. Nordhaus (1996). 5 The classic example of a single–product model is the cereal model, in which each annual yield can be divided partly into current consumption and partly into use in the form of seeds for future production (both savings and an investment), and interest can be calculated in a natural unit of measure (which expresses time preference, that is, the conversion between current consumption and future consumption). The two quantities can be compared directly in a natural unit of measure. However, this cannot serve as a model for a modern market economy where goods are sold and other goods purchased from the sum received, and where the price system must allocate resources among the various users. 4

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Part I: International and national experiences in economic convergence

of a microlevel (firm) production function, but is particularly difficult when constructing a macrolevel production function, which was imagined as the summary of microlevel production functions. The core of what is referred to in economic history as the Cambridge capital controversy was formulated by Joan Robinson: although the production function was originally defined for natural units of measure, many products with different physical features cannot be aggregated as anything else than monetary aggregates. However, the use of prices already contains income distribution (the price of capital goods already contains profit). Measuring the quantity of capital is required because it allows the deduction of the marginal product and thus the price. This calls for a unit of measure that is independent of distribution, but enables the aggregation of heterogeneous capital and labour inputs.6 In the absence of this, we cannot differentiate the relative price changes that stem from changes in productivity or changes in distribution. The production function appears at the same time, simultaneously and inseparably as a production and distribution function.7 The production function not only plays a central role in income distribution (addressed by the previous debate), but also in explaining capital and labour demand, i.e. the utilisation of factors, particularly unemployment. In mainstream theory, demand for production factors (capital and labour) depends on their marginal productivity, i.e. the additional output that can be achieved through the additional utilisation of a specific factor. The production function concept assumes that a given output level can be achieved through various ratios of capital and labour (factor substitution), and therefore it is always the factor the relative price of which decreases (capital or earned income) that is used in the highest proportion. Accordingly, in the event of unemployment, the decrease in wages results in higher employment demand and results in lower unemployment. For this reason, modern macroeconomic models implicitly contain a single product and no conclusion whatsoever from these models can be applied to models that contain even two products. For more on the consequences on macroeconomic adjustment, see Weeks (1989, 2012), Chapter 10. 7 Weeks (1989, 2012), Section 2.4. 6

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However, in the context of the Cambridge capital controversy, it came to light8 (primarily based on the work of Sraffa9) that this seemingly intuitive correlation does not materialise if – as is generally the case in modern economies – individual goods are produced with diverging ratios of capital and labour, and if goods produced by other production processes are also involved in the production process. In other words, if “capital” and the intermediary products themselves, along the consumer goods are produced goods. That is because relative changes in wages and profits may result in factor demand that is contrary to intuition: based on a specific capital-labour ratio, due to the decline in wages, output profitability yields increasing labour demand for a while, and then, as wages decrease further, beyond a certain point, output can only become more profitable with less labour and relatively more capital input, and thus labour demand diminishes.10 The other consequence conclusion of the controversy is that there is no fixed quantity of capital that is regarded as the baseline of short-term (business cycle) analysis: the quantity of capital also changes as a result of income distribution.11 Taking a modern economy featuring more than one production process or product (i.e. with at least two different capital-labour ratios), the impact on employment and capital valuation of relative changes in wages and profits at any given moment12 cannot be determined ex ante on the basis of the production function. Likewise, in the case of several The retrospectives of Harcourt (1969) and Cohen and Harcourt (2003) are standard references when presenting the controversy. The controversy played out between Cambridge located in the US and Cambridge located in England. 9 Sraffa (1960). 10 In practice, the proportion of capital and labour can often not be changed continuously. The equipment used in modern work processes requires a specific number of employees with specific qualifications, leaving little leeway in terms of headcount. In addition, a production process that has been set up cannot be easily switched to another in response to relative changes in profit and wages. Models featuring fixed capital and labour ratios are the most realistic, as changes in technology (switching to a procedure requiring a different capital and labour ratio) are time–consuming and costly, or often not feasible at all (irreversible investment). 11 The algebraic demonstration and graphical representation can be found in Weeks (1989/2012), Chapter 10. Kregel (1976) presents this using simple numerical examples. 12 In this moneyless economy, profit and interest are identical. 8

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Part I: International and national experiences in economic convergence

products, profit (or real interest) independent of income distribution cannot be deduced based on the production function, which would be equal to the marginal product of capital, and there is no fixed real wage that would ensure full employment. Some economists concluded from this that although consequences contrary to intuition are theoretically possible, in practice these are in all likelihood exceptional. Therefore, unless specifically warranted, this option can be ignored.13 Most textbooks of the past decades no longer mention this debate, and implicitly, waiving any further consideration, regard the conclusions of the single-product model as applicable to multiple-product scenarios and real-life economies. Others, however – drawing from Keynes and his followers – recommend entirely abandoning real analysis, of which the production function is the core element.14 Both the real and monetary processes of the economy must be analysed based on monetary aggregates, captured as the circulation of goods and services rather than the circulation of “value added”.15 Due to theoretical issues, the empirical works based on the production function are unsuitable to serve as the basis of economic policy decisions, including the relatively widespread recommendations based on total factor productivity.16

Zonghie and Scheffold (2006) examine the number of cases in which a result contrary to intuition is observed. 14 It should be noted that Wicksell (whose work is referenced when using the term “natural or neutral rate of interest”) recognised that the “quantity” of capital may change both as a result of changes in its physical quantity or relative price change, and a fixed real interest independent of distribution can not be deduced. See Kregel (1976), pp. 69–74. 15 Weeks (1989/2012), Chapter 1, Borio and Disyatat (2011), Appendix. 16 Felipe and McCombie (2013), Felipe and Fischer (2003). 13

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1. A brief summary of economic convergence theories

1.3.3 The role of technology

The next generation of growth models, referred to as endogenous growth models, attempted to correct this shortcoming. The term ‘endogenous’ in their name refers to the fact that production technology is not an external process, but rather the outcome of economic agents’ earlier decisions. Although similar concepts could already be found in the literature from the 1960s (e.g. Frankel 1962), Romer (1986) is one of the most widely cited papers on the topic. In his model, the level of production technology is determined by the economy’s capital stock. If a firm makes an investment, it not only increases the economy’s capital stock, but also the level of production technology. It thus attempts to model that productivity is boosted by the experience accumulated in the context of earlier activities (such as investment), and this experience is immediately shared with all enterprises, not just the one making the investment. The most important element of the model is that capital accumulation does not “run out of steam” as in the neoclassical models, because investment also raises the level of technology alongside the level of capital. This is because new investments simultaneously increase the level of technology within the economy, which in turn improves the marginal product of capital, providing new incentives for investment. There are numerous versions of the endogenous growth model in the literature, but they all share a common key mechanism, where the marginal product of capital does not dip below a certain level during the course of the growth process. This feedback mechanism is what distinguishes endogenous growth models from their predecessors, in which the marginal product of capital continuously declines. The key tenet of Romer’s model (1986) is that production technology is determined by the capital stock, which is clearly a substantial simplification of the modelling of research and development (R&D) activity. Subsequent papers (Romer 1987 and 1990; Aghion and Howitt 1992;

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Part I: International and national experiences in economic convergence

Basu and Weil 1998; Acemoglu and Zilibotti 2001) focused on a more in-depth modelling of R&D activity.

1.3.4 Other factors

Besides specific examples, the above papers also created a new analytical framework for investigating economic growth. The Solow model shed light on the fact that the investigation of the stock of physical capital alone can only explain a small part of the growth process, which quickly prompted alternative explanations. One of the key alternatives is human capital, which plays a central role in today’s modern economies. Jánossy (1966) investigated the reconstruction process in the wake of the Second World War, and already emphasised the role of this determinant, stressing that “Although labour, the core holder of productive forces, decreased quantitatively during the war, its structure and level of development were not only maintained, but continues to develope uninterruptedly...” (Jánossy 1966 p. 113). This ensures that the economic development process does not come to a halt. Later, the empirical findings of Mankiw et al. (1992) corroborated the role of human capital, and Lucas (1988) also built his model around the acquisition of human capital. Another factor that has been the focus of the empirical literature recently is the role of institutions. According to Acemoglu et al. (2002), the best explanation for differences in economic performance should be sought in the internal structure of society. Societies where the institutional system serves the protection of private property perform far better than societies where the institutional system attempts to concentrate power in the hands of a small elite, carrying the risk of expropriation for most of society. The strong correlation between corruption or legal certainty indices and economic performance seems to corroborate this argument, but the correlation does not necessarily represent a causal relationship. Reverse causality is also possible, that is, advanced — 42 —

1. A brief summary of economic convergence theories

economies might be better able to afford to maintain or create “good” institutional systems. The work of (Acemoglu et al. 2001, 2002) is interesting particularly because it attempts to demonstrate the impact of institutions on economic development through historical examples where reverse causality can be ruled out. Specifically, they analyse the establishment of colonial empires and the look at the impact of the institutional systems set up by colonisers on subsequent economic performance. In their 2002 paper, they show that economies that were more advanced prior to colonisation may have slipped back due to exploitative institutional systems, while less advanced areas exhibited development. This is because exploitative institutional systems were unwarranted in undeveloped areas, but were warranted in more developed areas.

1.4 The theory of economic convergence In light of the fundamental drivers of growth models, what conclusions can be drawn regarding economic convergence? Before applying the theoretical models in practice, we must clarify a key difference between theory and practice. As referred to above, in the Solow and Ramsey models, the economy features a state of equilibrium; once reached, no material change occurs in the model. This is referred to as the steady state, in which economic growth is exclusively shaped by external factors (population growth, technological progress) from the model’s perspective. When we talk about convergence in the model, we are referring to convergence towards the steady state, easily calculated within the model. When we talk about convergence in the context of economic policy analyses, we compare the economic performance (generally per capita income) of a less developed country (or region) to the performance of a more developed country (or region). This comparison can be linked to the model if we assume that the current state achieved by the more

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Part I: International and national experiences in economic convergence

developed region symbolises the steady state of the less developed region. As demonstrated below, this is quite a strong assumption. The models showcased in the previous chapter have clear-cut implications for convergence. In neoclassical models, countries featuring identical fundamentals – i.e. preferences, production technology and economic policy – achieve the same per capita income in the long run, irrespective of their initial level of development. This is called conditional convergence, where the condition refers to the equivalence of fundamentals. Unconditional (or absolute) convergence would refer to cases when countries starting out from different initial levels of development achieving the same per capita income irrespective of everything (including preferences, production technology and economic policy). In the basic endogenous growth theory models, the question of convergence can be answered in a relatively straightforward manner, although the answer is less favourable for undeveloped countries. In these models, convergence does not apply, there is no mechanism in the model that slows down advanced economies, and therefore initial income differences cannot be overcome. The fact that the two model frameworks give such clear answers to the question of convergence contrasts starkly with the experiences of the past half-century. As shown in Chart 1-3, there are numerous examples in the world for both convergence and the absence thereof. Chapter 1.4.2, entitled “Beyond simple models – convergence clubs”, addresses the ways of expanding the basic models to reproduce this phenomenon. Before doing so, a classification of the empirical findings on convergence is called for.

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1. A brief summary of economic convergence theories

1.4.1 Empirical results on convergence

The topic of economic growth is one of the few areas of economics where comparative or case studies coexist well alongside strict statistical and econometric analyses. The main reason is that, because the process of convergence spans several decades, sufficiently long time series are only available for a few countries, which limits the possibilities for statistical methods. In addition, there are also substantial differences between countries, and thus the list of explanatory and control variables is nearly endless: Durlauf et al. (2006) list 145 different factors (from education to corruption, through the institutional framework and geographical location) that shape growth according to some study. As the authors note, this number of factors is essentially equal to the number of countries on which we have data. As demonstrated above, the fundamental conclusion of the Solow and Ramsey models is conditional convergence. This is usually tested two ways in the literature. For one, if conditional convergence is fulfilled, the growth rate of per capita income among countries must be negatively correlated with their past (per capita) income level. In other words, by regressing income growth rates on past income levels (and other explanatory variables that control for fundamentals), we must obtain a negative β-coefficient. This is the origin of the concept of β-convergence. Another conclusion of the Solow and Ramsey models is that because conditional convergence prevails, the deviation of (per capita) income levels among countries must decrease over time. This is the origin of the concept of σ-convergence. As presented by Barro and Sala-i-Martin (2004), β-convergence is a necessary, but not sufficient condition for σ-convergence. In terms of the findings of empirical research, several studies identified β-convergence (see Barro and Sala-i-Martin 2004, Chapter 11) among the regions of certain larger economies (United States, Japan). — 45 —

Part I: International and national experiences in economic convergence

The databases that allowed the testing of β-convergence between countries were compiled towards the end of the 1980s. The first results were consistent with the existence of β-convergence (Baumol 1986; Barro 1991; Mankiw et al. 1992). However, subsequent articles called into question the significance of these findings. Durlauf et al. (2006) summarise the critiques that accumulated over time, most of which were methodological in nature: the exogeneity of explanatory variables and the handling of measurement errors. From the perspective of our analysis, the most significant problem with the empirical literature is that the estimated negative β-parameter, although consistent with conditional convergence, is also consistent with other models in which conditional convergence does not prevail, as demonstrated by Bernard and Durlauf (1996). Thus, these analyses cannot give conclusive results regarding convergence. There are versions of neoclassical growth models in which economies may converge towards one of several steady states.

1.4.2 Beyond simple models – convergence clubs

We refer to convergence clubs when countries with similar fundamentals converge towards different income levels as a function of their initial income level.17 Economies converging towards a similar income level – independent of fundamentals – can be regarded as belonging to the same club. This makes it possible for initially similar countries to follow very different growth trajectories in the long run. 1.4.2.1 Theoretical models of convergence clubs

Galor (1996) gives an overview of how convergence clubs are formed. According to the article, in a nutshell, the mechanism leading to conditional convergence in neoclassical models depends on two factors: (1) capital yields higher returns in less developed countries, and 17

We used the definitions of unconditional and conditional convergence, and of convergence clubs of Galor (1996).

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1. A brief summary of economic convergence theories

(2) investors (domestic or international) take advantage of this difference. In the previous chapter, we mentioned that in the endogenous growth theory, nonfulfillment of the first condition results in the absence of convergence, while the following section presents a few examples of how (conditional) convergence might fail in neoclassical models. Perhaps one of the most interesting examples consists of economies where – contrary to the assumption of the Solow model – the population saves more from its labour income than from capital income.18 As the economy grows, the ratio of capital income within total income increases. At a relatively low level of development, the ratio of savings may shrink to such an extent that the economy is no longer capable of generating sufficient savings to continue capital accumulation. Another example is when the acquisition of human capital is costly for certain generations, particularly those that must finance their education from credit. In the long run, this may give rise to a situation in which only families with sufficiently large initial wealth are able to continuously invest in education. This creates a divide within the population: the wealthy with ample human capital, and the poor with less human capital. Output is shaped by the ratio of these groups, so in the absence of intervention, initial wealth distribution may impact subsequent wealth distribution and output. There is therefore no guarantee that countries with similar fundamentals but different wealth distribution will end up at the same long-term equilibrium. 1.4.2.2 Do convergence clubs exist?

The answer to the question is a firm yes, as empirical analyses have successfully identified convergence clubs. At the same time, these 18

The fact that a household saves more from its earned income appears in several widely used economic models. For instance, in life-cycle models, older age groups use their capital income and capital to cover their consumption expenditures, and therefore their savings rate is negative; while younger age groups set aside a portion of their earned income in order to have enough money to cover their oldage expenditures.

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Part I: International and national experiences in economic convergence

clubs mostly consist of sharply distinct countries (or regions). In other words, although it is theoretically possible that similar economies follow largely different growth paths – as indicated by the three articles below – the probability of this is quite low. Durlauf and Johnson (1995) were the first to use a formal statistical approach (classification and regression trees, CART) to try to classify the various countries into different groups (based on initial GDP and the ratio of literate adults), and then examine the convergence process of these country groups separately. Only two of the four different country groups (those with the lowest initial income and those with medium income, but a high ratio of literate adults) exhibit conditional convergence towards their own long-term income level. Looking at data for the period between 1960 and 1985, the authors found that Ireland, Greece, Spain and Portugal were in the same group as Japan, South Korea, Hong Kong and Malaysia. In other words, according to this method, these countries were still on an identical growth path in 1985. This paper was followed by further articles that attempted to group economies according to various principles or statistical approaches. One of the most relevant examples – Canova (2004) – examines the convergence of the European Union’s NUTS2 regions over the 1980– 1992 period. It identifies four convergence clubs in a breakdown by per capita income and North-South. The average per capita income achievable in the long run by the poorest group (which primarily includes Greek and Portuguese regions) falls 45 per cent short of the EU average. In the group comprising the richest (primarily German and northern Italian) regions, this indicator exceeds the EU average by 15 per cent. In other words, the model predicts an approximately 2.5-fold sustained income difference between the poorest and the richest regions. It is also interesting that according to the estimate, there is very little probability of growth miracles: it predicts a mere 9 per cent chance for the income of a region starting out from the poorest group to outstrip the average EU income.

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The latest paper in this branch of the literature was published by Tan (2010), examining the performance of countries between 1960 and 1999. The author identifies three convergence clubs: the first group features high institutional quality, the second features lower institutional quality but comprises ethnically homogenous countries, while the most lagging group features a weak institutional environment and numerous ethnic groups. Per capita income in the poorest group varies between USD 1,300 and 1,600 (according to the various model specifications), between USD 4,100 and 4,700 in the middle group and between USD 17,200 and 22,300 in the richest group (measured in 1996 USD). Although the article does not provide an estimate for the countries in Hungary’s region, Western European countries are all classified in the richest group, with the exception of Greece (!). Emphasis on the importance of the institutional environment is consistent with the conclusions of numerous other papers, as referred to earlier. In summary, we can say that studies investigating convergence clubs distinguish only a small number of country groups (clubs), and therefore heterogeneity within the groups is relatively high. It is improbable that the different dynamics observed in recent years between the countries in Hungary’s region are sufficient to create sharply distinguishable groups using statistical methods (although we did not find any studies on the topic that covered the countries of this region). In conclusion of the section reviewing theoretical models, the performance of the Hungarian economy over the past decade is difficult to interpret using basic growth theory models, because in these models, convergence is a uniform process that does not allow for sustained interruptions. The perpetuation of income differences in this context signals that a less developed country converges towards a lower income level in the long run. However, in order to be able to unequivocally declare this fact, substantially longer time series are called for.

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Part I: International and national experiences in economic convergence

1.5 Economic growth and structural transformation The fact that the literature provides such an uncertain forecast of growth trajectories probably stems from the fact that the process is far more complex than theoretical models. One of the limitations of the neoclassical framework is that it describes the economy as a single prodution sector. However, this renders it unable to factor in the structural transformation unfolding during economic development. Herrendorf et al. (2013) summarise the models that make up for this shortcoming. As documented by Kuznets (1966), in the course of economic development, less advanced economies first see an increase in the ratio of industry to the detriment of agricultural production, followed by a shift towards the service sector as the key driving sector. An investigation by sector moreover yields new results for the process of convergence: For instance, in his paper based on data from 118 countries, Rodrik (2013) finds absolute convergence in manufacturing. In lower productivity economies, productivity grows at a faster rate compared to more advanced countries. This means that the process of industrialisation is capable of delivering rapid convergence. On the other hand, if there is convergence in manufacturing but not in the entire economy, convergence probably does not hold in other sectors. Duarte and Restuccia (2010) found results suggestive of this: Using their sample of 29 countries, they demonstrate that while productivity differences decrease in agriculture and manufacturing, there is no similarly strong trend in services. In terms of the countries in Hungaryâ&#x20AC;&#x2122;s vicinity, Bah and Brada (2009) argues that firstly, in the former communist countries, the number of people employed in agriculture and manufacturing was higher at the time of the political changeover compared to Western European economies, and secondly, service sector productivity did not converge as much towards the Western level as productivity in the other two

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sectors (in their sample ending in 2005). Another interesting result is that in the case of Hungary, the authors attribute only half of the convergence process to the rise in the capital stock, while the other half stems from productivity gains. These findings show that industrialisation is a recipe for economic convergence. At the same time, Herrendorf et al. (2013) rely on several international databases to demonstrate that manufacturing accounts for a relatively small part of modern economies (in terms of both the ratio of employees and value added produced); therefore economic convergence cannot be expected from industrialisation alone. Felipe et al. (2014) supplement this train of thought with the observation that with the globalisation of manufacturing, a country undergoing industrialisation must sustain its manufacturing in a setting of increasingly strong competition, as due to the rising wage levels accompanying development, lower value added manufacturers may opt to leave at an earlier point. The authors estimate that while an average developing country was able to increase the ratio of workers employed in manufacturing to up to 20 per cent, in 2010 such a country could only hope to achieve a ratio of 15 per cent. Rodrik (2015) comes to similar conclusions, also adding that ending industrialisation prematurely may be particularly dangerous for developing countries. For one thing, if this sector driving rapid convergence starts to shrink early, it dampens the economyâ&#x20AC;&#x2122;s growth prospects, moreover, it is not probable that the political institutions created during industrialisation are able to become firmly established in developing countries, which may hinder the democratisation process. During periods of successful convergence, country-specific factors or cyclical incentives may also play a role, but according to the literature, economic development and convergence are characteristically linked to the restructuring of economic sectors. According to Agenor and Canuto (2012), countries in low-income categories may rise to middle income status through factor utilisation. This phase is characterised

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by the influx of labour from low-productivity agriculture to higherproductivity manufacturing, shifting the economy from more labourintensive sectors towards more capital-intensive production. During this phase, rapid convergence may be fostered, alongside cheap labour, by the imitation of foreign technology, according to Perez-Sebastian (2007). However, the additional economic growth stemming from industrialisation and the imitation of foreign technology are not sufficient in and of themselves for dynamic real economic convergence as the country approaches middle-income status. Benefits stemming from the cost of labour may peter out over time as the economy’s structure changes, as real wage dynamics start picking up as additional labour is utilised, thereby decreasing the country’s competitiveness. International experiences show that reaching high-income status is primarily possible by improving productivity. In convergence towards the income level of advanced economies, both the level of and changes in productivity occupy a central role (OECD 2014). We can draw conclusions about the significance of high value added sectors from the specific level of productivity, while changes in productivity directly influence economic performance. The literature identifies a shift towards high-value production and services, and domestic innovation supplanting the imitation of foreign technology (Agenor and Canuto 2012). Diversification towards higher value added sectors also bolsters competitiveness and resilience to external shocks, in addition to productivity (OECD 2014). Middle income status countries characteristically become integrated into global trade during earlier phases of the convergence process, and become participants in global value chains. In order to reach highincome status, fostering domestic innovation is imperative, alongside an influx of FDI and the copying of foreign know-how. Creating domestic

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1. A brief summary of economic convergence theories

innovation capacities calls for fostering research and development and accumulating human capital (OECD 2014). Domestic innovation processes may stimulate economic performance through the higher real wages of (more productive) sectors boasting more developed technologies, as well as through the positive externalities stemming from the creation of knowledge networks (by disseminating knowledge and developing qualifications). Two-way causality can be identified between innovation and the educational system (Agenor et al. 2012). Countries where innovative sectors attract insufficient qualified labour are unable to rise from their middle level of development. Because real wages do not increase sufficiently as a result, there will not be proper incentives for obtaining the necessary qualifications, and thus neither for investment into education.

1.6 Growth traps According to the previous chapter, a slowdown in economic growth prior to reaching high-income status is not a unique problem. Numerous studies investigate what is referred to as the middle-income trap, i.e. a substantial slowdown in convergence which is typical in this phase of economic development. These papers are more descriptive in nature, rather than attempting to describe the reasons for the growth traps using mathematical models, and seek to identify the components contributing to development getting stuck at a certain level. Based on the World Bankâ&#x20AC;&#x2122;s classification, low-income countries are those with gross national income (GNI) per capita of less than USD 1,046, middle-income countries have GNI per capita of USD 12,746, while high-income countries have even higher GNI per capita (World Bank 2015). Felipe et al. (2012) defined the following income groups

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using World Bank income classification and the Maddison (2010) database, based on GDP per capita: • Low-income group: USD 0–1,999 (1990 USD in PPP) • Lower-medium income group: USD 2,000–7,249 • Upper-medium income group: USD 7,250–11,749 • High-income group: USD 11,750 or more Over the past nearly half century, only relatively few countries have managed to achieve high-income status. Relative to 1960, 13 of the 101 middle-income countries managed to achieve high-income status (OECD 2014). Four countries achieved high-income status (3 per cent of the sample) in 1960, 21 in 1980 (17 per cent of the sample), 23 in 1990 (19 per cent of the sample) and 32 in 2010 (26 per cent of the sample) based on the classification of Felipe et al. (2012). Based on historical data, periods characterised by dynamic economic growth can be identified for several countries, but these were typically brief periods. Rapid convergence over a sustained period was only observed in a relatively small proportion of countries. The uncertainties surrounding convergence theories may be reinforced by the fact that the vast majority of countries exhibited equal or slower economic growth than the USA over the past decades (Chart 1-4). In 2010, 35 of the 52 countries constituting the group of middle income countries faced the middle income challenge (Felipe et al. 2012). Countries exhibiting successful convergence can be grouped according to various criteria. The rise from middle-income to high-income status was mainly typical in East Asian countries in the past decades. Singapore, South Korea, Hong Kong and Taiwan managed to achieve substantial additional growth relative to the United States, and thus joined the group of the most developed countries based on GDP per capita (Chart 1-3).

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1. A brief summary of economic convergence theories

Chart 1-4: Additional growth relative to USA since 1960 35

Share of countries (per cent)

5 0

0 below –5

between –5 and –2

between –2 and 0

between 0 and 2

between 2 and 5

above 5

Additional growth relative to USA (percentage point) Note: Share of countries is calculated by average additional growth rates per decades between 1960 and 2011. Source: Penn World Table 8.1

Ireland, Austria and Finland, part of the group of successfully converging European countries, are also notable alongside the East Asian countries. The Irish economy grew dynamically from the mid1980s, approaching the US level of development by the 2000s. Among the new European Union member states which joined in 2004, Poland and Slovakia deserve mention, as they exhibited extraordinarily rapid growth until the 2008 global economic crisis. Chapter 2, entitled Successful international experiences addresses the mentioned country groups in greater detail.

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Part I: International and national experiences in economic convergence

Table 1-1: Features of growth in countries with successful convergence Country

Start of period

End of period

Average growth (%)

Relative Relative development development to USA at the to USA at the start of period end of period (%) (%)

Time span of fast growth (year)

Yearly average convergence to USA (percentage point)

Hong Kong

1960

2011

5.2

106

3.2

Japan

1950

1995

5.8

3.6

Korea

1981

2007

6.9

4.8

Singapore

1986

2007

7.2

135

5.2

Taiwan

1969

1997

6.7

4.7

Ireland

1986

2007

6.0

3.9

Austria

1954

1973

4.9

2.1

Finland

1993

2011

3.3

1.8

Slovakia

2000

2008

6.4

5.6

Poland

1991

2010

Average

5.3

3.6

5.8

3.8

Note: Measured in GDP/capita in PPP terms. Source: Penn World Table 8.1

Looking at the convergence processes of the aforementioned countries, it is apparent that successfully converging from middle to high development requires a robust growth period spanning more than 20–25 years. The countries under review surpassed US GDP growth by 3.8 percentage points on average during the periods characterised by exceptional economic growth (Table 1-1).

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1. A brief summary of economic convergence theories

Causes of the growth trap

In their studies, Eichengreen et al. (2012, 2013) investigate the causes of growth traps19 and offer an estimate of the amount of income that could engender a sudden expected slowdown in the growth rate. In their article, they identify these levels at GDP per capita of around USD 11,000 and 15,000 (at 2005 prices) and at 75 per cent of the GDP per capita of the comparison country. In terms of the causes, adverse demographic trends, an unsustainably high investment rate, terms of trade shocks and financial instabilities (crises involving foreign currency, the banking system, debt, the stock exchange or inflation) increase the probability of falling into an income trap, while the accumulation of human capital (participation in higher education) and the ratio of high-value services, coupled with the openness of the economy (Eichengreen et al. 2012) decrease this probability. Aiyar et al. (2013) and Agenor and Canuto (2012) identified similar causes. The latter two papers also highlight the importance of infrastructure and the institutional environment (ownership, a predictable regulatory environment, handling of labour market frictions). Numerous critiques of the middle-income trap theory have been offered in the literature. On the one hand, the estimate made by Eichengreen et al. (2013) is rather uncertain, with a standard error of the estimated higher income threshold of USD 6,000. The threshold therefore probably falls between USD 10,000 and 20,000, which is a very broad range. Looking at the sample used in the analysis more closely (Economist 2013), it appears that the vast majority of sudden slowdowns are linked to some kind of global economic crisis (such as the oil crises of the 1970s or the 1998 Asian crisis).

According to their definition, a country can find itself in a growth trap if a growth rate of 3.5 per cent achieved as a seven-year average decreases by at least two percentage points over the subsequent seven years in countries where per capita income at purchasing power parity is at least USD 10,000 (at 2005 prices).

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According to Pritchett and Summers (2014), an alternative explanation of the slowdowns may be the fact that Eichengreen et al. simply found a tendency for mean-reversion. After periods of extraordinarily rapid growth, the economy simply reverts to a growth path that is sustainable over the longer run. Based on the critique, earlier rapid growth may be a better predictor of the slowdown rather than a specific income level. By and large, there are few economies that did not face a substantial slump in their growth rate at some point during the convergence process. This also holds true for the countries touted as examples of successful convergence (Ireland, South Korea, Taiwan, Singapore). It remains to be seen therefore how much a more subdued period can be regarded as a major problem in terms of long-term convergence.

1.7 Conclusion Numerous countries face a slowdown in economic growth prior to reaching high-income status. The most likely cause is that the rapid growth potential afforded by industrialisation is used up by this point, and therefore the development of new industries is required for further growth. The countries that have succeeded in this are the ones that could establish high valueadded manufacturing and service sectors; were able to foster domestic innovation, which, in addition to boasting productivity also contributes to economic growth through the positive externalities stemming from knowledge networks. However, highly qualified labour force, well-developed institutional environment, economic and economic policy stability are all prerequisites for these. The following chapters of this book investigate the fulfilment of these conditions based on international and domestic experiences.

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References Acemoglu, D. – Johnson, S. – Robinson, J. A. (2001): The Colonial Origins of Comparative Development: An Empirical Investigation, American Economic Review, 91(5), pp. 1369–1401, December. Acemoglu, D. – Johnson, S. – Robinson, J. A. (2002): Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution, The Quarterly Journal of Economics, 117(4), pp. 1231–1294, November. Acemoglu, D. – Zilibotti, F. (2001): Productivity Differences, The Quarterly Journal of Economics, 116(2), pp. 563–606, May. Agenor, P-R. – Canuto, O. (2012): Middle-income growth traps, Policy Research Working Paper Series 6210, The World Bank. Agenor, P-R. – Canuto, O. – Jelenic, M. (2012): Avoiding Middle-Income Growth Traps, World Bank Other Operational Studies 16954, The World Bank. Aghion, P. – Howitt, P. (1992): A Model of Growth Through Destruction, Econometrica, 60(2), pp. 323–351, Mar. Aiyar, S. – Duval, R. – Puy, D. – Wu, Y. – Zhang, L. (2013): Growth Slowdowns and the Middle-Income Trap, IMF Working Papers 13/71, International Monetary Fund. Bah, E. – Brada, J. C. (2009): Total Factor Productivity Growth, Structural Change and Convergence in Transition Economies, Comparative Economic Studies, 51(4), pp. 421–446, December. Barro, R. J. (1991): Economic Growth in a Cross Section of Countries, The Quarterly Journal of Economics, 106(2), pp. 407–443, May. Barro, R. J. – Sala-i-Martin, X. (2004): Economic Growth, The MIT Press, 2nd Edition. Basu, S. – Weil, D. N. (1998): Appropriate Technology and Growth, The Quarterly Journal of Economics, 113(4), pp. 1025–1054, November. Baumol, W. J. (1986): Productivity Growth, Convergence and Welfare: What the Long-Run Data Show, American Economic Review, 76(5), pp. 1072–1085, December. Bernard, A. – Durlauf, S. N. (1996): Interpreting Tests of the Convergence Hypothesis, Journal of Econometrics, 71 (1–2), pp. 161–173. Borio and Disyatat (2011): Global Imbalances and the financial crisis: Link or no link?, Appendix, www.bis.org/publ/work346.pdf. Canova, F. (2004): Testing for Convergence Clubs in Income Per Capita: A Predictive Density Approach, International Economic Review, 45(1), pp. 49–77, February. Cass, D. (1965): Optimum Growth in an Aggregative model of Capital Accumulation, Review of Economic Studies, 32(3), pp. 233–240, July. Cohen, A. J. – G. C. Harcourt (2003): Whatever Happened to the Cambridge Capital Theory Controversies, Journal of Economic Perspectives–Volume 17, Number 1, pp. 199–214.

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Part I: International and national experiences in economic convergence Domar, E. (1946): Capital Expansion, Rate of Growth, and Employment, Econometrica, Volume 14(2), pp. 137–147. Duarte, M. and Restuccia, D. (2010): The Role of Structural Transformation in Aggregate Productivity, The Quarterly Journal of Economics, 125(1), pp. 129–173, February. Durlauf, S. N. – Johnson, P. A. (1995): Multiple Regimes and Cross Country Growth Behavior, Journal of Applied Econometrics, 10(4), pp. 365–384, October–December. Durlauf, S. N. – Johnson, P. A. – Temple, J. R. W. (2006): Growth Econometrics, in Aghion P. – Durlauf, S. N., editors, Handbook of Economic Growth, Amsterdam: North Holland. Economist, The (2013): The 1974 Trap, http://www.economist.com/blogs/freeexchange/2013/02/middle-income-trap-ii. Eichengreen, B. – Park, D. – Shin, K. (2012): When Fast-Growing Economies Slow Down: International Evidence and Implications for China, Asian Economic Papers, MIT Press, vol. 11(1), pp. 42–87, February. Eichengreen, B. – Park, D. – Shin, K. (2013): Growth Slowdowns Redux: New Evidence on the Middle-Income Trap, NBER Working Papers 18673, National Bureau of Economic Research, Inc. Felipe, J. – Abdon, A. – Kumar, U. (2012): Tracking the Middle-income Trap: What Is It, Who Is in It, and Why?, Economics Working Paper Archive wp_715, Levy Economics Institute. Felipe, J. – McCombie, (2013): Aggregate Production Function and the Measurement of Technical Change. ‘Not even wrong’, Edward Elgar. Felipe, J. – Mehta, A. – Rhee, C. (2014): Manufacturing Matters… but It’s the Jobs That Count, Asian Development Bank Working Paper Series No. 420, November. Fischer, F. – Felipe, J. (2003): Aggregation in production functions: what applied economists should know, Metroeconomica 54(2 & 3), pp. 208–262. Frankel, M. (1962): The Production Function in Allocation and Growth: A Synthesis, American Economic Review, 52(5), pp. 995–1022, December. Galor, O. (1996): Convergence? Inferences from Theoretical Models, Economic Journal, 106(437), pp. 1056–1069, July. Harcourt, G. (1969): Some Cambridge Controversies in the Theory of Capital, Journal of Economic Literature, 7(2), pp. 369–405. Harrod, R. F. (1939): An Essay in Dynamic Theory, Economic Journal, 49(193), pp. 14–33. Hayes, M. G. (2006): The Economics of Keynes. A New Guide to the General Theory, Edward Elgar. Herrendorf, B. – Rogerson, R. – Valentinyi, Á. (2013): Growth and Structural Transformation, in Aghion, P. – Durlauf, S. N., editors, Handbook of Economic Growth 2, Amsterdam: North Holland. Jánossy F. (1966): dasági és Jogi Könyvkiadó.

, Budapest: Közgaz-

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1. A brief summary of economic convergence theories Káldor N. (1963): Capital Accumulation and Economic Growth, in: Lutz, F. A. – Hague, D. C., editors, Proceedings of a Conference Held by the International Economic Association, London: MacMillan. Kregel, J. A. (1976): Theory of Capital, MacMillan, London and Basingstoke. Koopmans, T. C. (1965): On the Concept of Optimal Economic Growth, in: The Econometric Approach to Development Planning, Amsterdam: North Holland. Kuznets, S. (1966): Modern Economic Growth, New Haven: Yale University Press. Maddison, A. (2010): Historical Statistics of the World Economy: 1-2008 AD, http://www.rug.nl/research/ggdc/. Mankiw, G. N. – Romer, P. M. – Weil, D. N. (1992): A Contribution to the Empirics of Economic Growth, The Quarterly Journal of Economics, 107(2), pp. 407–437, May. Nordhaus, W. D. (1996): Do Real-Output and Real-Wage Measures Capture Realities? The History of Lighting Suggest Not, in: Timothy F. Bresnahan, T. F. and Gordon, R. J. (eds): The Economics of New Goods, University of Chicago Press, Chicago, http://www.nber.org/chapters/c6064.pdf. OECD (2014): Perspectives on Global Development 2014: Boosting Productivity to Meet the Middle-Income Challenge, OECD. Perez-Sebastian, F. (2007): Public Support to Innovation and Imitation in a Non-Scale Growth Model, Journal of Economic Dynamics and Control, 31 (December 2007), pp. 3791–3821. Pritchett, L. – Summers, L. H. (2014): Asiaphoria Meets Regression to the Mean, NBER Working Paper 20573. Ramsey, F. P. (1928): A Mathematical Theory of Saving, Economic Journal, 38(152), pp. 543–559, December. Robinson, J. (1953–54): The Production Function and the Theory of Capital, Review of Economic Studies, 21(2), pp. 81–106. Rodrik, D. (2013): Unconditional Convergence in Manufacturing, The Quarterly Journal of Economics, 128(1), pp. 165–204, February. Rodrik, D. (2015): Premature Deindustrialization, Institute for Advanced Study (Princeton) Working Paper, January. Roger, C. (1989): Money, Interest and Capital. A study in the foundations of monetary theory, Cambridge University Press, Cambridge. Romer, P. M. (1986): Increasing Returns and Long-Run Growth, The Journal of Political Economy, 94(5), pp. 1002–1037, October. Romer, P. M. (1987): Growth Based on Increasing Returns Due to Specialization, American Economic Review, 77(2), pp. 56–62, May. Romer, P. M. (1990): Endogenous Technological Change, The Journal of Political Economy, 98(5, part 2), pp. S71–S102, October.

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Part I: International and national experiences in economic convergence Samuelson, Paul A. (1962). Parable and Realism in Capital Theory: The Surrogate Production Function, Review of Economic Studies. June, 29(3), pp. 193–206. Samuelson, Paul A. (1966): A Summing Up, Quarterly Journal of Economics. November, 80:4, pp. 568– 83. Solow, R. M. (1956): A Contribution to the Theory of Economic Growth, The Quarterly Journal of Economics, 70(1), pp. 65-94. Sraffa, P. (1960): Production of Commodities by Means of Commodities, Vora and Co. publishers, Hungarian translation Sraffa, P. (1975): Áruk termelése áruk révén, KJK, Budapest. Swan, T.W. (1956): Economic Growth and Capital Accumulation, The Economic Record, 32(2), pp. 334–361. Tan, C. M. (2010): No One True Path: Uncovering the Interplay Between Geography, Institutions, and Fractionalization in Economic Development, Journal of Applied Econometrics, 25(7), pp. 1100–1127. World Bank (2015): Updated Income Classifications, http://data.worldbank.org/news/2015-country-classifications Zonghie, H. – Schefford, B. (2006): An empirical investigation of paradoxes: reswitching and reverse capital deepening in capital theory, Cambridge Journal of Economics, (September 2006) 30 (5) pp. 737–765.

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Successful international experiences István Ábel – Judit Baranyai Csutiné – Laura Komlóssy – Kristóf Lehmann – Annamária Madarász – Zoltán Szalai – Árpád Vadkerti – Noémi Végh

Literature on economic performance has long focused on the main drivers of growth and convergence, and the economic policy conclusions that can be drawn from such. In terms of developments in the various factors of production, investments play an important role in economic convergence. Countries serving as examples of successful convergence showed high investment rates, particularly at the beginning of the period investigated compared to their peers with more uncertain convergence. At the same time, countries with rates far in excess of the average also typically belong to the former group. The employment rate in the countries included in the sample generally increased, and was higher in successfully converging countries throughout the entire period. Higher productivity also played an important role in successful convergence. Besides the change in economic structure, other factors also contributed to more rapid productivity gains (MNB 2014). These include greater economic openness, i.e. more active participation in global trade primarily by increasing export volumes and achieving higher export market shares, producing for new export markets and through the capital import necessary for technological development. With an eye to boosting productivity, states – even market economies – stimulated and supported innovative development to some extent. Productivity in countries struggling with convergence fell short of the successful examples, especially during the crisis, as they were harder hit by the crisis due to their vulnerability. International experience shows that education is a key focus in the context of successful convergence. The development of labour force quality through an effective education policy can ensure the success of the economic structural transformation achieved in the context of convergence. Industries and services — 63 —

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representing a higher technological level and requiring greater expertise are gradually on the rise, and the resulting demand for skilled labour can thus be satisfied. Institutional economics stress the importance of economic institutions and the political institutions defining them.20 Guaranteeing the right of ownership and public goods, free enterprise and access to education are all factors that may shape the success of an economyâ&#x20AC;&#x2122;s convergence. By contrast, an institutional system which only serves the interests of small groups results in a more unfavourable development trajectory, as attested to by numerous examples throughout history.21

2.1 Select applied economics issues of successful convergence One of the key challenges in the literature addressing growth and convergence is explaining the performance of countries exhibiting rapid real convergence. One of the most important economic debates of the 1990s centred on the sources of Asian growth. After World War II, starting from an initially low level of development, East Asian countries managed to approach or even outstrip the level of development of advanced economies at a spectacular pace over the course of three decades, while the convergence of many other countries was slow and often punctuated by slumps.

2.1.1 Shortcomings of explanations based on the production function and total factor productivity

A central question in the discussion of rapid Asian convergence was to define its explanatory factors. The debate focused on defining 20 21

E.g. Acemoglu and Robinson (2013). Of the cases studied in this chapter, it occurs most strongly for Austrian economic policy for the developments of compromises.

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explanatory factors. The main tools of the analyses were the mainstream growth models (see the calculation of the Solow residual in the previous Chapter 1). The results of the first more comprehensive studies22 contradicted the preliminary expectations and the intuition of analysts with local knowledge, revealing that it was based predominately or in some cases exclusively on factor accumulation (i.e. capital accumulation and the involvement of new labour in production) while productivity (measured in terms of total factor productivity (TFP) only rose insignificantly, if at all. Based on the mainstream analytical framework, this led to the conclusion that the rapid growth rate stalls sooner or later and convergence slows. This is because a high ratio of savings and investments (often amounting to 40 per cent of GDP) cannot be maintained for several decades, and the migration of earlier agricultural populations towards urban areas and their urban employment rate hits limitations as the agricultural population shrinks. Similarly, the educational level cannot be raised at the earlier rate23 if the lion’s share of the population already holds secondary education qualification rather than just primary educational qualification or lower. Certain economists started investigating the reasons behind the fact that rapid Asian growth and convergence was not reflected in the productivity of Asian countries. Some explanations propose that the countries under Cf. Young (1992, 1995), Kim and Lau (1994), Krugman (1994), Nelson and Pack (1999). Young’s (1992) paper launched the debate with its comparison of the growth exhibited by Hong Kong and Singapore in 1965-1990, failing to find any productivity growth in the latter. In their paper, Kim and Lau arrived at an even more provocative outcome using a different method, finding no productivity growth for Hong Kong, South Korea and Taiwan. Krugman interpreted these results for the broader public opinion in an article addressing the development of rapidly developing countries compared to the Soviet Union’s growth. He added that the traveller can observe significant differences between the newly industrialised Asian countries and the Soviet Union, but these only reflect differences in the initial situation. Asian countries were already developed at an earlier time, and merely lacked capital for attaining higher income status. In the case of Singapore, the following result emerged: the 7 per cent average annual growth rate, achieved as a result of 5 per cent labour input and 9 per cent capital input growth, and labour and capital contribution of 50 per cent each, stems from capital in a ratio of 64 per cent and labour in a ratio of 33 per cent, and fully amounts to output — there is zero productivity growth. Felipe (2006), p. 185, footnote 6. 23 Krugman (1994). 22

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review import technology from more advanced regions and pay for this embodied technical knowledge through the price of imported products. As a result, although productivity increases in the countries under review, it is not reflected in the Solow residual, but is instead attributed to capital, as the price of capital goods incorporates this element. As a result, in empirical estimates, the contribution of capital to output is greater in Asian countries than in advanced economies. This argument sought to explain why capital contribution is higher on average in rapidly growing economies compared to already advanced or slower growing ones.24 In this manner, based on the mainstream theory presented in Chapter 1, TFP is regarded as the indicator of technical progress, but in reality technical progress actually appears primarily in capital and labour. Measuring these is difficult, as more advanced technology is generally reflected in the statistics as more capital. With the spread of computer technology tools, an additional problem came to the forefront, as technical progress did not materialise for the most part in the earlier sense because it is carried by various softwares. In these cases, the cost-free nature of copying causes many problems: their development is costly, but excludability is more difficult to attain than embodied technical progress, for instance in the case of a traditional manufacturing production line. Moreover, the labour force that uses this is far better qualified than the average, as without qualification it would not be able to use such equipment. Newer models have therefore adopted a human capital variable that attempts to capture additional knowledge along with labour in the traditional sense.25

In technical terms, the problem emerges from the perspective of the production function as follows: capital per worker rises rapidly in the context of rapid convergence, whereas in Asian countries the distribution between capital and labour remained. To interpret these developments in line with the production function, we must assume Hicks-neutral technical progress: labour-saving technical progress and the income distribution ratios between capital and labour over the last period. As we will see later on, the production function does not exist in reality, so this explanation only has theoretical relevance. 25 Reati (2001). 24

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However, the main problem cannot be resolved by finding the “right” index number. The price index tries to proxy something else, namely physical productivity. If the correction is not right, more advanced technology is not represented in a true-to-life manner, yielding more output with less input, but as if the higher output (interpreted as higher income to begin with) were the result of more capital (factor accumulation). Whereas a more productive producer in fact manages to attain lower output unit costs, i.e. lower input per unit than competitors by efficiently using modern and high quantity capital (high fixed costs) and labour, and thus attaining higher profitability in the selling price.26 These assumptions already show the types of difficulties we face when attempting to apply the Solow production function empirically. The production function was originally created for physical inputs and output. It was most often a firm, i.e. a micro-agent that the researchers envisaged. The aggregate production function can be imagined analogously to the microlevel production function: a macrolevel production function was deemed deductible as the aggregate of the many microlevel production functions. However, the aggregation cannot be applied to physical entities, as capital goods and labour are not homogenous in terms of their natural units of measure (see Box 1-1

Lazonick (1990), Appendix: The Basic Analytics of Shop-Floor Value Creation. The Solow Model assumes perfect competition, but does not present the process of competition in the course of which an innovative firm transforms higher fixed capital (HFC) into lower unit cost (LUC) and acquires market share from competitors, who are thus compelled to implement technological change. In reality, not every company applies the same production function, and its unit costs differ from the rest, and consequently its profitability as well, as well as subsequent development and innovative capacity. In reality, competition exerts an impact through imbalances, and not every producer achieves a return on its expenditure. In the Solow model, these processes disappear and we only see the end result, where the owners obtain remuneration for the input factors in the form of profit and wages, as if they were annuities. These growth theories do not contain, but implicitly presume the fierce competition that lends modern market economies their dynamism.

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in Chapter 1).27 Both capital and labour can be summarised as monetary aggregates, but in this case, nothing ensures that the underlying production function or technology is of the Solow or a similar type (such as CES, Translog). Moreover, as demonstrated by Felipe and McCombie in numerous studies,28 aggregate output according to national accounts and factor incomes (the functional distribution of national incomes between profits and wages) are not linked in any form to technical output. Y(t) ! W(t) L(t) + R(t) K(t) Y(t) ! W(t) L(t) + R(t) K(t) exhaustion theorem (or Euler’s theorem) Y(t) ! with time trend income distribution weights + W(t) L(t) + R(t) K(t) where Y is national income (GDP), W is the average wage, L is the number of workers employed, R is the average return on equity and K is the value of the capital employed. In certain estimates, the exhaustion theorem is presumed in the contribution of factors, which corresponds to accounting identity. If this condition is not applied in the estimate, there is regularly a residual, which is the weighted average of capital and labour growth (often not linear).

Due to the structure of national accounts, wages and profits are by definition always equal to national income. This identity is independent of the underlying production technology and of whether the circumstances of diminishing returns, constant economies of scale and perfect competition are valid, where every factor is remunerated equally to its marginal product. In practice, production function Indeed, varoius capital and labour input elements can not be aggregated in natural units even at micro or firm level. For this reason, the favourite examples of textbooks involves a corn model, where a single commodity serves as input as well as ouput and both investments and savings could be understood in the single ouput commodity. Find more about the problem of aggregation in Fisher and Felipe (2003). 28 See Felipe (2006), Felipe and McCombie (2006, 2009, 2010, 2012). The listed papers can also be found in Felipe and McCombie’s book of collected papers (2013). 27

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estimates do not use marginal products as their basis (these are not observable), but rather estimate actual wages and profits, the employment figures available in the statistics (headcount or working hours) and the value of capital using some kind of statistical procedure.29 In the estimates, the above accounting identity is often rewritten for growth rates and a residual is also permitted. This residual, considered the indicator of technical progress, is often the average of the two factors’ growth rate weighted by factor income distribution ratios. When this residual does not fit exactly, in most cases it is often enough to allow the time trend to be nonlinear.30 Felipe and McCombie (2006) demonstrate that the adequately rearranged macroeconomic accounting identity cannot be distinguished from the production functions used in the estimates. Another empirical rebuttal of the existence of the production function is the simulation performed by intentionally not fulfilling the conditions of the production function and applying national accounts data to this relation. Due to the use of distribution data, the estimate in this case shows that the production function “behaves well”. This suggests that it rather reflects actual income distribution data, echoing the findings of empirical works. The estimates pertain to an accounting identity, but do not refer to the nature of the underlying technical relationships. Actual income distribution is shaped by many other factors besides the technological relationship of inputs interpreted as physical entities and the resulting output. Wage negotiations, market competition, pricing power all influence income distribution. Productivity variables regularly change their relative proportions, while the composition of inputs and output also changes over time, as well as quantitatively and qualitatively. Due to these factors, prices are not necessarily guiding in terms of technical ratios.

Most often using the perpetual inventory method, which factors in amortisation. The price of capital goods is estimated based on some kind of capital rental price. In essence, the quantity of capital is defined not in physical units, but as a monetary value. 30 Felipe and McCombie (2006) p. 194. 29

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Chart 2-1: Growth rates and total factor productivity in select Asian and European countries (1990–2007) 10

Per cent

y = 0.8357x + 0.0296 R2 = 0.23

GDP growth rate (1990–2007)

8 7 6 5 4 3 2 1 0 –2

–1

Total factor productivity growth rate (1990–2007) Note: Sample includes China, Japan, Malaysia, Phillipines, Singapore, Taiwan, Thailand, Austria, Bulgaria, Czech Rep., Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Poland, Portugal, Slovak Rep., Slovenia, Spain. Source: Feenstra et al. (2015)

On the basis of the above, it is not surprising that a close correlation cannot be found between the growth rate and the growth rate of total factor productivity, i.e. the measured or calculated factor productivity does not show what growth rate can be expected in a country or a group of countries (Chart 2-1 ).

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2.1.2 Explanations emphasising the phases of convergence

The other strand of the debate on Third World convergence emphasises the structural transformation of economies and the phases of these transformations. According to this approach, less developed countries feature certain structural idiosyncrasies compared to advanced economies. As a common trait, industries (referred to as primary industries) which involve little processing and often focus on the extraction of natural assets are predominant and account for the bulk of their export (such as agriculture or mining). They import more highly processed or manufactured goods and generate the international means of payment needed for this through exports. Prebisch31 made the observation that the terms of trade of primary commodities and manufactured goods deteriorates to the detriment of the former, which is a structural idiosyncrasy of the global economy and prevents developing countries from reaching advanced status. It stems from this analysis that – along with more equal international exchange – convergence is also conditional on developing countries taking the path of industrialisation. During the 2000s, prior to the crisis there was a lively debate about the global rise in commodity and energy prices. The question was whether it was a durable trend confirming a “reverse Prebisch–Singer hypothesis” which was an inevitable consequence of primary commodity scarcity and uninterrupted economic growth. The developing countries assuming the path of industrialisation saw that the relative price of the manufactured goods they increasingly exported started falling relative to primary products, which jeopardised the success of their earlier development strategy. The relative price decrease in manufactured goods was referred to as commodification,32 Harvey et al. (2010), Prebisch (1950). This is referred to as the Prebisch–Singer hypothesis, according to which the deterioration in the terms of trade for developing countries stems from the fact that the monopoly companies and organised workers of advanced economies play a decisive role in defining global economic prices, while less developed countries, competing between each other and with unorganised workers, are merely price takers. The beneficiaries of unequal international trade are therefore developed corporations and their employees, as opposed to developing corporations and their employees. 32 UNIDO (2013). 31

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suggesting that countries undergoing industrialisation and seeking convergence became each other’s competitors on the global market and in the context of price competition, that their products do not include the value added surplus that they were expecting when they launched their development programmes, and that convergence may thus become doubtful even on the path of industrialisation. The change in the terms of trade benefited developing countries which did not engage in industrialisation. In the wake of the global financial crisis, falling commodity prices ended the rise in prices, and the debate on terms of trade petered out following the unexpected plunge in energy prices, but was not resolved.

2.1.3 Qualitative indicators of output and exports

Participants in the debates on convergence agree that middle or high-income status cannot be achieved without a certain level of industrialisation,33 but industrialisation alone is no guarantee for sustainable convergence. Today, industry, agriculture and services are all highly differentiated. To address these problems, Hausmann et al. (2007) started elaborating a more sophisticated analytical framework34 which seeks to draw conclusions on the growth and export potential of a country from a broad range of qualitative indicators rather than merely from the volume of investments, the interpretation of the residual from the production function as technical progress, and the ratios of the main economic sectors and branches. They created the “Complexity Atlas” of the global economy, which investigates countries from the perspective of the diversity and sophistication Rodrik (2015) uses the term premature desindustrialisation for the process in which a less developed country is unable to preserve the level of industrialisation achieved on par with real output, for instance due to excessive foreign competition. In advanced economies, desindustrialisation in terms of employment observed as a result of productivity growth, in the course of which increasingly fewer people work in the industrial sector, cannot be considered premature, because real industrial output does not decline. 34 See also Hausmann and Hidalgo (2011), Hidalgo and Hausmann (2009). 33

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of the products they are able to produce, and how widely they are able to sell them in the global economy (for more, see Box 2-1). The newly available, more detailed databases, processed with the modern methodology of network analysis, are able to provide a more reliable forecast of a country’s growth and export potential compared to traditional analyses.35 Box 2-1 Growth Complexity” for 2014

The economic complexity indicator captures the diversity and sophistication of a country’s production capacities. The expansion of production capacities and the development of technology-intensive industries may yield a complex, diversified and more flexible export structure, which may boost the economy’s growth potential. This alternative economic indicator applies the classification of goods and countries used in foreign trade statistics. On the one hand, the indicator takes into account the number of goods that a country is able to export with a revealed comparative advantage and the number of other countries exporting these goods with a revealed comparative advantage. On the market of a specific product, a country has a revealed comparative advantage if its market share on the market for these products exceeds the product’s global market share. In defining a country’s economic complexity index, in addition to the volume of exported products with a revealed comparative advantage, the number of countries capable of exporting the product with a similar revealed comparative advantage is also relevant. Based on the economic complexity index, in 2014 Japan, Germany, Switzerland, South Korea and Sweden had the most complex product baskets within export, while Hungary ranked prominently in ninth place among

Source: Harvard Complexity Atlas: http://atlas.cid.harvard.edu/

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the 124 countries listed (Chart 2-2), Hungary has managed to improve its economic complexity ranking by four places since the 2013 survey. Since 1995, Hungary achieved the strongest progress in the Visegrád Group, with only the Czech Republic ranking higher in 2014 among its regional peers. Chart 2-2. Hierarchy between the top 50 countries based on the Economic Complexity Index (ECI) in 2014 Japan Germany Switzerland Korea, Rep. Sweden Austria Czech Republic Finland Hungary United Kingdom Slovenia Singapore Slovak Republic United States Italy Ireland France Hong Kong China Denmark Belgium Mexico Israel Netherlands Estonia Thailand Poland Malaysia Romania Spain Belarus Croatia Norway Lithuania Latvia Portugal Bosnia and Herzegovina Bulgaria Canada Philippines Turkey Ukraine Panama India Greece Tunisia Jordan New Zealand Russia Uruguay

Source: The Atlas of Economic Complexity

Based on the economic complexity indicator, economic growth may still be faster in emerging markets compared to advanced economies, but the difference in growth may gradually narrow. Visegrád countries face stable growth prospects and the Central and Eastern European region is considered Europe’s centre of growth.

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The more sophisticated and complex the goods and services that a country is able to produce, the more likely that it will be able to do so for markets where price competition is lower and consumers are willing to pay more, i.e. prices have a higher income content. At the same time, they also demonstrated that economic development entails constant change, with countries constantly needing to switch to new and broader product ranges. The set of indicators devised by them also carries information on the capabilities of individual countries within this process: that is because individual countries are generally capable of easily switching to the production of goods that are close in terms of complexity and sophistication to the goods and services already produced by them. WIIW researchers36 applied a similar approach in order to provide a better approximation of the growth and export potential of Central and Eastern European countries since the 1990s. Their analysis is based on the assumption that diverging quality is reflected in diverging prices within each product group. The quality improvement in a country’s export composition can be adequately monitored if we take into account the changes in export price developments relative to competitors over the years. The studies revealed that Central and Eastern European countries were characterised by gradual quality improvements, albeit to different degrees during the various periods. At the beginning of the 1990s, Hungary was top-ranking in terms of quality improvements. Hungary’s productivity approached Austria’s productivity to the greatest degree, while wages remained competitive. Hungary’s exported goods converged towards those of advanced economies in terms of price and quality at the same rate as the rapidly industrialising Asian countries (Landesmann 2000).

Landesmann and Székely (1995), Landesmann (2000).

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2.1.4 Value chains and value added

Looking at growth potential from another dimension, it became important for corporations to form value chains in the globalised economy, placing the various elements of these chains in different countries. It holds particularly true for smaller countries that they supply specialised components to large corporations operating larger-scale, geographically diversified value chains, while few global or regional large corporations operate in these countries. It is not only important which sectors are present in a country, as this is not a clear indication of the country’s potential, but also the value added represented by the work phases performed in the country. In the case of Central and Eastern European countries, there were many debates on whether the established foreign large corporations opt to install high value added production processes, or only operations with a lower income content, referred to as “screwdriver industries”. According to the Leitner and Stehrer (2014) paper, Hungary is among the countries capable of taking relatively good advantage of the new opportunities provided by integration into value chains.

2.1.5 Economic policy conclusions

The economics of convergence and growth has offered numerous recommendations for government politics over the past decades. The early literature suggested increasing savings and investments in order to increase capital accumulation. In this context, a significant portion of the agricultural population was channelled into industry, while agriculture and other primary industries were increasingly mechanised. Some degree of government control or incentives were regularly used in market economies to shape the process, especially because substantial infrastructure developments were also necessary. There was debate among economists on which industries are worth developing first, and national idiosyncrasies played a role in this debate along with military — 76 —

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policy considerations (for instance when deciding between heavy and light industry, means of production or consumption goods). The role of international capital flows has always been at the centre of debate. In the 1960s and 1970s, governments tended to base their external financing on intergovernmental loans and avoided foreign direct investment, as they feared giving excesses political influence to large corporations (cf. the activities of large US corporations in Latin America). Fearing external influence, Asian countries were even loathe to take out loans until the 1990s, when they undertook financial liberalisation at an already higher level of development. One possible form of technology transfer was the adoption of licenses, i.e. the purchase of only the production procedure and perhaps machinery from the leading foreign corporation. Although this results in smaller direct dependency, the manufacturer will still only possess second or third-order technology (see the case of the Soviet Lada cars). In order to rise to the vanguard, own developments are needed, or as shown by the Asian example37 licenses may also be useful for gradual convergence if used consciously, but are merely one step in the overall process. When the former socialist countries shifted to a market economy in the 1990s, under the umbrella of the Washington Consensus, market and FDI-driven convergence was the predominant view. At that time, there was heated debate about the Asian development strategies and the role of the state in this context. Although Asians considered it unequivocally proven that the unparalleled pace of convergence, elevating large masses, was the achievement of state-controlled industrialisation, the World Bank was reluctant to accept this as an explanation in its publication dedicated to the topic.38 The debate remains unresolved: During the Cold War, technology transfer was also restricted by various prohibition lists of products and technologies that could be put to military use. These included the most cutting-edge information technology tools (such as the COCOM list). 38 World Bank (1993): The Japanese government was willing to fund the publication because it expected it to showcase the achievements of Asian development policies. However, the final document only concedes very few positive findings on the potential positive role of the state. 37

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mainstream economists still generally prefer convergence driven by market and private capital and emphasise the risks of state development policies.39 Nevertheless, in certain areas – where the market fails – they consider some form of state intervention acceptable (Mazzucato 2013). These voices became louder in the aftermath of the crisis, and there is now greater willingness to once again define development priorities (such as the European Union’s Juncker Plan) and to supply state funding for these priorities. The debate therefore remains open, and the following section takes a closer look at the experiences offered by various countries for crafting convergence policy. International examples show that successfully converging countries (Austria, South Korea, Finland, Ireland, Poland, Singapore, Slovakia, the Republic of China (Taiwan) exhibited higher investment and employment rates during the period under review compared to uncertainly converging countries (Greece, Italy, Spain, Portugal; Chart 2-3). Countries that underwent a successful convergence process exhibited higher investment rates during the first half of the period under review, while the countries with doubtful convergence saw a decline in their investment rates during the first half of the period. Meanwhile, countries exhibiting rates far in excess of the average also generally fall within the former group. It should be noted that in many countries (mainly in Asia), the initially underdeveloped infrastructure also contributed significantly to the initially high investment rate. The employment rate in the countries included in the sample generally improved, in which demographic developments may have played a central role. The rate was higher in successfully converging countries over the entire period, while countries struggling with convergence saw a decline in the employment rate during the first half of the period and at its tail-end.

For more, cf. the reform package labelled as the Washington Consensus and the economic thinking that surrounded it (Williamson 2000 and Rodrik 2006).

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Developments in productivity also play an important role in the convergence process. The productivity of countries struggling with convergence fell short of the successful examples particularly during the crisis, and they were harder hit by the crisis due to their vulnerability. Chart 2-3: Factors of production in the period of convergence Investment rate (as a percentage of GDP) 80

Per cent

Employment rate Per cent

1.8 1.6

70 80

1.4 1.2

1.0

0.8

0.6

0.4

10 0

Productivity (USA=1)

0.2 1 6 11 16 21 26 31 36 41

1 6 11 16 21 26 31 36 41

Countries with uncertain convergence

1 6 11 16 21 26 31 36 41

Successful countries

Note: Successful countries include Austria, Finland, Ireland, Korea, Poland, Singapore, Slovak Rep., Taiwan. Countries with uncertain convergence are Greece, Italy, Portugal, Spain. Taiwan is omitted from the sample on employment rate due to lack of data. Source: Penn World Table, World Bank WDI

Experience shows that in successfully converging countries, the government spent larger amounts on average as a percentage of GDP on education outlays (Chart 2-4). This is partly due to this fact that holders of university qualifications represent a larger share of the labour force (Chart 2-5). This ratio exhibited an increasing trend in the period that followed the end of the 1990s in all of the countries under review. â&#x20AC;&#x201D; 79 â&#x20AC;&#x201D;

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By providing broad access to education and improving the standard of secondary and tertiary education, the countries under review were able to import new technologies, boost productivity and thus shift towards production processes generating higher value added, and during the later phases of the convergence process, to satisfy rising labour demand within the service sector. Chart 2-4: Government expenditure on education (per cent of GDP) 8

Per cent

1 0

0 1

Countries with uncertain convergence

Successful countries

Note: Successful countries include Austria, Finland, Ireland, Korea, Poland, Singapore, Slovak Republic. Countries with uncertain convergence are Greece, Italy, Portugal, Spain. Source: World Bank WDI

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Chart 2-5: Labor force with tertiary education (percentage of total) 40

Per cent

5 0

0 PRT

AUT

ITA

SVK

POL

SGP

GRC

1998

KOR

ESP

IRL

FIN

HIC

2008

Note: PRT – Portugal, AUT – Austria, ITA – Italy, SVK – Slovak Rep., POL – Poland, SGP – Singapore, GRC – Greece, KOR – Rep. of Korea, ESP – Spain, IRL – Ireland, FIN – Finland, HIC – average of high-income countries. Source: World Bank WDI

In the following section, we present case studies serving as examples for the successful convergence of certain countries from middle-income to high-income status. At the end of the chapter, we briefly address the partial convergence of Southern European countries, with uncertain outcomes for the time being.

2.2 Convergence in East Asia South Korea, Singapore and Taiwan were the first developing countries to rapidly rise to the rank of industrially advanced countries after the Second World War (Sakong 1993). From the early 1960s, over the course of more than four decades, the fifteen most rapidly developing countries — 81 —

Part I: International and national experiences in economic convergence

included nine East Asian countries. Economic growth was robust and the income level multiplied (Durlauf et al. 2005). Two theoretical schools attempt to explain the East Asian growth miracle in the literature. The developer state school stresses the role of state measures as the basic pillar of rapid growth, while the neoclassical school explains the success of East Asian countries with market liberalisation, the success of free market pricing and limited state presence. The shortcoming of the neoclassical school is that it is unable to explain the strong state presence that characterises the region, while the developer state approach fails to explain why strong state measures did not contribute to successful development in other developing countries (see Latin American countries). According to Lin (2001), the level of industrial and technological developments in these Asian countries was in line with their comparative advantage compared to Latin American countries. Firm state-led development policy was conducted in all of Asia’s converging countries, albeit the country specific differences. In most East Asian countries, rural industrialisation prevailed in the 1960s. While in South Korea large family conglomerates supported by state measures were created, known as chaebols, Taiwan saw the establishment of smaller, more labour-intensive factories. South Korea also experienced a shift from labour-intensive industries to capital-intensive ones, which played out in the context of “guided capitalism”, characterised by strong state influence. These included planned economic development programmes, various tax incentives and extraordinarily cheap funding through the state-controlled banking system, often at negative real interest rates. By contrast, in Taiwan, key sectors such as the chemical and steel industry remained in state control. The key difference between the two countries is best presented through the automotive industry. Taiwan specialised in the manufacturing of car parts, allowing it to achieve a higher profit margin, while South Korea is engaged in total car production with a minimal profit margin (Stiglitz and Yusuf 2001).

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Industrialisation played a significant role in Singapore as well: in the 1960s, in an effort to eradicate unemployment and successfully shore up the economy, an industrial park (Jurong Industrial Estate) was set up on Jurong Island, created through land reclamation. Furthermore, targeted, state-subsidised funding was also a key tenet of development policy, the main motive of which was export competitiveness-based financing. Firms or corporate groups performing better on the export market were granted discounted loans for further developments and capacity expansions. In the context of industrial policy, efforts were made to foster development without foreign capital, primarily using domestic funding. This and the Economic Development Board (EDB) set up for attracting FDI founded rapid economic development in Singapore.40 The flying geese model may have also played a pivotal role in industrial development. According to the strategy, symbolised by flying geese, where Japan is the lead goose, followed by Hong Kong and Singapore, then South Korea and Taiwan, and finally Malaysia, Thailand, the Philippines and Indonesia. The order of the countries reflects the level of industrial development and income per capita within the economy. The symbol refers to the fact that economic ties to Japan greatly contributed to the development of East Asian countries. Japan had already defined the countries to which it would transfer its shed technological know-how at the beginning of the century in order to switch to new technologies (Pleskovic and Stiglitz 1997). According to Rohwer (1995), the extremely rapid growth stemmed from four factors characteristic of Asian countries: labour quantity and quality, the quantity of physical capital and efficiency. The quantity of labour rose rapidly, driven by unparalleled Asian diligence

Singapore Economic Development Board: https://www.edb.gov.sg

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and long work hours.41 Southeast Asian countries also proved exceptional in their capacity to rapidly improve the quality of their labour force through effective educational policies.42 During the early phase of their development, they invested huge amounts of physical capital – machinery and tools – in the economy. The fourth driver of growth, high productivity, i.e. efficiency stemming from the spread of technology, its use within the population, social values, culture and receptiveness to modern economic life and foreign ideologies. Asian productivity has grown significantly over the past 60 years, also driven, along with the above elements, by pragmatism.

2.2.1 South Korea

Korea’s economy underwent an extraordinary structural transformation in the 20th century. Until its colonisation by Japan in 1910, the country was almost entirely agricultural and underwent industrialisation during the 35 years of Japanese rule. In 1945, as the war ended and Korea was liberated, the country was split in two. The southern part was specialised in agriculture, while the partitioned northern part was rich in natural assets. The initial difficulties were compounded by the Korean War, which lasted until 1953, and was followed by stable growth with strong foreign assistance (from the US), initially coupled with high inflation. The labour that remained in the country was unqualified and the economy had to be rebuilt essentially from scratch (Sakong 1993). South Korea’s (Republic of Korea) industrialisation was largely fostered by the creation of the Economic Planning Board in 1961 with the Among OECD countries, South Korea ranks second based on the total hours worked/capita with 2,163 hours/worker. In 2013, workers only put in longer hours in Mexico. https://data.oecd.org/emp/hours-worked.htm 42 Among OECD countries, South Korea has the highest number of university degree holders within the total population. This figure stood at 67.14 per cent in 2013, which was more than the double of Hungary’s figure (30.87 per cent). https://data. oecd.org/eduatt/population-with-tertiary-education.htm 41

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involvement of US experts. Five-year plans were created to develop the economy in the context of “guided capitalism”. The country upheld both the system of free enterprise and market economy, allowing corporations to develop in a market environment with strong state support, exposed to global market competition. Large family conglomerates known as chaebols, similar to Japan’s keiretsu,43 were able to finance their development from extremely cheap state loans. Due to its geographic location, South Korea maintained a strategic and political relationship with the US, which supported the country’s development with capital, technique and technology. In addition, South Korea’s foreign policy leeway was significantly influenced by its relationship with Japan. From 1965, Park Chung-hee struck a friendly note with Japan, and the former coloniser paid reparations of USD 800 million to South Korea in order to resolve the relationship between the two countries, and Japan became South Korea’s largest key export market in tandem with the US (Faludi 2005). South Korea’s robust development was largely driven by developments in labour quantity. The country’s population grew by nearly 2.5-fold between 1949 and 2009. This resulted from the baby boom at the end of the 1950s, when population growth averaged 3.1 per cent and was coupled with rapid urbanisation. The rapid early economic growth created more jobs and the unemployment rate shrank until 1979. In 1980, the second oil crisis, poor rice yields and political instability had an impact on the labour market, and the unemployment rate once again rose to 4-5 per cent. With market liberalisation, labour demand increased within manufacturing and the service sector, which brought the unemployment rate down to 2.5 per cent and kept it low until the 1997–98 Southeast Asian financial crisis. Labour supply and demand did not meet in various sectors, resulting in a labour shortage

The difference between chaebols and keiretsu was that the former were typically linked to banks, closely intertwined with the government.

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that was satisfied by incorporating the elderly and women into the labour force (Sakong and Koh 2013). Until the 1980s, borrowing was guided by the state, so large Korean corporate groups known as chaebols were able to access foreign loans extremely cheaply, backed by state collateral. During the period under review, at the end of the 1980s, energy prices, international interest rates and the value of the South Korean won against the Japanese yen were all low, which fostered international market liberalisation. Rapid (albeit partial) market liberalisation shook the stability of the financial system. By this time, chaebols were able to access foreign capital directly, and they found themselves in a difficult financial position after the onset of the 1997â&#x20AC;&#x201C;1998 Southeast Asian crisis. After the crisis, thanks to the IMF lifeline, the economy, isolated until then, was compelled to fully liberalise its money market, to depreciate the Korean won and to raise interest rates. Industrial structural transformations were also implemented, which saw foreign ownership in chaebols increase (Sakong and Koh 2013). An important condition for buoyant growth is the quality of the labour force. From the 1960s, elementary school was made mandatory, creating a steady supply of labour for manufacturing. The development of education was adapted to the levels of economic development and labour demand. Thanks to the 1981 educational reforms, university degree holders doubled, which explains the decline in the number of workers employed in manufacturing and the parallel rise in tertiary sector employment starting from 1989 (Chart 2-6). In the early 1990s, several suburban universities were established, raising the number of university students, but fears regarding the quality of education emerged. After the turn of the millennium, an educational policy targeting self-development and capable of standing ground in a globalised world was undertaken (Sakong and Koh 2013).

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Due to population growth, the number of people in employment nearly doubled between 1963 in 1980, after which this figure grew at a slower pace. Today, South Korea’s labour force comprises over 25.5 million individuals. In the wake of successful industrial and educational policy, the number of people employed in agriculture declined to almost onethird, coupled with a strong shift towards the tertiary service sector, which accounts for 70 per cent of employment today. Between 1988 and 1995, over half of GDP was generated by the service sector, which rose slightly while the share of agriculture shrank. The ratio of industry has remained broadly the same throughout the period under review, but its structure exhibits a strong shift towards the mechanical industry requiring higher know-how (Chart 2-7). Chart 2-6: Structure of employment by sector in South Korea (1963–2014) 100

Per cent

100

1963

1970

1980

1990

2000

2010

2014

Services Construction Manufacturing Agriculture, forestry and fishing Note: Data for “mining and quarryings” and “public utilities” are not presented here because their shares are very small (less than 1 per cent).

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Part I: International and national experiences in economic convergence

By and large, the shift towards higher value added manufacturing and service sectors is closely followed by the number of participants in higher education, and therefore support for educational policy and high-tech development significantly drove economic growth in South Korea. Chart 2-7: Sectorial breakdown of manufacturing in South Korea (1963-2006) 100

Per cent

100

Chemicals Food, beverages and tobacco Machinery and transport equipment

2005

2003

2001

1999

1997

1995

10 1993

10 1991

1989

1987

1985

1983

1981

1979

1977

1975

1973

1971

1969

1967

1965

1963

Other manufacturing Textiles and clothing

Source: World Bank

South Korea’s GDP per capita increased steeply from the 1970s and caught up with the world’s advanced economies between the late 1980s and in the mid-1990s, which was preceded by an extraordinarily high growth rate (Chart 2-8).

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Chart 2-8: GNI per capita, Atlas method in South Korea since 1962 30,000

US dollar I.

US dollar II.

III.

30,000

IV.

25,000

20,000

15,000

10,000

5,000

0 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

South Korea

World Bank. Under section I. the country was labeled as low-income, under section II. lowermiddle-income, under section III. upper-middle-income, while under section IV. high-income. Source: World Bank

2.2.2 Taiwan

Taiwan underwent industrial development similar to South Korea, which resulted in similar challenges. Owing to its agricultural attributes, Taiwan long served as a food producer in the region, especially for its coloniser, Japan. Its agriculture provided the seed capital that fuelled its subsequent industrialisation. In the course of industrialisation, production was performed in state-owned factories typically far smaller than South Korea’s chaebols (Stiglitz and Yusuf 2001). During the talks that followed World War II, Japan relinquished all of its claims pertaining to the island, but did not specify to whose benefit. The People’s Republic of China has not recognised Taiwan — 89 —

Part I: International and national experiences in economic convergence

(Republic of China) as an independent state, but the latter nevertheless holds democratic elections. Due to the island’s strategic position, the United States maintains good economic and political ties with Taiwan (Biztonságpolitikai Szemle 2010). Similarly to South Korea, its relationship with the US, which supported the country’s development with capital, technique and technology, played a prominent role. The Taiwanese government’s focus shifted to technologically advanced industries based on its human capital in an effort to move away from sectors heavily reliant on imports and large quantities of oil, which was becoming more expensive. During the convergence period to high-income status, the number of people employed in agriculture and manufacturing shrank between 1986 in 1993, while the service sector drew an increasing number of workers (Chart 2-9). Chart 2-9: Structure of employment by sector in Taiwan (1987-2014) 100

Per cent

100

1987

1990

1995

2000

2005

2010

2014

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The government’s educational and industrial policy guided the economy towards technologies requiring higher know-how. Nowadays, the number of people employed in agriculture has dwindled to almost half, and a significant shift has taken place towards the service sector requiring greater know-how, while the number of people employed in manufacturing has broadly remained unchanged. Taiwan achieved upper-middle income status in 1986 and exhibited accelerating growth from that point onwards (Chart 2-10). The country managed to achieve high-income status in 1993. What then followed was a period of robust growth, interrupted briefly only by one-off external shocks (the 1997–1998 East Asian crisis and the 2008 global financial crisis). Chart 2-10: GNI per capita in Taiwan since 1951 25,000

US dollar I.

US dollar II.

III.

25,000

IV. 20,000

15,000

10,000

5,000

1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

20,000

Taiwan

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2.2.3 Singapore

During the British colonisation, the People’s Action Party (PAP) was founded in 1955, and has become Singapore’s governing party since 1959. Singapore is often presented as a state-controlled economy that functions with exceptional efficiency (Vietor 2007). After British colonisation, economic growth was based on industrial policy led by the state. Until then, the labour force primarily served British soldiers, and unemployment rose after the British forces were withdrawn. The PAP established the Housing Development Board (HDB) which began building public housing and later infrastructure, allowing it to eradicate unemployment (Vietor 2007). Meanwhile, the Economic Development Board (EBD) was set up in an effort to involve and effectively serve US and European multinational and transnational corporations. To achieve successful growth, Singapore’s government adopted three main measures. For one, strategic sectors (energy, banking and transportation sectors) were kept under state control. Moreover, it successfully developed its labour force in line with demand, ensuring that labour was involved in the highest possible echelons of corporate supply chains, in the activities producing the highest value added. Thirdly, under the umbrella of national industrial development, it created what are referred to as clusters, combining the government’s priority sectors into organisations in order to compete more effectively against multinational companies (Kaushik 2012). In order to attract potential investors, the Board supported new industries such as the petrochemical, ship repair, metal and electronic industries. By the end of the 1970s, labour market demand had outstripped supply and had to be met by attracting foreign labour force, a testament to the success of the EDB’s programme.44 The state not only fostered the growth of various industries through discounts, but also had direct

By 2014 almost 40 per cent of Singapore’s labour force consisted of non-citizens (Singapore Ministry of Manpower).

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control over strategic sectors through the giant corporation Temasek Holdings45 (Vietor 2007). The country’s special social security system may have also contributed to the economy’s development. The Central Provident Fund (CPF) was created in 1955 and initially served as the pension fund for workers in Singapore, keeping separate accounts for employee payments. This shields savings from uncertain money market volatility, as they were invested in low risk, non-tradable government securities. They were used to fund the development of infrastructure and state-managed corporations. So the contributions paid by employers and employees provided part of the seed capital needed for development. As the country prospered, its social security system also started developing, and individual accounts are now divided into subaccounts dedicated to various purposes besides social insurance, such as schooling or housing finance (Vietor 2007). Singapore’s development was also greatly supported by its monetary policy. The country remains Southeast Asia’s financial centre, with financial services accounting for 13-15 per cent of its GDP. The Asian dollar market, modelled on the euro-dollar market, was created in Singapore, functioning initially as an interbank market and subsequently adding foreign currency, bond issuance and fund management to its operations. In addition, the Asian Currency Unit (ACU) introduced in 1968 was also a major contributor to the development of the country’s financial system. Singapore’s central bank, the Monetary Authority of Singapore (MAS) was established in 1971, initially serving as a currency board maintaining a fixed exchange rate. In addition, the country featured an extremely regulated banking system and bond market. From the 1970s until 1996, the central bank continuously revalued the Singapore dollar upward against the US 45

Temasek consists of over 40 corporations, including public utility companies, the Singapore development bank, the Singapore airline and telephone company (SingTel). However, the company’s management is fully independent of the government, and it competes successfully with other large multinational firms in global trade (Vietor 2007).

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dollar, and then gradually revalued it downwards in the wake of the 1997–1998 Southeast Asian crisis. Partly due to the extraordinary level of banking system regulation, not one bank in Singapore fell victim to the Southeast Asian crisis, and the country only incurred minimal loss compared to its East Asian peers. The 1973 oil crisis shook Singapore, which was involved in oil refining, with inflation rising rapidly at around 20 per cent between 1973 and 1974. By contrast, the second oil crisis of 1979–1980 impacted Singapore’s economy less adversely. The central bank managed to keep inflation low after the oil crisis, in the vicinity of 8 per cent, before decreasing it to around 3 per cent by 1982 (World Bank). After the crisis, Asian countries such as China, Malaysia and Thailand started emerging and lured away foreign corporations by offering far lower labour costs. However, Singapore’s government opted to hike wages instead of cutting them, with the intention of attracting foreign firms’ high-tech production operations, which generate greater value added, to their Singapore facilities. Unemployment spiked in 1985, and manufacturing investments decreased. In the early 1980s, the board created to ensure high productivity recommended cutting employer contributions and adopting more flexible wage setting, which improved corporate competitiveness. The measures were effective in stimulating growth. With these rapid and effective changes in strategy, Singapore managed to become an investor into cheap labour (Vietor 2007). Looking at the 1975–2013 period, the proportion of certain sectors based on their contribution to GDP did not change in earnest. Agriculture saw its proportion gradually decline, from 2.2 per cent of value added in 1975 to less than 1 per cent by 1985, and a mere 0.03 per cent by 2013. Industry represents value added of 32 per cent on average, of which

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manufacturing accounts for value added of 24 per cent. A gradual, albeit slight, decline in industrial activity has taken place over the past four decades. Services account for the largest portion of value added, averaging 68 per cent of GDP. Contrary to the industrial sector, the tertiary sector exhibited a gradual expansion, accounting for 75 per cent by 2013. From 1975 onwards, the textile industry saw its respective weight decrease gradually, while the production of machinery and vehicle equipment and chemicals, requiring a large amount of knowhow, saw its weight increase (Chart 2-11). Chart 2-11: Sectorial breakdown of manufacturing in Singapore (1975-2011) 100

Per cent

100

Chemicals Food, beverages and tobacco Machinery and transport equipment

2011

2009

2007

2005

2003

2001

10 1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

Other manufacturing Textiles and clothing

Source: World Bank

Similarly to South Korea and Taiwan, Singapore’s educational policy also contributed successfully to the supply of qualified labour, enabling it to become involved in manufacturing at the echelons of the corporate value chain generating higher value added. In the 1980s, a research and development centre and universities were created in the immediate vicinity of the industrial park, primarily with German and — 95 —

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French support, transforming the effective country into even more: an effective country that supports innovation.46 By 1950, Singapore had joined the ranks of low-income countries, by 1978 it had joined the ranks of upper-middle income countries and then over the span of a decade, it joined the ranks of high-income countries (Chart 2-12). Chart 2-12: GNI per capita, Atlas method in Singapore since 1962 60,000

US dollar

US dollar I.

II.

60,000

III. 50,000

40,000

30,000

20,000

10,000

1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

50,000

Singapore

World Bank. Under section I. the country was labeled as lower-middle-income, under section II. upper-middle-income, while under section III. high-income. Source: World Bank

Rapid growth was driven by the service sector generating high value added and high-tech development, propelling it to the global vanguard. The country also saw significant FDI inflows, incentivised 46

Singapore Economic Development Board: https://www.edb.gov.sg

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by Singapore’s government by creating the most modern technological environment and infrastructure. By and large, in all three Asian countries, the state successfully attracted FDI through its education and industrial policy, allowing the economies to grow robustly. All three countries exhibited a decline in traditional agricultural activity and a rapid expansion of the service sector. Singapore’s example shows that the proportion of the textile industry, built earlier on cheap labour, shrank significantly, while industries requiring greater know-how, such as the chemical industry – or the auto and machine industry in South Korea and Taiwan – saw their ratio rise sharply. The following section presents the convergence process of three European Union member states: Austria, Finland and Ireland. Due to their heterogeneous initial situation, the three countries achieved convergence through different factors and economic policy actions. During the classical convergence process, contrary to the Asian countries presented in the previous section, industrialisation was achieved with less state intervention. Austrian economic policy successfully mitigated the fluctuations of the economic cycle, and its magic pentagon policy created a stable institutional and economic environment. In Finland, during the economy’s structural transformation, industrialisation occurred concurrently to the expansion of the service sector, while Ireland achieved convergence thanks to an active fiscal policy, its accession to the European Economic Community and certain sub-market regulations.

2.3 Austria: The magic pentagon policy Austria’s economic convergence was not a linear process. After the war, it exhibited annual growth of 17 per cent between 1945 and 1950, reaching and surpassing its earlier record output. At the beginning of the 1950s, stabilisation interrupted the dynamics of growth. From 1954 onwards, another rapid growth period began, at a rate averaging 6.4 per — 97 —

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cent until 1960. Although momentum decreased after 1960, it was still upwards of an annual 4 per cent. In the nearly two decades between 1954 and 1973, GDP multiplied by 2.5-fold in real terms. During this period, the average growth rate was 5.3 per cent (Richter and Székffy 1987, 23), propelling Austria to join the ranks of Western European (high-income) countries. It achieved upper-middle income status based on per capita income in 1964, and climbed to further over the next 12 years to reach high-income status by 1976 (Abdon et al. 2010, 24). The 1960s and 1970s were characterised by a rise in the popularity of the Social Democratic Party of Austria (SPÖ) and the economic policy formulated by party leader Bruno Kreisky. Growth was the key focus of debate within the upper echelons of economic policy governance, and many were convinced that “economic social structure can be shaped through central will” (Richter and Székffy 1987, 24). In this context, the institution of social partnership was extended to a sort of consultation system through a parity-based method applied in education, territorial planning, energy and transportation strategy. The Austro-keynesian economic policy, based on compromise, fostered the country’s convergence. Economic policy practice consisted of cooperation geared towards compromise between parties and business interest groups, allowing the crafting of unified and comprehensive economic policy strategy. The other key element was the desire to join the European integration process. The pillars of the economic policy coined as Austro-keynesianism were the maintenance of external balance and a balanced budget, increasing employment, stimulating economic growth and maintaining price stability. This set of five objectives was referred to as the “magic pentagon”.47 Traditional Keynesian stabilisation policy was supplemented with growth policy, creating a new approach. Austro-keynesianism is therefore a social 47

http://countrystudies.us/austria/87.htm Solsten, E. – McClave, D. E. – Keefe, E. K. (1994): Austria: a country study. Library of Congress, Washington, D. C.

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and economic reform concept that aims to mitigate the uncertainties stemming from the nature of the market economy and to enforce decision-maker objectives in a balanced manner, contributing to the stabilisation of economic expectations. Economic policy is therefore not aimed at retroactively correcting individual economic actions, but rather at shaping the decision-making process itself. Because any economic policy initiative may inevitably come up against individual strategies that may undermine its enforcement, the impact of economic measures on interest groups is closely monitored. This approach stresses that the success of state economic policy hinges upon its capacity for compromise. It assumes institutions which focus on the common interests of various economic agents above all and work towards compromise (Richter and Székffy 1987, pp. 30–31). Thanks to this economic policy, the convergence period was accompanied by increasing GDP per capita, improving employment data, rising wages, growing productivity, expanding export and the early sectoral transformation of production. During the convergence period, the change in the sectoral composition of employment between 1964 and 1977 is a good reflection of the economy’s structural transformation (Chart 2-13). In the course of structural transformation, the share of agriculture and forestry decreased significantly and the share of industry decreased slightly in terms of employment. Meanwhile, employment expanded substantially in the service sector, both in private and public sector services, with the number of workers rising by nearly 1.5-fold (1,068,000 and 1,426,000 individuals WKO-Statistik).

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Part I: International and national experiences in economic convergence

Chart 2-13: Changing Sectoral Structure in Austria (1964-1977) 100

Per cent

100

1964 1977 Sector's share in GDP Agriculture

1964 1977 Sector's share in total employment Industry

Services

Source: WIFO (1981)

During this same period, the sectoral compositions of GDP production evolved somewhat differently from employment. In the course of rapid convergence, the contribution of agriculture to GDP shrank, while the contribution of industry and services expanded. Table 2-1 illustrates developments in the economic structure reflected in the composition of GDP. The share of agriculture and forestry shrank from 7.5 per cent to 5.4 per cent of GDP. The ratio of industrial production rose from 42.3 to 44.5 percent, while the service sector contributed more or less to the same degree to GDP in both years (50.1 and 50 per cent). During this period, the rise in exports drove GDP growth strongly. Exports relative to GDP grew from 21.4 to 26.9 per cent. The composition of exports also changed, characterised by a shift from light industry (textile industry, paper production) to the export of electronic goods.

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Table 2-1: Sectoral Shares in GDP Ágazat

1964

1976

változás

Agriculture and forestry

7.5

5.4

–2.1

Mining

1.2

0.6

–0.6

Food processing

4.8

4.5

–0.3

Textile and garment

2.9

2.7

–0.2

Lumber

1.8

2.2

0.4

Paper

2.7

2.1

–0.6

Chemicals

1.8

2.8

Oil

1.6

1.9

0.3

Glass

2.1

–0.1

Basic metals

1.8

2.7

0.9

Metallurgy

9.3

10.8

1.5

Energy and water

2.6

3.2

0.6

Construction

9.7

–0.7

Trade and retail

12.5

13.2

0.7

Catering

3.7

2.9

–0.8

Transport and communication

4.8

5.4

0.6

Banking and Insurance

5.9

9.1

3.2

Other private services

7.9

5.4

–2.5

Public services

15.3

–1.3

Source: Skolka (1985) p. 734

The unemployment rate remained low throughout this entire period, standing at 2.8 per cent in 1964 and 2 per cent in 1976. In accordance with economic policy, the government also contributed to convergence with its educational programme (school construction programme, higher education reform) and labour law measures (workplace democracy, improvements to working conditions, adoption of the 40hour workweek, rules on sick pay; Kreisky 100). The success of the Austrian model became apparent during the crises of the 1970s, when Austria’s economic performance remained far more stable compared to other OECD countries. Austria’s economic policy successfully mitigated economic cycles and also managed to recover — 101 —

Part I: International and national experiences in economic convergence

faster from downturns. The openness of the Austrian economy, its close ties to the German economy, positive developments in the structure and size attributes of industry and well-timed economic policy actions contributed to this result. The unique, parity-based political structure also stabilised the institutional system and provided a sound institutional background for the economy.

2.4 Finland During the first half of the 20th century, Finland was still a poor economy based on GDP per capita, focusing primarily on agricultural production, before it then converged successfully to the EU-15 during the second half of the century through industrialisation and emphasis on the service sector (Hjerppe 1987). Finland’s economic convergence already started in the early 1900s and picked up speed from the 1960s. Convergence was initially slow and significantly set back by both World Wars, so a real economic turnaround only occurred in the 1960–1980 period. During this period, not even the oil crises interrupted its momentum, and it was during this period that Finland caught up to the other European Union member states (Chart 2-14). In terms of its structural transformation, Finland’s economy took a different path in the last century compared to other developed economic countries: the country underwent industrialisation at a later stage, and therefore the decline of the industrial sector as a percentage of GDP also began much later.48 In addition, the labour force also flowed from agriculture into the service sector alongside industry, so in contrast to the EU15, no clear distinction can be made between the industrialisation and post-industrialisation phases (Hjerppe et al. 2006). The industrial policy that followed the wars included individual measures, and the late 1970s saw the adoption 48

Industrialisation began later than in Sweden or the EU15, so while manufacturing was already on the decline in other Western European countries, Finland’s industrial production as a percentage of GDP still held strong in the 1970s.

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2. Successful international experiences

of the first real programmes supporting industrialisation, and from then on the government assumed a more prominent role in industry (Botos 2010). Industrial policy only contributed partially to convergence, but also played a pivotal role in the economic developments of the subsequent period. Chart 2-14: GDP per capita in Finland, Sweden and EU15 between 1960 and 2000 45,000

USD (constant 2005 USD)

45,000

40,000

35,000

30,000

25,000

20,000

15,000

10,000

5,000

0 1960

1970 Finland

1980 Sweden

1990

2000

EU15

Source: World Bank

During the period of rapid convergence, the Finnish economic structure also underwent a significant transformation. Between 1945 and 1980, the share of agricultural production within GDP shrank substantially (from 42 per cent to 10 per cent), while both industrial production and the service sector saw their share increase (Chart 2-14, left panel). At the same time, between 1980 and 2003, only the share of services increased, which represented a significant shift towards the service sector. Among the three main sectors, industrial production’s contribution to growth was the most significant prior to convergence, while during the convergence period (1965–1980) and afterwards, rapid — 103 —

Part I: International and national experiences in economic convergence

industrial growth only partially explained GDP growth, which was also significantly driven by the expanding service sector (Chart 2-15, lower panel). Chart 2-15: Developments of economic structure (upper graph) and growth contributions of productive sectors (lower graph) in Finland between 1945 and 2003 100

Per cent

100

0 1945

1965 Agriculture

2.5

1980 Industry

2003 Services

Per cent

2.5

2.0

1.5

1.0

0.5

0.5 0.0

0.0 1945–1965 Agriculture

1965–1980 Industry

1980–2003 Services

Source: Based on Hjerppe et al. (2006), tables on page 11 and 14

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2. Successful international experiences

Accession to the European Union came somewhat after economic convergence, in 1995, when the collapse of the Soviet Union put an end to its political influence over Finland. The Finnish economy gradually converged to the EU-15, but the crisis during the 1990s temporarily widened the gap relative to the EU-15. The period of rapid growth following 1997 allowed Finland to catch up once again, thanks to an industrial policy that adressed the structural issues of the Finnish industry relatad to the high share of traditional industries such as forestry and the wood industry. Consequently, industrial production shifted towards knowledge and technology-driven sectors in the 1990s, with the government supporting this process and, in this context, supplying resources and creating regulations for the knowledge-based service sector (Botos 2010). The development of education, undertaken in the 1960s, was pivotal for the shift to a knowledge-intensive service sector. The Finnish educational model, which is still widely talked about today, was the result of this process, and elevated Finland’s education to a successful and high standard according to the PISA surveys conducted since 2000. Increasing intellectual capital has remained a priority for Finland’s economic policy since the second wave of convergence. Thanks to these measures, Finland is currently a rich welfare state with a high standard of living, where the government plays a central role in economic development, and which boasts a high standard of social security, healthcare and education. In summary: Finland’s economic convergence between 1965 and 1980 was only partially driven by the rapid growth in industrial production, as the service sector’s expansion also significantly contributed to more rapid GDP growth. In addition, the industrial output and services contribution to growth was positive during the last two decades of the 20th century, so the disadvantage caused by the crisis of the 1990s was made up for in terms of GDP per capita. The Finnish government conducted a supportive industrial policy throughout the period, but its impact on economic growth has been the most pronounced since moving towards a knowledge-based economic model. — 105 —

Part I: International and national experiences in economic convergence

2.5 Ireland (1975–1990) Ireland achieved high-income status in 1990. GDP per capita was above USD 14,000 by 1990, up from merely USD 3,000 at the beginning of the period of convergence under review, when Ireland still ranked as a lower-middle income country.49 The evolution of GDP per capita (Chart 2-16) clearly shows that a strong turnaround in growth occurred in the Irish economy from the mid-1980s, as pointed out by Barry (2003). While GDP per capita had grown at a rate of 4.5 per cent on average between 1985 and 1990, the growth rate between 1979 and 1984 was a mere 1.6 per cent. Chart 2-16: Convergence process (the evolution of GDP per capita) 10

Per cent

Current US dollars

13,000

11,000 9,000

7,000

5,000 3,000

1,000

GDP per capita growth

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

–1,000 1975

–2

15,000

–3,000

GDP per capita (right-hand scale)

Note: The horizontal line indicates the value of GDP per capita (USD 12,000) corresponding the high level of income. Source: World Bank

Irish economic growth did not come to a halt at the time, but continued at a dynamic rate of 5 per cent between 1990 and 1995, and nearly 10 per cent between 1996 and 2000, which was achieved by drawing the lessons of the period under review in creating government policies, coupled with increasing inflows of FDI and EU funding. In this chapter, however, we specifically investigate the circumstances of convergence to high-income status.

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The international environment was volatile in the convergence period defined by Felipe (2012). Several significant events affecting Ireland occurred: at the beginning of 1973 the United Kingdom, Denmark and Ireland were admitted to the European Economic Community (EEC) during the first round of expansion. This step brought broader export markets for Ireland. In addition, joining the EEC also fostered Ireland’s economic convergence through inflows of EU funding. The oil crises of the 1970s led to a spike in the price per barrel of oil, followed by an oversupply of oil until the mid-1980s as prices fell after the crisis. The Irish government attempted to offset the negative impacts of the oil crises through fiscal policy measures. Ireland’s economy became more open during the convergence period, and the rising share of exports, which increased by 16 percentage points as a percentage of GDP during the convergence period, from 38 to 54 per cent, was a key driving factor in this regard (Chart 2-17). Earlier, in the 1960s and the first half of the 1970s, the economy performed worse than other European countries due to high rent-seeking, a protectionist economic policy – seen less in the weak export rate, but more so in the high export contribution of low value-added agriculture – and the excessive weight of agriculture (Ó Gráda and O’Rourke 1996). The protracted impact of these factors restrained economic performance at the beginning of the convergence period, along with the destabilising impacts of the adverse external environment on the macroeconomy. Besides the fact that joining the European Economic Community meant a strong commitment to opening the economy, it also gave Ireland access to new export markets,50 previously mainly limited to the United Kingdom. The expansion of the export sector led to a 25 per cent rise in employment by foreign corporations (Powell 2003). Besides making Ireland a more attractive investment target, joining the EEC also entailed an intense inflow of FDI, which triggered the structural 50

Accession gave Ireland access to the markets of the EU15 countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, (whereas before, the majority of exports were absorbed by the United Kingdom).

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Part I: International and national experiences in economic convergence

transformation of the economy (Chart 2-18) and a shift towards higher value added manufacturing output and continental markets exhibiting more rapid growth (Barry et al. 1999). Chart 2-17: Economic openness, export and purchasing power parity 120

Percentage of GDP

US = 1

0.9

110

0.8

100

0.7

0.6

0.5

70 0.4

0.3

Export

Purchasing Power Parity (right-hand scale)

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

0.1 1977

30 1976

0.2

1975

Openness

tive to the GDP of the given year. Source: World Bank, Penn World Table

After the first oil crisis, the Irish government conducted expansionary demand-stimulating (procyclical) fiscal policy until the mid-1980s. The government accumulated substantial budget deficits with growing capital accumulation (Chart 2-19), rising wage-type expenditures in the wake of wage agreements and a growing general government sector aimed at slowing the rise in unemployment (Powell 2003). In response,

â&#x20AC;&#x201D; 108 â&#x20AC;&#x201D;

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Chart 2-18: Supply side of GDP 100

Per cent

100

Agriculture

Industry

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

Services

Source: EU Klems

in the early 1980s, instead of scaling back budgetary expenditures, the government attempted to create a budget surplus by levying higher taxes. However the budget remained in deficit as fiscal policy was still procyclical, causing economic contraction. As a result, government debt to GDP increased further, and in 1987 – when government debt hit 107 per cent – expenditure cuts enabled the future reduction of tax burdens, which led to a reversal of the high real wages stemming from certain earlier factors – and also creating labour market imbalances, and a decline in the unemployment rate, which had risen to 17 per cent. The positive turn of events on the labour market was accompanied by an expansion in the employment of the cost-sensitive service sector and employment growth in resident-owned manufacturing (Barry 2003).

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Part I: International and national experiences in economic convergence

Chart 2-19: Demand side of GDP 100

Percentage of GDP

100

Final consumption

Gross fixed capital formulation

1990

1989

1988

1987

1986

1985

–20

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

–20

Net export

Source: World Bank

At the same time, the expenditure cuts made many investments uncertain (such as the modernisation of the telephone network), but the rising inflow of European Union funding came to the rescue. Funding nearly doubled starting from 1987, which provided additional support. In addition, a number of changes to individual state regulations were also important factors: the deregulation of air traffic and the development of the telecommunications network51 contributed to accelerating growth by boosting tourism and freight forwarding and facilitating the establishment of foreign corporations. In the wake of the liberalisation of air traffic in 1986, the number of tourists doubled over the decade that followed, while the construction of the digital telephone network and its operation based on aggressive pricing also 51

The development of the telecommunications network was orchestrated under the guidance of a newly created authority in 1979. The institution later operated the network on a commercial basis and attracted customers by pricing its international telecommunications services.

— 110 —

2. Successful international experiences

attracted corporations that were otherwise not involved economically in the country (Barry 2000). Broadly speaking, Ireland’s convergence in the period under review was fostered by a significant rise in net exports, accession to the European Economic Community, the resulting inflow of development funds and FDI and certain institutional and regulatory changes. The economy underwent a classical convergence process,52 which achieved substantial foreign trade openness during the period. Joining the EEC not only accelerated this, but also the inflow of external funds, which enabled the completion of significant infrastructure developments boosting the country’s attractiveness. The failure of the government’s procyclical fiscal policy was reflected in Ireland’s high government debt, uncompetitive resident industrial firms due to high taxes and elevated unemployment stemming from the social security contributions imposed on wages. By reversing these factors through expenditure cuts – and in the hopes of future tax cuts – economic growth started accelerating from the mid-1980s. The following section presents the convergence of Slovakia and Poland among the countries of Central and Eastern Europe. Both of these countries exhibited rapid convergence until the 2007 financial crisis, which slowed thereafter. Among the convergence processes different from those exhibited by the European countries presented earlier, it can be mentioned that the contribution of credit-fuelled consumption and investment to growth was higher, and substantial volumes of capital flowed into the region in the wake of the positive impact of the Great Moderation.

2.6 Convergence in the Central and Eastern European region Central and Eastern Europe was characterised by extraordinarily rapid growth from the 1990s until the 2008 global economic crisis, supported 52

The emphasis shifted from low value-added agricultural production to high valueadded industrial production and services.

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Part I: International and national experiences in economic convergence

by growing confidence in the region’s convergence towards Western European income levels, along with a favourable global economic environment. Growth in the region as a whole was around 6 per cent on average, contributing to rising incomes. Accession to the European Union in 2004 was a real milestone for these countries. Growing financial market optimism provided direct access to private financing, allowing these countries to finance their economies from sources other than the IMF’s loan programmes. At the same time, economic reforms generally slowed during this period, and buoyant growth was driven by credit-fuelled consumption and investment, leading to an exceptional rise in the external balance deficit. In the wake of the 2008 global economic crisis, the region suffered huge output losses and confidence in convergence also waned (IMF 2014).

2.6.1 Economic growth and economic structural transformation

In our study, we take a look at the convergence process of Poland and Slovakia, located in the same region as Hungary, from the period starting in 2002 until the present, after the end of dramatic period of transition that made a deep impact on the region and the conclusion of the series of emerging market crises. Two periods can be distinguished in Slovakia and Poland during the period under review: both countries characterised by rapid convergence until 2007–2008, while the convergence process slowed after the onset of the crisis (Chart 2-20). The rapid convergence characterising the initial period was supported by several factors. For one, the drastic economic transformation of the preceding periods came to an end. The reallocation of factors of production and accession to the single European market had a positive impact on economic growth. In addition, parallel to un upward trend in the global economic, the region’s capacity to attract capital also improved, and the period was marked by a large-scale — 112 —

2. Successful international experiences

Chart 2-20: Evolution of GDP per capita (USD) and real GDP growth 20,000

USD

Per cent

15,000

10,000

6 4

5,000

0 –2

-5,000 –10,000

–4 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

–6

Real GDP growth, Slovakia (right-hand scale) Real GDP growth, Poland (right-hand scale) GDP per capita, Slovakia GDP per capita, Poland Source: World Bank

capital inflows. The reallocation of factors of production and accession to the single market must be interpreted as one-off impacts, while the massive capital inflow characterised the country until the 2008 crisis. The convergence process slowed after the onset of the global financial crisis, and in contrast to earlier years, it continued at a far slower pace (EBRD 2013). Table 2-2: Real GDP growth in Visegrád countries Poland

Slovak Czech Hungary Republic Republic

Average growth between 1991-2003 (per cent)

3,4

4,1

1,1

2,3

2,2

Average growth between 2004-2014 (per cent)

4,0

2,4

1,3

1,1

Average growth between 1991-2014 (per cent)

3,7

4,1

1,7

1,8

1,7

GDP per capita 1991 (USD)

2193

2680

2867

3334

16422

GDP per capita 2004 (USD)

6640

10655

11668

10254

27719

GDP per capita 2014 (USD)

14343

18501

19530

14029

36423

Source: Worldbank

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Part I: International and national experiences in economic convergence

From 2002, Slovakia’s GDP growth was approximately 4 per cent on average, while Poland exhibited a somewhat lower growth rate, averaging 3.7 per cent. Poland’s moderate growth at the beginning of the period stems mainly from earlier strict fiscal measures. At the same time, it is notable that Poland was the only European economy that managed to avert a recession following the onset of 2008 financial crisis. Growth was sustained by the depreciation of the real exchange rate, a robust domestic market, low exposure to international trade, low household and corporate debt and the incentives provided by fiscal and monetary policy measures (Piatkowski 2013). For Slovakia, the near 5 per cent downturn that occurred in 2009 was significant even by international standards, but it managed to restore GDP growth to the positive range by the following year. One of the most conspicuous phenomena of economic development is the transformation of economic activity, i.e. changes in the respective weight of sectors. During the first phase of the process, the role of industry and services increases while agricultural production decreases. In the following period, services continue to grow to the detriment of industry and agriculture. In terms of the structural transformation of Poland’s and Slovakia’s economy (Chart 2-21), during the period under review the ratio of agricultural output within GDP was very low and continued to shrink further at a slow rate over the years. At the same time, both industrial production and the service sector maintained a high ratio, with the latter even underwent a slight expansion after 2008 in both countries. Industrial production remained significant in both countries, but a gradual decline may be seen in the subsequent decades parallel to economic development. In the course of its economic structural transformation, Slovakia specialised in a focused manner on auto manufacturing.

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2. Successful international experiences

Chart 2-21: Developments in economic structure (production side)

100

Percentage of GDP

Poland

Percentage of GDP

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Agriculture

100

Percentage of GDP

Industry

Slovakia

Services

Percentage of GDP

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Agriculture

Industry

Source: World Bank

â&#x20AC;&#x201D; 115 â&#x20AC;&#x201D;

Services

Part I: International and national experiences in economic convergence

Looking at the composition of GDP by expenditure, net exports contributed negatively to economic growth throughout much of the period. Investments in Poland stood at around 20 per cent of GDP throughout the entire period, thus falling short of Slovakia’s figure, but consumption, at just above 80 per cent in Poland, exceeded Slovakia’s ratio of consumption to output. Parallel to economic development, the role of the service sector increases. Chart 2-22 illustrates the correlation between the weight of the service sector and economic development in the countries of the EU (with the exception of Luxembourg). In less developed countries – where GDP per capita is lower – the service sector also plays a smaller role, while in more developed countries, where GDP per capita is higher, the service sector accounts for a larger share of GDP. The estimated linear line reflects this correlation, i.e. that a rise in the ratio of services is accompanied by economic development. In both Poland and Slovakia, the service sector represents a far smaller proportion compared to advanced EU economies, and they are both in the middle range in terms of average GDP per capita. The transformation of the structure of economic activity also entails a change in the proportion of sectoral employment. Parallel to a decline in agricultural production within GDP, the number of workers employed in the sector also decreased over the years (Chart 2-23). The number of workers employed in the service sector rose in parallel, particularly after the crisis. The number of people employed in industry remained broadly the same in both Poland and Slovakia during the period under review, standing close to 40 per cent in Slovakia and somewhat lower, around 30 per cent in Poland. The share of the construction industry within total employment grew somewhat in both countries. Manufacturing saw some decline in the number of workers within the sector in the aftermath of the crisis, which was followed by a slight increase during the post-crisis years.

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2. Successful international experiences

Service sector, value added (percentage of GDP), average 2002–2014

Chart 2-22: Relationship between the service sector and GDP per capita 85

Per cent Cyprus

Latvia

France United Kingdom Belgium Netherlands Denmark

Greece

Lithuania

Germany

70 65

Italy

Portugal

Croatia Bulgaria

Estonia

50 12,000

Austria

Hungary

Slovak Republic

Ireland

Finland

Slovenia

Poland

Spain

Sweden

Czech Republic Malta

Romania

17,000

22,000

27,000

32,000

37,000

42,000

47,000

GDP per capita, PPP current USD, average 2002–2014

Source: World Bank

Chart 2-23: Employment by sectors as a proportion of total employment 70

Per cent

70 60

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Poland

Slovak Republic Employment in services Employment in industry Employment in agriculture

Source: Eurostat

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Part I: International and national experiences in economic convergence

The weight of industry within production remained significant in both countries, and industrial production continues to be characterised by large territorial differences. Large cities and their surroundings are the most important geographic areas, as qualified labour, infrastructure development and the changing industrial structure attract foreign capital (HCSO 2007). Poland’s Western regions are the most highly developed on account of their proximity to Germany, and they attract significant FDI, while the inefficient heavy industry production of traditional industrial areas face serious issues. The northeastern areas, engaged mainly in agricultural production, are the most lagging regions. Thanks to its favourable geographic location, cheap labour and tax incentives, Slovakia is able to attract many investors, primarily in automobile manufacturing and the electronic and machine industries (Beblavy 2010). After the turn of the millennium, Slovakia became one of the fastest developing automobile manufacturing countries. Development was concentrated mainly in the surrounding of Bratislava, which, coupled with the decline in traditional heavy industry production located mainly in Slovakia’s Central and Eastern regions, further exacerbated geographic differences. These differences were also reflected in incomes and unemployment rates. The fact that structural unemployment remained high in both countries drew attention to the necessity for further structural changes.

2.6.2 Role of government policy in convergence

Slovakia undertook a number of comprehensive measures under the second Dzurinda administration from 2002 (Beblavy 2010). Fiscal consolidation and deep structural reforms were aimed at improving the budget deficit and achieving long-term fiscal sustainability. Meeting the Maastricht criteria became the main priority for economic policy, as a result of which Slovakia was admitted to the ERM II in 2005 to prepare for the adoption of the euro in 2009. The rate of fiscal consolidation between 2002 and 2003 was exemplary (Chart 2-24), nevertheless an excessive deficit procedure was launched against Slovakia between — 118 —

2. Successful international experiences

2004 and 2008. Poland also successfully decreased its budget deficit between 2002 and 2007, which allowed the lifting of the excessive deficit procedure, instituted four years earlier; in 2008, however, the European Commission relaunched the procedure after the deficit spiked in 2009, and it was finally lifted in 2015. Similarly to Poland, Slovakia’s budget deficit was elevated after the onset of the crisis, which spurred the European Commission to relaunch the EDP in 2009, which was lifted in 2014. A key difference in the two countries’ fiscal policies conducted during the crisis was that while Slovakia’s economy faced a significant downturn, Poland’s economic output did not decrease, and thus the deficit was attributable to countercyclical policy.

Per cent

–1

–2

–3

–4

–5

–6

–7

–8

–8 –9

–9 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Poland

Slovak Republic

Source: Eurostat

The Slovakian government also introduced substantial economic policy changes besides scaling back the budget deficit. In 2004, a structural reform package geared towards boosting the efficiency and success of public sector spending was introduced. As the first step of the — 119 —

Part I: International and national experiences in economic convergence

reform package, Slovakia’s government introduced a flat rate tax. Income tax, corporate income tax and VAT were all set at 19 per cent. Simplifying taxation and discounts granted to strategic foreign investors created a fertile environment for enterprise, scaling back the black and shadow economy. The next step of the reform package set the objective of transforming social policy, in the context of which the government focused on increasing employment and pension reforms. This pensionable age was raised to 62 years for both genders, and Slovakia’s citizens were also given the opportunity to set aside some of their pension contributions on individual capital accounts. The reform package also included measures targeting healthcare, but the government later discontinued the most unpopular measures (the medical visit charge, the daily hospital inpatient treatment fee and the prescription charge) (Beblavy 2010). The Polish government decided to increase the pensionable age in 2012, setting it uniformly at 67 years. The new age limit will come into force in 2040 for women and in 2020 for men. In addition, similarly to Slovakia, Poland also managed to significantly scale back social expenditures from 2006 (Table 2-3). Table 2-3: Social protection in Visegrád countries (as a percentage of GDP) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Czech Republic 18.2

18.1

18.8

18.0

17.8

17.4

17.5

19.7

19.5

19.8

20.2

Hungary

19.5

19.1

20.0

20.9

20.4

21.5

22.0

22.3

22.5

23.0

22.6

21.9

21.6

Poland

19.1

20.5

20.7

19.8

19.4

19.2

18.0

18.9

20.1

19.5

18.6

17.6

Slovakia

18.8

18.4

18.5

17.8

16.6

15.9

15.7

15.5

15.6

18.3

18.1

17.7

17.9

Source: Eurostat

Both Poland and Slovakia underwent a successful convergence process, as a result of which the OECD and the World Bank ranked Poland among high-income countries in 2011, and Slovakia even earlier, in 2007. At the same time, convergence slowed in both countries in the aftermath of the crisis. Lowering external debt, stimulating investments, increasing labour market participation and maintaining innovation and competitiveness were all pivotal to successful convergence. — 120 —

2. Successful international experiences

2.7 Southern European countries facing uncertain prospects of convergence Southern European countries (Greece, Italy, Portugal, Spain) converged towards developed Western European countries after their accession to the European Union and after the adoption of the euro. Although the very rapid initial growth was followed by a slowdown in each country, the group is heterogeneous, as each country exhibited a different degree of economic convergence and was impacted differently by the crisis (Chart 2-25). One of the main drivers of convergence was the rapid and significant decline in (real) interest rates (with the exception of Italy). Meanwhile, growth in investment and consumption demand was also driven by the rapid rise in private sector credit and asset prices, based in part on excessively optimistic income expectations. In most cases, fiscal policy also contributed to the boom, although this was only apparent in Greece and Portugal during the buoyant period. Chart 2-25: Real convergence of Southern European countries (real GDP/ capital, PPP, Germany = 100) 100

Per cent

100

Portugal

Source: IMF, WEO (2015)

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Greece

2014

2013

2012

2011

2010

2009

2008

2006

Spain

2007

2005

2004

2003

2002

2001

2000

1999

1998

1996

1997

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The rapid expansion in domestic demand resulted in rising employment and high nominal wage growth. As a result of these developments, the rapid rise in unit labour costs and substantial capital inflows materialised. The financial crisis highlighted the shortcomings of convergence, economic growth paired with indebtedness, the lack of sufficiently productive investments and relatively less competitive economic structures. Each of these countries was hit hard by the crisis, and they significantly lost some of the convergence that they had achieved in terms of income per capita.

2.7.1 Greece

Greece’s convergence to the level of EU member states began from the second half of the 1990s from a higher level of development relative to Eastern European countries. The Greek economy is an example of how EU membership is not sufficient in and of itself for successful convergence, as the latter also hinges upon various well-orchestrated economic policy measures. Between the time of accession to the EU (1981) and 1995, Greece exhibited a lag instead of convergence, and the latter only occurred later as result of macroeconomic policies and structural reforms (Vamvakidis 2003). Fiscal policy consolidation and a significant reduction in inflation contributed to growth from the side of macroeconomic policies, while the reduction in the state’s role in the economy and market liberalisation contributed from the side of structural reforms. The economic policy reforms were primarily geared towards joining the euro area (Greece joined in 2000), but also contributed to the acceleration of economic growth. Between 1995 and 2000, the general government deficit as a percentage of GDP, government debt and inflation all decreased. At the same time – as it later came to light – Greece in fact failed to satisfy the fiscal criteria and the deficit grew further. In the context

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of structural reforms, increasingly more emphasis was placed on educational development, improving competitiveness against foreign competition and increasing domestic competition, along with information technology and research and development activities (Vamvakidis 2003). Thus, in the context of structural transformation, industrial production, already low relative to GDP, shrank from 13.4 per cent to 21.5 per cent, while the ratio of services rose from 70.5 per cent to 82.8 per cent between 1995 and 2014. Along with the surprisingly high growth rate, since 2005 the fiscal position has improved substantially, yet it is still far from the medium-term fiscal target (MNB 2008). While Greece’s productivity growth exceeded the EMU average in the mid-2000s, the 2008 crisis revealed the fragility of Greece’s economic convergence. One of the factors behind this is that despite the reforms, the country continued to be characterised by substantial goods and labour market rigidities that prevented the rapid adjustment of prices and wages, and thus the allocation of capital and labour to more rapidly growing sectors during the crisis. In addition, fiscal policy overestimated the future growth impacts of the pick-up in domestic demand accompanying the significant private sector indebtedness, which proved excessively procyclical as a result, and the government’s excessive spending led to a rise in external imbalances, rendering the Greek economy fragile (ECB 2015). After the introduction of the euro, Greece saw its real interest rates decline, which contributed to growing private and public sector debt indebtedness, while the majority of investments implemented from debt were unproductive and only made a short-term contribution to economic growth, as did higher demand. As a result of these factors, the case of Greece proved that growth financed by excessive spending and rapid private and public indebtedness is not sustainable.

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2.7.2 Italy

Although Italy’s real economic convergence to high-income status was already completed in the 1960s, the economic upswing continued in an uninterrupted manner until the 2000s. The reconstruction, marketisation and industrialisation that followed the Second World War lasted until 1960s, when the liberal economic policy was replaced by Keynesian economic policy aimed at fostering aggregate demand. This period was characterised by a high growth rate, but by the 1970s it was also accompanied by fiscal spending overruns and growing state interventionism. Fiscal spending overruns led to a rapid rise in government debt. The 1990s were marked by a turnaround in fiscal policy and macroeconomic stabilisation: in order to meet the Maastricht criteria that were preconditions for the introduction of the euro in 1999, fiscal expenditures were reduced while revenues were increased, and the welfare system was restructured. The period between the introduction of the euro and the global financial crisis was characterised by slow growth and rising unemployment. The Italian economy was hit hard by the 2008 crisis for two reasons: high government debt, inherited from the 1970–1980s, rendered the economy fragile, and the productivity shock linked to the introduction of the euro which (further) dampened the country’s competitiveness. The economic crisis only exacerbated the already existing issues. In order to address the high government debt (which was one of the ECB’s demands prior to commencing secondary market intervention53 (Meardi 2012), the ruling governments adopted austerity measures, which entailed not only expenditure cuts and the restructuring of social benefits, but also the reform of laws affording trade unions and employees a (traditionally) excessively strong bargaining position. These were called for because without them, the budget had remained without reserves in the past, and thus automatic fiscal stabilisers offsetting 53

The ECB requested budgetary adjustments in a letter, also drawing attention to institutional and structural changes, such as the self-evidently necessary conditions for secondary market intervention.

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anaemic economic performance could not be functioning (MNB 2008). The strong protection of employee interests can also be regarded as one of the reasons for the lag in competitiveness, as it greatly rendered wage adjustment difficult. Due to this and poor productivity, the country’s economy only managed to expand by 0.75 per cent on average over the past 15 years, which is lower than the interest burden on government debt, which has been higher than 100 per cent of GDP since 1991; accordingly, the crisis resulted severe financial stresses for the economy (Lin et al. 2013). Unemployment increased significantly in parallel with the deterioration in economic performance (particularly among young career starters), while employment decreased. The necessary reforms were only implemented slowly and without an adequate strategy and were consequently unable to yield meaningful results. Labour market liberalisation and attempts to boost competitiveness and productivity of industrial sectors were only adopted later.

2.7.3 Portugal

After joining the European Union in 1986, Portugal exhibited a significant economic upswing and convergence towards the EU average in terms of GDP per capita. European Union grants were primarily focused on creating infrastructure while improvements to the quality of human capital and labour fell to the wayside, and thus the grants did not foster convergence (Viegas and Antunes 2013). Portugal cut its key policy rate, which allowed it to be one of the first to join the European Monetary Union in 1999, to meet the Maastricht convergence criteria and to foster economic growth. This measure entailed a decline in private savings and a rise in investments, which in turn led to an extraordinary increase in output, a fall in unemployment, higher wages and a rapidly growing balance of payments deficit (Blanchard 2007). Growing demand pushed wages higher than the level of productivity, significantly dampening the country’s competitiveness (Portugal 2015). — 125 —

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After joining the euro area, Portugal’s initially rapid convergence was interrupted and even reversed. Due to the stimuli preceding the adoption of the euro, its fiscal leeway shrank even further and could not be used to offset the protracted stagnation and slow recovery (MNB 2008). Until the end of 1999, Portugal’s GDP growth outstripped the euro area average, but this trend then took a gradual downward path, reaching its trough in 2003. Portugal was the first country to come under the excessive deficit procedure in 2001. It then undertook a drastic corrective programme which consisted of scaling back public sector spending and cutting corporate income tax in order to boost competitiveness. The reforms had a positive impact, and Portugal’s GDP started rising steeply, but the trend came to a halt by mid-2004. At the time, the country faced many structural difficulties, including amongst other things low human capital, a broad public and a weak private sector. The reforms created a clearly noticeable growth trajectory for the country, interrupted first by the expansion of the European Union and later by the economic crisis (OECD 2004). Portugal faced severe macroeconomic imbalances well before the 2008 financial crisis, reflected by both the external debt which became stuck at a high level and the general government deficit. Initially, the financial system was not jeopardised by the crisis thanks to its low exposure to toxic assets. Central European and Asian countries were more attractive investment targets, and therefore Portugal drew a smaller volume of FDI (Lin et al. 2013). The country was characterised by extremely weak economic growth. Two other factors contributed to the pause in growth: firstly, the extremely low human capital investments stemming from a very low level of educational investments. The poor standard of education resulted in anaemic productivity growth. Secondly, ineffective labour market institutions also contributed to a lack of growth (Portugal 2015). The main objective of the new fiscal programme adopted in 2009 was to boost research and development by providing tax incentives. Although the country’s GDP has approached the euro area average since 2014, Portugal is still regarded as risky due to its high external exposure and structural imbalance (Lin et al. 2013). — 126 —

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2.7.4 Spain

The Spanish economy exhibited a sustained growth trend: income per capita rose dynamically and approached the European average. The 2008 financial crisis interrupted this growth trend. Growth was supported by capital accumulation along with intensive job creation (Mas et al. 2009). Key infrastructure developments were completed thanks to strong financial support, but the government failed to reduce regional differences. High unemployment had plagued the country chronically for decades, but the reforms managed to significantly decrease the unemployment rate, also supported by an upswing in the construction industry from the 2000s (Meardi 2012). The construction industry was the main driver of the Spanish economy in the 2000s, accounting for almost 20 per cent of GDP growth. From 1996, prices rose by nearly 200 per cent on the Spanish housing market, but this steep uptrend was interrupted in early 2007. The earlier strong demand waned somewhat, giving rise to significant oversupply on the housing market. At the same time, the financing environment grew increasingly adverse, with gradually rising interest rates in the euro area. The strong pressure of oversupply on housing prices was further exacerbated by rising inflation, which contributed to a decline in the real value of housing. The bursting of the housing bubble hit the Spanish economy hard, resulting in a substantial slump in construction industry output and a consequent rise in the unemployment rate and the volume of nonperforming loans (IMF 2009). In terms of economic structure, Spainâ&#x20AC;&#x2122;s volume of investments as a percentage of GDP was the highest in the European Union. The contribution of industry to GDP was around 30 per cent until the onset of the crisis, while the value created by agriculture decreased gradually. Consistently with this, the number of people employed in agriculture also decreased over the years, while the number of people

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working in industry rose in the wake of the upswing in construction.54 The service sector’s value added started rising slightly from the 2000s and accelerated after the onset of the crisis, reaching 75 per cent by 2014. Spain was hit hard by the 2008 financial crisis, and although the decline in its GDP was somewhat smaller compared to Germany or Italy in 2009, unemployment more than doubled, spiking to 24 per cent by early 2012. In reaction to the crisis, the Spanish government adopted numerous labour market reforms, but failed to reduce the unemployment rate. In the wake of the fiscal measures adopted in an effort to stimulate the economy, the budget deficit widened to around 10 per cent and government debt to GDP nearly tripled between 2008 and 2014. Parallel to the slowing of economic growth, the convergence process was also significantly set back, and continues at a more subdued rate.

2.8 Conclusion The early literature suggests increasing savings and investments in order to increase capital accumulation. The growth models that became predominant in economics argue that the rate of growth cannot be sustained based purely on capital accumulation, improving productivity can ensure maintaining the growth rate. According to the widespread analytical framework, total factor productivity (TFP) is the best indicator of whether growth based on the accumulation of factors of production, i.e. capital and labour, is able to achieve convergence that is sustainable in the long run. However, the theoretical and empirical problems related to the production function render this approach unreliable and unsuitable for supporting economic policy decisions. Instead, approaches that focus on improving labour productivity, treating their quantitative and qualitative aspects together, may prove useful. Conclusions on a country’s growth and export potential can be 54

During the period preceding the bursting of the housing market bubble.

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drawn from a broad range of qualitative indicators. However, it should be stressed that based on the literature, there are no universally applicable rules of economic convergence. Less developed countries feature certain structural idiosyncrasies compared to advanced economies. The significant role of what are referred to as primary industries constitutes a common starting point. An investigation of the contribution of economic sectors to GDP and their weight within employment reveals that a rise in the ratio of services accompanies economic development. According to the correlation gleaned from the data, a decline in traditional agricultural activity and a rapid expansion of the industrial and service sector can be observed. Parallel to a decline in agricultural production within GDP, the number of workers employed in the sector also tends to decrease, while the number of people employed in the service sector tends to gradually increase. A more moderate but gradual rise in employment can be observed in industry, with a shift in structure towards industries requiring higher know-how and representing a more advanced level of technology. In the wake of the financial crisis and the success of Asian countries, opinions emphasising the role of state-led development policies have gained traction. After the Second World War, firm stateled development policies were conducted in all of Asiaâ&#x20AC;&#x2122;s rapidly developing countries. Governments can also support the success of knowledge and technology-driven sectors through educational policy. International experiences show that the ratio of education spending as a percentage of GDP is higher in successfully converging countries. Successful economic policy may attract large inflows of FDI, which may foster long-term growth. The financial crisis shed light on the dangers of unsustainable convergence. In Southern European countries, the growth in investment and consumption demand was also driven by a rapid rise in private sector credit and asset prices, and fiscal policy also contributed to the â&#x20AC;&#x201D; 129 â&#x20AC;&#x201D;

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extraordinary performance in several cases. However, this led to the emergence of macroeconomic imbalances, and high government debt rendered the affected economies vulnerable. Similar developments were also observed in the Central and Eastern European region. Buoyant growth was fostered by credit-fuelled consumption and unproductive or poorly productive investments, leading to an exceptional rise in the external balance deficit. In other words, optimistic income calculations and the rising supply in cheap funding in the wake of falling real interest rates broadly materialised in the form of factors fostering short-term economic development, such as unproductive investments that failed to raise potential growth and domestic demand. The economic growth achieved in this manner concealed the vulnerability of the convergence processes, while the countries saw their external indebtedness deepen. The recession that followed the global economic crisis exacerbated the imbalances and shed light on the unsustainable nature of this economic structure. According to neoclassical growth theory, capital accumulation and thus economic convergence can be accelerated by external financing. However, experience shows that external financing does not necessarily yield additional economic growth. Stimulating investments, increasing employment, maintaining competitiveness, supporting education and a smoothly functioning financial system are the factors that can contribute to successful convergence.

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References Abdon, A. – Bacate, M. – Felipe, J. – Kumar, U. (2010): Product Complexity and Economic Development. Levy Economics Institute Working Papers No. 616. Acemoglu, D. – Robinson, J. A. (2013): Miért buknak el nemzetek? – A hatalom, a jólét és a szegénység eredete. HVG Kiadói Rt., Budapest. Barry, F. (2000): Convergence is not Automatic: Lessons from Ireland for Central and Eastern Europe. The World Economy, Vol. 23, No. 10, pp. 1379–1394. Barry, F. (2003): Integration and Convergence in the Cohesion Countries. Journal of Common Market Studies, Vol. 41., No.5, pp. 897–921. Barry, F. – Bradley, J.– O’Malley, E. (1999): Indigenous and Foreign Industry: Characteristics and Performance. In: Understanding Ireland’s economic growth. Basingstoke, Hampshire: Macmillan, 1999, pp. 45–74. Beblavy, M. (2010): Slovakia’s Transition to a Market Economy and the World Bank’s Engagement. Centre for European Policy Studies (CEPS), Comenius University. Biztonságpolitikai Szemle (2010): sület.

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Blanchard, O. (2007): Adjustment within the euro. The difficult case of Portugal. Portuguese Economic Journal, Volume 6, Issue 1, April, pp. 1–21. Botos B. (2010): Az iparpolitika metamorfózisa. L’Harmattan Kiadó. Durlauf, S. N. – Johnson, P. A. – Temple, J. R. W. (2005): Growth Econometrics. In: Aghion, P. – Durlauf, S. (eds.): Handbook of Economic Growth, edition 1, volume 1, chapter 8, pp. 555–677, Elsevier. EBRD (2013): Transition Report 2013. Stuck in Transition? European Bank for Reconstruction and Development, London. ECB (2015): Real convergence in the euro area: evidence, theory and policy implications. ECB Economic Bulletin, Issue 5. Faludi P. (2005): Pak Csong-Hi gazdasági programja – a modernizáció gazdaságpolitikája Dél-Koreában. Kül-Világ 2005/4 II. évfolyam, pp. 13–27. Feenstra, R. C. – Inklaar, R. – Timmer, M. P. (2015): The Next Generation of the Penn World Table. Forthcoming American Economic Review, available for download at www.ggdc.net/pwt. Felipe, J. (2006): A decade of debate about the sources of growth in East-Asia. How much do we know about why some countries grow faster than others? Estudios de Economia Applicada, Vol. 24–1, pp. 181–220.

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Part I: International and national experiences in economic convergence ----------- (2012): Tracking the Middle Income Trap: What is It, Who is in It, and Why? ADB Economics Working Paper, No. 306, March. Felipe, J. – McCombie, J. (2006): The Tyranny of the Identity: Growth Accounting Revisited. International Review of Applied Economics, Vol. 20, Issue 3, pp. 283–299. ----------- (2009): On Accounting Identities, Simulation Experiments and Aggregate Production Functions: A Cautionary Tale for (Neoclassical) Growth Theorists. In: Setterfield, M. (ed): Handbook of Alternative Theories of Economic Growth, Cheltenham, Edward Elgar, CCEPP WP 01–09. ----------- (2010): What is wrong with aggregate production functions. On Temple’s ‘aggregate production functions and growth economics’. International Review of Applied Economics, 24, no. 6, pp. 665–684. ----------- (2012): The Tyranny of the Accounting Identity Works Full Time: A Rejoinder to Temple. CCEPP WP01-12. ----------- (2013): Aggregate Production Function and the Measurement of Technical Change. ‘Not even wrong’. Edward Elgar. Fischer, F. – Felipe, J. (2003): Aggregation in production functions: what applied economists should know. Metroeconomica 54:2 & 3, pp. 208–262. Harvey, D. I. – Kellard, N. M. – Madsen, J. B. – Wohar, M. E. (2010): The Prebisch Singer hypothesis: four centuries of evidence. The Review of Economics and Statistics, 92(2), pp. 367–377. Hausmann, R. – Hidalgo, C. (2011): The network structure of the output. Journal of Economic Growth, December 2011, Volume 16, Issue 4, pp. 309–342. Hausmann, R, – Hwang, J. – Rodrik, D. (2007): What you export matters. Journal of Economic Growth 12(1), pp. 1–25. Hidalgo, C. – Hausmann, R. (2009): The building blocks of economic complexity. Proceedings of the National Academy of Sciences 106(26), pp. 10570–10575. Hjerppe, R. (1987): Main trends in Finnish economic development in 1860–1985. Bank of Finland Monthly Bulletin, Vol. 61. No. 12, December. Hjerppe, R. – Kokkinen, A. – Jalava, J. – Hannikainen, M. (2006): Catching-up in Europe: Finland’s convergence to Sweden and EU15 on GDP per capita. XIV International Economic History Congress, Helsinki, August. IMF (2009): Spain: 2008 Article IV Consultation–Staff Report. IMF Country Report No. 09/128, International Monetary Fund. IMF (2014): 25 Years of Transition, Post-Communist Europe and the IMF. Regional Economic Issues, Special Report, International Monetary Fund. Kaushik, D. (2012): Evolution of Industrial Landscape in Singapore. JTC Corporation, Singapore. Kreisky 100: Für Österreich – Meilensteine der Ära Kreisky. http://www.kreisky100.at/meilensteine/ index.html

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2. Successful international experiences HCSO (2007): A gazdasági fejlettség alakulása a kelet-közép-európai régiókban. Statisztikai tükör, volume I, issue 54, pp. 1–5. Krugman, P. (1994): The myth of Asia’s miracle. Foreign Affairs; Nov/Dec 1994; 73, 6; ABI/INFORM Global, pp. 62–78. Landesmann, M. (2000): Structural Change in the Transition Economies, 1989-1999. Economic Survey of Europe, No. 2/3. Landesmann, M. – Székely, I., eds. (1995): Industrial Restructuring and Trade Reorientation in Eastern Europe. Cambidge. Lazonick, W. (1990): Competitive Advantage on the Shop Floor. Harvard University Press. Leitner S. M. – Stehrer, R. (2014): Trade integration, production fragmentation and performance in Europe – blessing or curse? A comparative analysis of the New Member States and the EU-15. The Vienna Institute for International Economic Studies. Lin, J. Y. (2001): Comparative Advantage, Development Policy, and the East Asian Miracles. In: Stiglitz, J. E. – Yusuf, S. (eds.): Rethinking the East Asian Miracle. The International Bank for Reconstruction and Development / The World Bank, Oxford University Press. Lin, C. Y. Y. – Edvinsson, L. – Chen, J. – Beding, T. (2013): National Intellectual Capital and the Financial Crisis in Greece, Italy, Portugal, and Spain. Springer, New York. Mas, M. – Pérez, F. – Quesada, J. (2009): The Sources of Spanish Regional Growth and Convergence. Universidad de Valencia and Ivie. Mazzucato, M. (2013): The Entrepreneurial State., Anthem Press. Meardi, G. (2012): Peripheral convergence in the crisis? Southern and Eastern European labour markets and industrial relations. Paper for the SASE Annual Meeting, Boston, 28–30 June 2012. MNB (2008): Report on Convergence. Magyar Nemzeti Bank, Budapest. MNB (2014): Growth Report 2014 Magyar Nemzeti Bank, Budapest. Nelson, R. N. – Pack, H. (1999): The Asian Miracle and Modern Growth Theory. The Economic Journal, Vol. 109, No. 457. (Jul., 1999), pp. 416–436. OECD (2004): Economic Surveys – Portugal. Volume 2004/13, November 2004. Ó Gráda, C. – O’Rourke, K. (1996): Irish Economic Growth, 1945–88. In: Crafts, N. – Toniolo, G. (eds.): Economic Growth in Europe since 1945. Cambridge University Press, Cambridge, UK, pp. 388–426. Piatkowski, M. (2013): Poland’s New Golden Age, Shifting from Europe’s Periphery to Its Center. Policy Research Working Paper 6639, The World Bank. Pleskovic, B. – Stiglitz, J. E. (1997): Annual World Bank Conference on Development Economics 1997. The World Bank, Washington, D. C.

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Part I: International and national experiences in economic convergence Portugal, P. (2015): The Portuguese Economic Crisis: Policies and Outcomes. Policy Brief, Bertelsmann Stiftung. Powell, B. (2003): Economic Freedom and Growth: The Case of the Celtic Tiger. Cato Journal, Vol. 22, No. 3. Prebisch, R. (1950): The Economic Development of Latin America and Its Principal Problems. Economic Bulletin for Latin America 7, pp. 1–12. Reati, A. (2001): Total Factor Productivity – a misleading concept. BNL Quarterly Review, no. 218, September, pp. 313–332, Banca Nazionale del Lavoro. Richter, S. – Székffy, K. (1987): dasági és Jogi Könyvkiadó, Budapest.

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Rodrik, D. (2006): Goodbye Washington Consensus, Hello Washington Confusion? Journal of Economic Literature, vol. 46, No. 4., pp. 973–987. Rodrik, D. (2015): Premature deindustrialisation in the developing world. Vox.EU, 12 September, http://www.voxeu.org/article/premature-deindustrialiation-developing-world. Rohwer, J. (1995): Asia Rising. Touchstone, Rockefeller Center, Simon & Schuster, New York. Sakong, I. (1993): Korea in the World. Institute for International Economics, Washington, DC. Sakong, I. – Koh, Y., eds. (2013): The Korean Economy: Six Decades of Growth and Development. Cengage Learning Asia Pte Ltd., Singapore. Skolka, J. (1985): Entwicklungstendenzen in der Verflechtung von Nachfrage und Produktion in Österreich 1964 bis 1976. WIFO Monatsberichte vol. 58, issue 11, pp. 733–738. Stiglitz, J. E. – Yusuf, S., eds. (2001): Rethinking the East Asian Miracle. The International Bank for Reconstruction and Development / The World Bank, Oxford University Press. UNIDO (2013): Industrial Development Report 2013. Sustaining Employment Growth: The Role of Manufacturing and Structural Change. United Nations Industrial Development Organization. Vamvakidis, A. (2003): The convergence experience of the Greek economy in the EU: lessons for EU accession countries. National Bank of Poland, 23–24 October 2003. Viegas, M. – Antunes, M. (2013): Convergence in the Spanish and Portuguese NUTS 3 Regions: An Exploratory Spatial Approach. Intereconomics 48(1), pp. 59–66. Vietor, R. H. K. (2007): How Countries Compete. Strategy, Structure, and Government in the Global Economy. Harvard Business School Press, Boston, Massachusetts. WIFO (1981): Entwicklung der Arbeitsproduktivität in Österreich 1964 bis 1977. WIFO Monatsberichte 1/1981, pp. 19–31.

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2. Successful international experiences Williamson, J. (2000): What Should the World Bank Think About the Washington Consensus? World Bank Research Observer. Vol. 15, No. 2, pp. 251-264.World Bank (1993): The East-Asian Miracle, Economic Growth and Public Policy. Oxford University Press for the Word Bank. Young, A. (1992): A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore. NBER Macroeconomic Annual, Volume 7, pp. 13–54. ----------- (1995): The Tyranny of Numbers: Confronting the Statistical Realties of East Asian Growth Experience. Quarterly Journal of Economics, Volume 110, Issue 3, pp. 641–680.

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Financing economic convergence

Financing models from a macro perspective Balázs Kóczián – Péter Koroknai – Rita Lénárt-Odorán – Balázs Sisak

A high level of investments is of crucial importance in the convergence process, but the situation is far from being so straightforward in terms of the funding of investments. While there is a close link between investments and the size of domestic savings, consensus is lacking regarding the direction of the causation. In addition, attracting external funds may also be beneficial if these funds contribute to the implementation of more productive investments, as this can substantially increase an economy’s capital stock and productivity, and economic growth. Thus, overall, it can be stated that the financing of investments from domestic savings is essential for the financing of converging economies, but external funds may be an important supplement to them. Based on the theories, there is no uniform view on whether corporations’ external financing should be in the form of FDI or by increasing external debt. At the same time, the crisis shed light on the fact that the drying up of sources of finance can more severely impact countries with higher external debt. In addition, an influx of FDI has many indirect and positive impacts on other macro indicators which positively affect the growth and external perception of economies attracting FDI. On a macroeconomic level, FDI liabilities are generally regarded as a better source of financing compared to debt because they are generally spent on investments by the corporate sector. By contrast, excessive external household and public sector indebtedness involves sustainability risks. At the same time, it is also important to stress that FDI is only one possible source of investment financing; investments can also exert this positive impact if implemented from other sources through external or domestic loans.

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The experiences of successfully converging countries fundamentally corroborate the view that many different paths can lead to convergence, as the various groups of countries that have successfully broken away from the middle-income group followed largely different paths. In the Tiger Cub Economies of Southeast Asia, the very high investment necessary for convergence was mainly funded by domestic savings, along with a strong state role. An economic policy that fosters export generally results in a current account surplus, while net external debt decreases. By contrast, for the EU’s convergence countries, the process typically started out with higher net borrowing, which more or less disappeared as development grew. As in the aforementioned Asian countries, the state also assumed an active role, and the influx of FDI was negligible; the current account deficit was mainly financed by external borrowing. For the newly acceding EU member states, investments far outstripped domestic savings, and accordingly this is where the stimulating impact of external funds on growth was the most apparent. The relatively high current account deficit was mainly financed by the influx of FDI, while external debt also increased slightly. The low external debt ratios and the low renewal requirement made these economies more resilient in the face of the crisis. By contrast, the excessive indebtedness of the general government and households in Hungary before the crisis created reliance on external funds and a rise in external vulnerability. Along with the experiences of successfully convergent countries, the Mediterranean countries can serve as a counter-example, where the catchingup process proved unsustainable in light of the financial crisis. In their case, the earlier characteristic rapid economic growth was coupled with excessive external and internal indebtedness. All of this – presumably together with the less flexible economic structure due to the introduction of the euro – necessitated substantial adjustments in the aftermath of the crisis and may lead to the renewed decline of certain national economies.

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3.1 Introduction Our analysis focuses on the net lending and financing structure of converging economies. We investigate the extent to which economies successfully converging to high-income status (Southeast Asian countries, Finland, Austria and Ireland among the converging European countries, and Slovakia and Poland in Hungaryâ&#x20AC;&#x2122;s region) rely on domestic and external funding, and the role of FDI within external funding. In general, the literature regards external indebtedness as an adverse process during the initial phases of convergence, and a high ratio of FDI funding as positive. An overview of the literature investigating external financing reveals that there is no single recipe for choosing between the various types of funding: debt financing is not necessarily bad in the corporate segment, but an influx of FDI may convey a negative message regarding a specific economy. The convergence periods of the countries under review also exhibit diversity: convergence materialised alongside domestic savings in some places, and accumulating external debt or significant FDI in others. Our analysis is structured in the following manner: we first present the key messages of the relevant literature and outline a few fundamental empirical correlations between savings, investment and external financing. We then specify the external financing position of these country groups, the relationship between savings and investments and the role of various forms of financing. Lastly, in addition to successfully converging economies, we address the indebtedness process of Southern European economies (Spain, Portugal, Italy, Greece), which subsequently proved unsustainable, and the lessons that can be drawn from them.

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3.2 Theoretical background and stylised facts Based on economic theory, domestic savings foster economic growth and higher growth potential can be achieved alongside higher savings rates. External funding may also play a pivotal role in converging economies, and the intense absorption of external funding may give rise to external imbalances and external indebtedness. In terms of financial stability and sustainability, the relevant question in this case is: What purpose does the economy use external funding for? “Good” indebtedness from this perspective consists of channelling a high ratio of external (and domestic) funds into investments that contribute to boosting productivity, and thus “cover” the cost of funding by increasing future income. The positive impact of FDI on growth has been confirmed by numerous studies; it must be added, however, that investments may also be carried out using other debt funding as well. Distinguishing FDI from debt within the corporate sector is therefore not necessarily warranted from a financing perspective.

3.2.1 Convergence fuelled by domestic or external funding?

One of the fundamental questions of convergence is whether the necessary investments should be financed from domestic or external funding. That is because if the investment requirement within a national economy exceeds domestic savings, it is satisfied through external financing. The current account balance (CA), i.e. the difference between exports (X) and imports (M) and the sum of the balance of foreign incomes and transfers, is equal to the difference between gross savings (S) and investments (I), where domestic savings is the portion of disposable income not spent on consumption. X – M + net income and transfers = CA = Y – C – I = S – I In an open economy, investments are thus financed not only from domestic, but also from foreign savings. Open economies thus — 142 —

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accumulate liabilities vis-à-vis the rest of the world through the current account deficit. The current account deficit in this case stems from the fact that insufficient national economic savings are incapable of financing the investments needed for convergence. In more rapidly growing, but weakly capitalised countries, the current account deficit may also indicate that there are more investment opportunities than available domestic funds. An influx of foreign savings may also indicate that return is relatively high in the economy, which thus offers an attractive investment destination for nonresident investors. Less developed economies are characterised by lower wage costs and higher capital incomes compared to richer advanced economies, and so according to neoclassical economics, capital flows from rich, advanced economies into more underdeveloped countries lacking in funding. On this basis, it seems that using foreign savings is beneficial to both underdeveloped domestic and developed nonresident economic agents, representing an opportunity for higher income. At the same time, high external financing may increase the economy’s external vulnerability and thus may even reduce the economy’s potential growth. Based on the foregoing, it begs the question of whether a developing economy can rely primarily on external savings to finance the investments necessary for its convergence. Although according to the theory, investments financed from external liabilities lead to a higher income level in the long run both domestically and abroad, the final outcome may be negatively impacted by numerous factors. Low domestic savings and a high external financing requirement may dampen potential growth through multiple channels (Erhart et al. 2014). • If external funds are not used for investment, but rather for consumption or fiscal spending, it entails sustainability risks and may later restrain economic growth through the interest expenditures payable. — 143 —

Part I: International and national experiences in economic convergence

• If external financing is not denominated in the domestic currency, it may further exacerbate external vulnerability, as a potential depreciation can significantly reduce spendable incomes and thus indirectly even future investments. • If a country’s vulnerability increases due to external financing, it can create a problem particularly during times of crisis: in a crisis situation coupled with the withdrawal of capital, sources of finance dry up, which may not only decrease the investments of the corporations directly affected, but also harm overall investor sentiment, which may broadly undermine economic growth.55 Numerous empirical studies that investigate the direction and closeness of the relationship between investment and savings can be found in the literature. According to several empirical studies, net capital flows do not flow from high-income countries towards low-income countries (“Lucas paradox”, Lucas 2010) as claimed by neoclassical theory. Differences in fundamental factors and information asymmetry among nonresident investors is generally offered as the explanation for the Lucas paradox (addressed later). According to the Feldstein–Horioka puzzle (Feldstein–Horioka 1980), also based on an empirical approach, there is a strongly positive correlation between savings and investments, which also suggests that – contrary to the conclusions of the theory presented earlier – it is primarily domestic savings that finance the majority of domestic investments within the global economy. Although the positive correlation between domestic investments and savings has weakened significantly over the past two decades, this has primarily affected advanced economies (Blanchard and Giavazzi 2002). On an international scale, there is still a positive correlation between domestic savings and investments. Although consensus is lacking regarding the direction of the causal relationship in the literature, 55

György Matolcsy’s book Balance and Growth (2015) provides an in-depth analysis of the link between external indebtedness and growth.

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3. Financing models from a macro perspective

there is a robust link in an international comparison (Chart 3-1). According to the data, investments are high in economies exhibiting an elevated domestic savings rate. A high level of investments may increase potential output, which may lead to more rapid convergence by improving productivity. At the same time, it should be noted that in accordance with the theory, domestic savings generally exceed investments in advanced economies, while the opposite holds true for converging economies. Chart 3-1: Relationship between saving and investment rate on crosssectional data (average of 1990-2013) 35

Total investment as a percentage of GDP

SK LV 25 HU

LT 20

AU CL

FI BE PH BG MX FR DE SE NL IS CO CA IE DK PL US IT BR GB ZA AR NZ

15 20 25 Gross saving as a percentage of GDP

Source: WEO database

In the case of less developed countries, domestic financing may be particularly important, as the data show that it enables more stable and higher economic growth in the longer run (Prasad et al. 2007). The self-financing ratio shows the portion of the capital stock financed from domestic savings. In an article published in 2013, employees â&#x20AC;&#x201D; 145 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

of the Turkish central bank (Ganioğlu 2013) investigated a selffinancing indicator calculated separately for converging and advanced economies and found that in low-income countries, the self-financing ratio exhibits a positive correlation with average real growth, while in higher income countries, such a correlation is less apparent (Chart 3-2). This is corroborated by the study according to which domestic savings must be regarded as a form of collateral from the perspective of nonresident liabilities in countries that are technologically lagging, thereby improving nonresident investor confidence in new projects and mitigating the risks accompanying a drying-up of capital inflows (Aghion et al. 2009). At the same time, the positive correlation does not mean that a higher self-financing ratio can lead to faster convergence. The case of Korea in 1997 highlights that the growth sacrifice of a balance of payments crisis may be lower in countries with a higher self-financing ratio (Aizenman 2007).

domestic savings and economic growth Proportion of capital stock financed by internal savings (1993–2010) 1.4 Emerging Developed economies economies NO 1.3 1.3

1.4

1.2

CN TH ZA ID CL AR TR MX 0.9 ES BR PH CY CO PE PL RO 0.8 PT SK BG HU 0.7 0 2 4 6

1.1

1.1 1.0

1.0

NP SE FI

DK FR AT CA

DE IT

0.9

GB US

Per 12 cent

0.7

0.8

Average of GDP growth (1993–2010)

— 146 —

KP IE

Per 12 cent

3. Financing models from a macro perspective

The economic crisis drew attention to the importance of external imbalances: to scenarios where imbalance is good and bad, and when it can be considered sustainable. For instance, the literature regards it as a good imbalance when an aging society has a current account surplus, to cover subsequent high pension expenditures, or if the current account deficit mainly finances investments (Blanchard– Milesi-Ferretti 2009). At the same time, high domestic savings are not necessarily healthy if the population exhibits high propensity to save due to precautionary considerations (for instance due to the shortcomings of the social security system). However, low domestic savings or growing government indebtedness are unequivocally bad imbalances. According to one approach offered in the literature, the current account deficit is sustainable if net external debt indicators stabilise over the medium term (Lane–Milesi-Ferretti 2006). According to another popular approach, imbalance is considered sustainable if it does not diverge from the level explained by economic fundamentals (Phillips et al. 2013). Therefore, according to the literature, we can conclude that high domestic savings are fundamental for successful convergence, and nonresident funding focusing on investments may be an important supplement to it, which is capable of accelerating economic growth. In economies lacking capital, attracting foreign capital is necessary for raising the economy’s technological level. However, foreign financing cannot replace domestic savings. If a high savings rate can act as an incentive for foreign capital inflows while alleviating the financing constraints of resident corporations, more rapid economic growth can be achieved through a rise in the investment ratio.

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Part I: International and national experiences in economic convergence

3.2.2 Choice between debt and non-debt type funds

In addition to investigating the necessity of external financing, its various forms are also worth looking at. We sought to answer the justifications driving the choice between debt or equity, or whether any justification can be provided at all. The general government and households characteristically rely on debt-type funding. The state finances its fiscal deficit by issuing bonds and borrowing, while households generally take out consumption and housing loans. In terms of the state’s financing, it may come into direct contact with the nonresident sector as some of the government securities issued by it are purchased by nonresident investors. By contrast, the household sector becomes indebted mainly towards the domestic banking system. As the banking system may also seek external liabilities to fund domestic lending, domestic indebtedness comes into play indirectly in a country’s external financing via the banking system’s external financing. It is worth noting that among the various types of financing, indebtedness linked to household consumption and the state – characteristically not used to finance investments – is considered the riskiest type of financing. Within corporate sector financing, equity funding is also characteristic alongside debt, and the choice is primarily between these two types of financing within the sector. When a firm acquires ownership, a stake in another firm, or a loan is granted within the corporate group, it is referred to as foreign direct investment (FDI). Corporate financing may therefore take on several forms: bank borrowing, corporate bond issuance or financing through direct equity holdings. The key difference between FDI and debt financing is that while the debt funds have a definite maturity and are associated with interest payments, shares have no maturity and acquiring them conveys ownership rights and dividend payments. At the same time, it is important to note that irrespective of maturity, the investor may alienate either type of

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financing, whether it be – debt – government securities (selling them prior to maturity) or an equity investment (by selling the ownership share). Box 3-1:

Corporations’ capital structure can be approached from the aspect of the determinants of financing decisions. The Miller–Modigliani theorem (1958) proposes that alongside perfect capital markets and a neutral tax regime, corporate financing policy does not influence a firm’s value. However, by easing the basic assumptions, we can identify factors that may impact a firm’s financing decisions. The following section takes a look at the literature on corporations’ capital structure. Among the theories linked to financing decisions, the trade-off and pecking order theories are worth highlighting, as the majority of the relevant literature addresses these theories and tests their conclusions on an empirical basis. • The trade-off theory generally leads to the conclusion that corporations move towards a lower level of debt when faced with weaker profit prospects. According to the theory, firms take into account tax rules, the cost of finance and the costs of a potential bankruptcy and strive to achieve a level of debt deemed optimal on the basis of these factors. In their financing decisions, it is important that their debt converge towards this level, which is deemed optimal. In this framework, expected profitability influences indebtedness positively, in other words, firms tend to further reduce their indebtedness if their income prospects are weak. The impact of company size is also positive, linked to the costs of a potential crisis: a larger firm will have a more diversified capital structure and the onset of a crisis will incur lower costs for it. • According to the pecking order theory, debt is contracted when an investment exceeds the amount of reinvested earnings, in other words, at a given level of investment, less profitable companies contract

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Part I: International and national experiences in economic convergence

more debt. The pecking order theory loosens the assumption linked to perfect capital markets and places emphasis on the role of information asymmetry (Myers 1984). The theory postulates that firms first use their reinvested incomes, that is, internal financing to finance their investments. Once the investment exceeds these reinvested earnings, the firm seeks debt financing, and only after this is depleted does it resort to equity-type forms of financing. As another entity acquires ownership, the opportunity for external control is greater in this case. Under this approach, less profitable firms become indebted, in addition to those for which the expected investment is higher at a given profitability level. However, according to another interpretation of the theory, higher investments are carried out alongside lower levels of debt, taking into account the future costs of financing. A firm is able to do this by paying low dividends during the period, or by raising equity (Fama–French 2002). The two main theories arrive at contradicting conclusions in certain cases, and their conclusions cannot be necessarily justified empirically. According to the trade-off theory, an increase in debt may reflect profitability that is deemed positive, while the pecking order theory posits that a rise in profitability pushes firms towards internal financing (reinvested earnings). These two theories, for instance, arrive at contradicting conclusions in a scenario when the firm’s current level of debt is higher than optimal and the firm must make a decision on financing (de Jong-Verbeek-Verwijmeren 2011). The trade-off theory projects a reduction in debt, while the pecking order theory projects a further increase in debt. When the firm decides on the repayment of its debt and its current level of debt is below optimal, according to the trade-off theory, it will pay back share-type liabilities (thus approaching the optimal debt level), while according to the pecking order theory, it will pay back debt. (In the other cases – for instance when the level of debt is below optimal – the different theories yield identical conclusions, both suggesting an increase in debt). Some of the studies in the literature corroborate certain conclusions of the

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3. Financing models from a macro perspective

pecking order theory: these include Fama and French (2002), Lemmon et al. (2008), Ghazouani (2013), while others – Fama and French (2002), Frank and Goyal (2009) – corroborate certain conclusions of the trade-off theory. External financing for the corporate sector can also be approached from the side of nonresident investors: high FDI financing is not necessarily a positive phenomenon, as it may reflect uncertainties about the economy. Equity investments convey far more information and control rights compared to debt-type investments (see: the above papers and Neumann 2003). Based on this train of thought, nonresident investors show a preference for the forms of financing that decrease their information disadvantage. According to Komáromi (2007), based on another approach, nonresident agents will prefer forms of investment exhibiting low “expropriation” risks. Daude and Fratzscher (2006) confirmed empirically that the role of FDI in financing is higher in countries with a weaker institutional system or a poorly developed financial system. Therefore – although FDI may have a positive impact on the economy of the destination country – a high influx of FDI compared to other forms of financing may be linked to the economy’s lack of development. The data pertaining to European countries confirm this: a look at the data for 2007 reveals that in countries with higher GDP per capita, the ratio of FDI within total external debt is generally smaller. (See Chapter 2.3 for more in-depth information on this).

FDI funds are generally regarded as a better source of financing compared to debt because they are generally spent on investments by the corporate sector (Chart 3-3). Elevated FDI financing most probably reflects the implementation of investments, while debt is not necessarily used for funding investments. From the perspective of stability and sustainability, the sectors that attract external funds and what they use them for are relevant. Debt financing within the corporate sector may be channelled into investments just like FDI, therefore distinguishing debt and non-debt financing is not necessarily warranted at the corporate

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Part I: International and national experiences in economic convergence

level. However if households and the state become indebted, it may entail sustainability risks. Chart 3-3: Illustration of the risks linked to various

ain

Government debt

ust

sin

rea

Inc

Household indebtedness

isk

ilit

Corporate loans Foreign direct investment

Source: MNB

The benefits often associated with FDI financing cannot necessarily be justified at the corporate level, and therefore distinguishing the different forms of financing is not necessarily warranted. According to the literature, there is no uniform view on the fundamental determinants of corporate financing structure, and the different theories cannot necessarily be corroborated empirically. Based on this alone, we can conclude that there is no clear formula for the form of financing that is warranted during a period of positive investment prospects, characteristic of convergence (for more in-depth information on the theories on corporations’ capital structure, see Box 3-1 entitled Theories on corporations’ financing decisions). At the same time, the question arises whether certain benefits in terms of financial stability, sustainability or other factors are associated with various forms of financing. According to Komáromi (2007), the potential stability of non-debt financing and the associated positive externalities can both be called into question.

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3. Financing models from a macro perspective

The author concludes that the level of external funds, rather than its structure, is decisive in terms of sustainability. Preference for FDI can further be nuanced by taking into account the yields paid on FDI: within the Hungarian economy, FDI is a far more expensive form of financing compared to debt. Box 3-2: The economy’s disposable income

The most widespread indicator used as a metric of growth is gross domestic product (GDP), which only measures the income produced, but conveys no information on developments in the situation of individual institutional units. This is what gross national product (GNI) is used for, which adjusts GDP with net foreign income transfers and ultimately shows the disposable income of a country’s residents. Formally: GNI = GDP + Incomes received from abroad (profit, interest, wages, EU transfers) – Incomes paid abroad (profit, interest, wages, EU transfers) As presented earlier, converging economies – including Hungary and the countries in its vicinity – are characterised by an influx of FDI. Due to the cost of FDI, GNI is thus lower than GDP (Chart 3-4). Therefore, while in general greater growth can be achieved through the investments implemented using external funding (FDI or foreign loans), this may also come at a significant cost. It is worth noting that the profit paid on FDI is generally higher proportionally to the capital invested than the interest paid on a similar loan, as it may fluctuate due to cyclical reasons, and also represents greater risk. The chart clearly shows that in the countries in the region, the amount of net income paid to nonresident owners of FDI was around 2–6 per cent of GDP before the crisis. The larger shortfall in GNI in Hungary stemmed from significant foreign indebtedness and an elevated volume of FDI, and

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Part I: International and national experiences in economic convergence

the high profitability of nonresidents’ FDI in the Czech Republic (developments in Czech FDI are particularly interesting in light of the fact that the country’s net external debt is negative, i.e. their external assets exceed their liabilities). In the years following the crisis, the gap between GDP and GNI narrowed in Hungary, driven by several factors: for one, corporate profitability deteriorated in the wake of the crisis, and external debt also shrank substantially as a result of deleveraging by domestic agents, fostered as well by the interest environment, and finally, the influx of EU transfers also rose gradually. Chart 3-4: Developments in gross national income in the region 102

Percentage of GDP

102

Hungary

Czech Republic

Source: MNB

— 154 —

Poland

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

100

2000

100

Slovakia

3. Financing models from a macro perspective

3.2.3 Relationship between FDI in growth

Foreign direct investments – both over the short and longer run – may foster economic growth through numerous channels. One type of external financing is foreign direct investment (FDI), which gives nonresidents long-term influence in a corporation, or consists of establishing a new corporation in the context of a greenfield investment. Incoming FDI may also be perceived as positive from the perspective of economic growth, as FDI may drive GDP growth in the short run by increasing investments. In the longer run, higher production activity, improved productivity thanks to investments, growing consumption driven by employee incomes and rising net exports driven by corporations’ export performance may all shape growth. It should also be mentioned that in addition to a growth impact, FDI can also improve the general government balance by boosting tax receipts, thereby contributing to reducing government debt and thus risk spreads. Along with its direct impacts, foreign direct investment is generally associated with numerous indirect impacts. Much of the literature focuses on the relationship between FDI and growth, and essentially identifies two types of impacts on growth. • Direct impact: The primary direct impact of FDI may be growing investment through the newly created enterprise, and higher production later on. In this regard, it is generally mentioned – primarily in converging economies – that the productivity of enterprises with nonresident owners generally exceeds the productivity prevailing in the country on account of its know-how accumulated earlier and higher capital stock.

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Part I: International and national experiences in economic convergence

• Indirect impact: At the same time, numerous indirect impacts are often mentioned in relation to FDI. Completed investments may inject new know-how and technology into the economy, which may have a positive impact on other operators’ productivity. Employees gain familiarity and learn to use the new technology, and may later transfer this know-how to other domestic corporations, further improving productivity across the entire economy. Supplies to nonresident corporations may also play a particularly important role, as technological progress may be greater in these sectors. These are generally referred to as spillover impacts. At the same time, it is worth noting that such investments can be completed from other sources of funding besides FDI or external funds. The literature generally identifies a positive correlation between FDI and economic growth, but the strength of the impact can be influenced by numerous factors (such as the level of development, the qualification of human capital or financial system development). According to certain theories, the growth impact of the funds also depends on the level of development of the destination economy. Wellqualified labour may be necessary on one hand for FDI to create a larger growth impact than investments completed from domestic funds (Borenstein et al. 1998). Moreover, the development of the economy’s financial system is also vital for FDI to make a meaningful contribution to economic growth (Alfaro et al. 2004). Technological development is generally not only observed in the enterprise directly receiving the funding, but may also have an indirect impact on other enterprises in the sector. It could have a further positive impact if it engages in supply activities for a company with a nonresident owner. When measuring the indirect impacts in Hungary, Schoors and van der Tol (2001) found that the spillover effects are particularly significant in foreign trade sectors, i.e. it is in these sectors that foreign investments have the greatest impact

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3. Financing models from a macro perspective

on the productivity of competitors and the sector as a whole. At the same time, due to strict commercial rules, technological development and rising productivity may be lower (Mastromarci and Simar 2015). Halpern and Muraközy (2005) examine Hungarian corporate data and find that FDI exerts a positive impact on not only the specific corporation, but also other corporations located physically further from the investment. Engaging in supply to a foreign-owned company may also have a positive impact on the applied technology, as demonstrated by Gorodnichenko (Gorodnichenko et al. 2014) based on his estimations. According to the theories, the growth impact of FDI is significant in converging countries, while a similar impact can only be identified in certain sectors of advanced economies. All of this also suggests that in more advanced economies, FDI may play a smaller role in financing. Some of the theories found that FDI only exerts a truly significant growth impact during the early phases of convergence, and its role diminishes during later phases. A paper by Castejon and Wörz (2006) confirms this outcome, finding that FDI yielded greater growth impacts in certain sectors. For one, this holds true in particularly labour-intensive sectors (such as the textile and wood industry) and technology-intensive and thus capital-intensive industries (such as the oil and chemical industry). According to this idea, the authors find that FDI may have a greater impact on growth in converging economies, while in advanced economies, FDI has a growth impact in technologyintensive sectors. Komáromi (2007) also refers to this, stating that more advanced economies tend to seek out debt funding instead of FDI (Chart 3-5).

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Part I: International and national experiences in economic convergence

Chart 3-5: Link between FDI and economic development 70

FDI stock/External liabilites (per cent) SK

60 CR

50 RO 40

HU EE

LT 30

DK FL

10 0

SI GR

100

GDP per capita (on PPP, USA =100) Note: 2007 data. The Greek, French, Slovak and Romanian data were only available for 2008. Source: Eurostat, WEO database

In the early 2000s, the influx of FDI contributed to the growth of economies in the euro area and Central Eastern Europe. Although according to the theories, FDI plays a smaller role in the growth of advanced economies, Pegkas (2015) nevertheless empirically demonstrated that the influx of FDI also contributed to the growth of euro area countries between 2002 and 2012. By contrast, looking at Central and Eastern European countries, Szkorupová (2014) found that rising exports play a bigger role in economic growth than the influx of FDI. However, the author identified a long-term correlation between the influx of FDI and growth in the case of Slovakia, on the basis of which FDI may have contributed to economic growth. On the basis of the above, an increase in FDI may materially support the growth and convergence of an economy both over the short and the longer run. Therefore, a rise in external debt in the wake of foreign

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3. Financing models from a macro perspective

direct investment may be beneficial to converging economies. We also investigated the correlation in the countries of the European Union, where the countries attracting more FDI exhibited faster economic growth (Chart 3-6). According to the literature, this may suggest to that FDI was coupled with higher GDP growth in these countries, however it should be noted that higher growth was observed in converging countries. This corroborates the theory that the impact of FDI is greater in converging countries compared to advanced economies. Chart 3-6: Developments in FDI* and GDP growth in EU countries 5

GDP growth

PL RO

SE FI 2

AT PT

DE DK

IT 0 –4

–2

Foreign direct investments (as a percentage of GDP)

Payments Manual). Source: Eurostat

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Part I: International and national experiences in economic convergence

economic convergence In the following section, we present the aspects discussed in the previous chapters through the convergence periods of countries that managed to climb from upper-middle income status to high-income status. When defining phases of convergence (similarly to the previous chapter), our starting point was Felipe’s (2012) paper. These are the following: • Southeast Asia (Korea 1988–1995, Singapore 1978–1988, Taiwan 1986– 1993) • Austria 1964–1976 • Finland 1964–1979 • Ireland 1975–1990 Although Poland and Slovakia have not yet joined the high-income group, they have a good chance of doing so based on the past period, and so their experiences may also be useful for us. We also present the indebtedness process of Southern European economies (Spain, Portugal, Italy, Greece), which subsequently proved unsustainable. We focus primarily on external balance processes, taking an approach from the side of domestic savings and investments. Where data are available, we also examined the external financing structure in greater depth, in particular emphasising the role of FDI in funding.

3.3.1 Tiger Cub Economies of Southeast Asia: South Korea, Singapore, Taiwan

The main driver of economic growth in the Asian Tiger Cub Economies, successfully converging towards advanced status, was generally export growth, which was followed by a rise in investments in profitable industries. The common trait in these countries was that

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3. Financing models from a macro perspective

much of the growth materialised alongside rapid export growth. In addition, the driver of economic growth in these countries was generally exports, and a rise in imports only followed with a substantial lag. The rise in exports thus created profitable industries and generally led to a more rapid rise in investments. In a nutshell: economic convergence was achieved thanks to dynamic export growth (Booth 1999). In Southeast Asia, numerous government measures – both direct and indirect – fostered export-oriented industries; these included capital controls. According to Stiglitz (1996), the common trait among Southeast Asian countries was that governments supported exports and technological development. Strong exports also bolstered the economy’s competitiveness to a greater extent than a scenario driven solely by corporations producing for domestic markets, as there is a greater possibility of competition emerging on export markets compared to a domestic, closed market consisting of fewer players. Infrastructure developments played a pivotal role in fostering production for export markets, including the active development of electricity and telecommunications networks as well as ports and transportation routes. The state contributed to the development of export industries by facilitating greater access to capital, and in some cases, through tax incentives to select industries. The strict regulation of imports also contributed to the development of export industries in these countries. All exporting firms were granted exemptions from these rules in each of these countries (Krueger 1990). High investments as a percentage of GDP played a pivotal role in the rapid growth exhibited by Korea, Singapore and Taiwan, which was also financed by domestic savings to a large extent, and thus the current account only turned into a deficit to a small extent and temporarily. As a general observation, investments played an important role in the nearly 10 per cent average GDP growth that accompanied the rise of the three Tiger Club Economies from upper-middle income to high-income status (Chart 3-7). They amounted to 35–40 percent of

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Part I: International and national experiences in economic convergence

GDP in Korea, which, coupled with high domestic savings, allowed to the current account to remain balanced, and thus investments to be predominantly completed from domestic funds. The investment ratio was even higher during certain periods in Singapore, standing at 45 per cent of GDP, which, however, was not funded by high domestic savings, but was accompanied by significant external financing. However, the continuous rise in domestic savings and the subsequent decline in the investment ratio to 35 per cent of GDP turned the current account deficit into a surplus, and thus external debt indicators decreased in Singapore by the end of its convergence. Taiwan saw a significant rise in investments during the period, even though they only amounted to 25 per cent of GDP on average, and were fully completed from domestic funding; therefore, the current account continuously exhibited a surplus. Chart 3-7: Investments and savings, and developments in the current account in Southeast Asian countries 25

Percentage of GDP

50 45

–5

–10

–15

1988 1989 1990 1991 1992 1993 1994 1995 1980 1981 1982 1983 1984 1985 1986 1987 1988 1986 1987 1988 1989 1990 1991 1992 1993

Korea

Singapore

Investment (right-hand scale) Savings (right-hand scale) Source: IMF, Central Bank of Korea

— 162 —

Taiwan Current account GDP growth

3. Financing models from a macro perspective

Broadly speaking, during their convergence period, the countries under review (with the exception of Singapore) did not attract FDI and also deleveraged their debt liabilities. This is consistent with the theory that these countries were no longer in the initial phase of convergence, when FDI plays a more prominent role in financing convergence. FDI played an important role during the initial phase of economic development in developing countries, although there is substantial heterogeneity in terms of the volume of incoming funds. From a financing perspective, FDI contributed to the initial phase of capital accumulation in Southeast Asian countries. Here, the know-how accompanying FDI should also be mentioned, as foreign investment substantially developed the technologies used, bringing new knowhow into the economy. However, its extent differed from country to country (Booth 1999): • In Korea and Taiwan, FDI only financed a mere 1-2 per cent of investments on average between 1970 and 1990. High domestic savings significantly drove a rise in the economy’s claims on the rest of the world. This was primarily reflected in an increase in external assets, with particular emphasis on the role of central bank reserves. • During the same period, in Singapore over 15 per cent of investments were financed by FDI, and this ratio even increased to nearly 30 per cent between 1986 and 1990. The influx of FDI remained high during the convergence years, and did not dry up with the restoration of current account equilibrium – thus net external debt further decreased parallel to a rise in FDI (in the form of growing external assets). Despite the fact that FDI only financed a smaller portion of investments, it nevertheless played an important role in technological progress. However, because investments exceeded domestic savings, the current account deficit was primarily financed by an influx of debt liabilities

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Part I: International and national experiences in economic convergence

during this period, contracted partly by the state and partly by the private sector (Chart 3-8). Its level was relatively low, remaining below 1-2 percent of annual GDP, as the country did not need to attract additional external financing thanks to its high level of domestic savings.

Percentage of GDP

20 15

–5

–10

–15

–20

–25

1988 1989 1990 1991 1992 1993 1994 1995 1980 1981 1982 1983 1984 1985 1986 1987 1988 1986 1987 1988 1989 1990 1991 1992 1993

Korea

Singapore

Debt-type financing Transactions related to derivatives

Taiwan Non-debt type financing Net borrowing

of zero. Source: IMF, Korean central bank, MNB calculation

By and large, convergence in Southeast Asian countries may have been facilitated by active steps taken by the government in support of foreign trade, as well as an influx of FDI and know-how during the initial phase of convergence. At the same time, the elevated domestic

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3. Financing models from a macro perspective

savings played a far larger role in the convergence of the Tiger Cub Economies, along with the high investments in foreign trade sectors that had materialised earlier. Thus, these economies relied far less on external financing during this phase of development.

3.3.2 EU convergence countries: Austria, Finland and Ireland

Austria’s convergence materialised in conjunction with a balanced current account, i.e. domestic savings broadly covered investments, and external financing was not needed despite the elevated 4–6 per cent rate of real growth. After the collapse of the Bretton Woods system, Austria introduced a narrow intervention band system. It initially pegged its own currency to a currency basket, and then to the Deutschmark in an effort to mitigate the uncertainties stemming from exchange rate fluctuations. The domestic market was protected against speculative capital movements with capital controls in the interest of exchange rate regime sustainability (Fenz–Schneider 2006; Hochreiter– Knöbl 1991). The current account deficit was close to zero during the convergence period under review, until the first oil crisis hit in 1974. The same period was characterised by an influx of FDI and shrinking net external debt, although neither to a significant degree. After 1974, as a result of the adjustment related to the oil crisis, the current account deficit rose substantially, which was reflected in the state’s foreign borrowing due to the restrictions on private capital movements that remained in force (Chart 3-9). Austria tried to offset the increase in inflation stemming from rising oil prices by appreciating the schilling while preserving competitiveness through administrative restrictions on wage growth (Gnan 1994). The country’s vulnerability – stemming from low net and gross external debt enabled by convergence achieved mainly from domestic funding – did not increase in earnest even after the oil crisis.

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Part I: International and national experiences in economic convergence

Chart 3-9: Financing structure of Austria’s convergence (1964-1976) 4

Percentage of GDP

Inflow

8 6

–1

–2

FDI Debt-type financing Net errors and omissions

1976

1975

1974

–6 1973

1972

1971

1970

1969

1968

1967

1966

1965

1964

–3 –4

–4

Outflow

–8

Current account Real GDP growth (right-hand scale)

Source: IFS

The convergence of the Finnish economy occurred with higher external imbalance compared to Austria, albeit not significant, and external indebtedness, while the state assumed a pivotal role in the convergence process. The investment ratio in the Finnish economy quickly rose to nearly 25 per cent of GDP after the Second World War, which the high gross savings were more or less able to finance until the mid-1970s. At the beginning of the convergence period, the state assumed its role in both investments through public corporations (heavy industry, energy industry) and the budget surplus, which peaked at 8 per cent of GDP (Jantti et al. 2006). The state intervened in the form of administrative price controls, and interest rates were kept low using administrative tools in an effort to incentivise investments. Due to the significant role assumed by the state through its public corporations, the influx of FDI was low during this period (Chart 3-10). In order to preserve competitiveness, the central bank depreciated the Finnish markka from time to time, moving within a narrow intervention band.

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3. Financing models from a macro perspective

These developments, coupled with the oil crisis, led to significant internal and external imbalances, reflected in high inflation and the spike in the current account deficit (Hochreiter–Knöbl 1991). After the tightening of fiscal policy and the depreciation of the markka, the current account deficit quickly improved and competitiveness was maintained. Chart 3-10: Financing structure of Finland’s convergence (1964–1979) 10

Percentage of GDP

Percentage of GDP 10 Inflow 8

8 6

–2

–4

–6

FDI Debt-type financing

–8 1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

1965

1964

–8 –10

–6

Outflow

–10

Current account Real GDP growth

Source: IFS

The convergence of the Finnish economy was not completed by the 1980s, and economic growth continued to remain high afterwards. The convergence of Finland’s economy from middle-income to high-income status was mainly defined by the productivity gains in manufacturing and the energy sector according to the literature on “latecomer” economies (Gerschenkron 1952; Kaldor 1967). The rapid development of the electronics industry, including Nokia, was decisive in the 1990s in terms of convergence. In addition, the rise in service sector productivity

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exceeded Sweden’s gains in productivity even before the oil crisis, and the difference increased further afterwards. Thus, during the period until the turn of the millennium, the development of the service sector alongside industry was pivotal for Finland, catching up to the Swedish economy (Kokkinen et al. 2007). During the period of dynamic growth characterising the Irish economy during the second half of the 1970s, the current account deficit rose to over 10 per cent of GDP, but underwent a major reversal in the years following the oil crisis. The deterioration in the external position primarily reflected the rapidly rising deficit in the balance of goods and services (net exports), linked to import demand in excess of exports. During these years, the external balance deteriorated while the budget deficit and government debt both swelled significantly. The economy was therefore in the state of a twin deficit when the oil crisis hit, and its reliance on external funding remained high during the years of the crisis. After the crisis dissipated, a gradual improvement materialised in external balance indicators: net exports was able to improve from year to year, accompanied by a pick-up in growth. The improvement in the external balance was driven, along with positive export performance, by a decline in investments and the more restrained import dynamics associated with it, while consumption grew on par with GDP. All of this occurred while the general government deficit also began shrinking and a significant turnaround in the direction of fiscal policy occurred, which played an important role in the subsequent convergence of the Irish economy (Honohan–Walsh 2002). The deficit – and also rapid economic growth – stemmed from investments that substantially exceeded the relatively low domestic savings. We can approach developments in the external imbalance from the perspective of the relationship between savings and investments (Chart 3-11). According to the available data, investments as a percentage of GDP significantly exceeded domestic savings at the beginning of the period. This also reflects that investments were

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3. Financing models from a macro perspective

implemented using substantial volumes of FDI. After the onset of the crisis, the external balance improved while the investment level decreased, and domestic savings also levelled out around 15 per cent of GDP. Chart 3-11: Developments in the fundamental determinants of the current account in Ireland 30

Percentage of GDP

GDP growth Current account

Gross savings Net export

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

–15

1978

–15

1977

–10 1976

–5

1975

–5 –10

Investments

Source: IFS and WEO database

Debt was the major form of funding in the Irish economy’s external financing structure, but was characterised by the repayment of external debt by the end of the period under review. The characteristically high current account deficit that persisted for several years was accompanied by an accumulation of external debt (somewhat mitigated by a rise in the foreign exchange reserve as the economy’s external assets). Net debt-type financing inflow was around 5 per cent of GDP on average in the years preceding the crisis (between 1975 and 1978), and far outstripped the influx of FDI. The role of FDI within financing structure was therefore not significant compared to

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debt: it only stood at no more than 2 per cent of GDP during the years characterised by high investment dynamics. In parallel with the external balance adjustment that characterised the post-crisis years, the rate of debt financing also decreased, and the data indicated a net decline in debt by the end of the 1980s as the current account balanced out. Debt financing was partly linked to the general government and partly to the banking system. At the beginning of the period – in parallel with a high deficit – the state increased significantly it’s external debt, while during the two years leading up to the crisis, the rise in external debt was driven more by the banking system (Chart 3-12). By contrast, during the years following the crisis, a clear change occurred, with the state’s external financing replaced by an outflow of funds, with the exception of 1987.

a percentage of GDP 15

Per cent

Inflow 10

Net Net Net Net

FDI external debt (including foreign reserves) borrowing (based on financial account) borrowing (current and capital account)

Source: IFS and WEO database

— 170 —

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

–5

1980

1979

1977

1976

1975

–10

1978

Outflow

–5

–10

3. Financing models from a macro perspective

3.3.3 New EU member states in the region: Poland and Slovakia

Slovakia and Poland, which are located in the same region is Hungary, grew during the second half of the 1990s and the 2000s in the context of lively investment dynamics and rising consumption. Both economies exhibited a similar growth structure in the period between 1995 and 2008. During the second half of the 1990s and in certain years following accession to the European Union, GDP growth over 5 per cent materialised together with high investment dynamics, while household consumption was also elevated, but typically fell short of GDP growth (Chart 3-13). Chart 3-13: Real growth in the components of GDP in the region 30

Per cent

0 –5 –10

–15

–20

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

–5 –10

Slovakia GDP Import

Poland Export Investment

Household consumption

Source: IFS, Eurostat

Along with dynamic growth, Poland’s current account deficit was under 5 per cent, while Slovakia’s current account deficit was above 5 per cent on average, which was not considered high in the Central and Eastern European region. In Slovakia the investment level reached — 171 —

Part I: International and national experiences in economic convergence

as high as 35 per cent of GDP in the second half of the 1990s, followed by a trend-like decline in investments as a percentage of GDP in the period leading up to the 2008 crisis. A similar trend emerged in Poland, but the level of investments was lower (25 per cent of GDP) compared to Slovakia (Chart (3-14). Meanwhile, in both economies the level of gross savings, with the exception of a year or two, did not diverge materially from investments, meaning that their external financing was not salient. In the case of Slovakia, although a current account deficit of around 10 per cent emerged in the second half of the 1990s, this high external dependency was quickly corrected and the economy continued to grow, with a current account deficit of 6 per cent on average (between 1999 and 2008), also driven by gradually improving net exports. Chart 3-14: Developments in the fundamental determinants of the current account in the region Percentage of GDP

Percentage of GDP

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

40 35 30 25 20 15 10 5 0 –5 –10

Slovakia GDP growth Current account

Poland Gross savings Net export

Source: IFS and WEO database

— 172 —

Investment

40 35 30 25 20 15 10 5 0 –5 –10

3. Financing models from a macro perspective

The Polish economy’s initially lively growth in investments was also coupled with a deteriorating net borrowin, with the current account deficit averaging 5 per cent in the 2000s. It should also be added that the income balance deficit contributed increasingly to the two countries’ net lending: the growing external debt entailed rising interest and profit outflows. According to Ca’ Zorzi (Ca’ Zorzi et al. 2009), the external imbalance of Visegrád countries was consistent with economic fundamentals and a stable external debt trajectory based on estimations. The 1990s were characterised by a high net borrowing from nonfinancial corporations, but the corporate and state net borrowing decreased by the years leading up to the crisis. The sectors that become indebted and the ones that rely on external financing are relevant from the perspective of external sustainability. A high corporate net borrowing naturally accompanies buoyant investment periods (Chart 3-15). During the initial phase of this convergence period, households’ high net lending offset this in both Poland and Slovakia. At the same time, the easing of liquidity constraints, an increase in household indebtedness and a decline in net savings naturally accompany the development of the financial system. In the case of both Poland and Slovakia, we observed that in parallel with a decline in household savings, corporations’ net borrowing also shrank, in other words, private sector saving developments did not put pressure on the banking system, requiring it to access external funding due to insufficient domestic funding. In terms of the budget position, the 1990s in Slovakia and the 2000s in Poland were punctuated by periods with a higher net borrowing, however these had reversed by the 2008 crisis.

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Chart 3-15: Net lending of various sectors within the region, transactions as a percentage of GDP Per cent

Per cent

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

10 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

Slovakia

10 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

Poland

General government Non-financial corporations

Household sector

Source: Eurostat

FDI played a pivotal role in the financing of the Slovakian and Polish economies. The Polish economy already started seeing an intense influx of FDI in the 1990s, while this materialised somewhat later in Slovakia, from the 2000s (Chart 3-16). Therefore, other forms of funding (bank or foreign loans) may have presumably initially contributed to financing the significant investment growth observed in Slovakia. At the same time, the intense influx of FDI in Poland was consistent with the initially elevated net borrowing of the corporate sector. According to Ca’ Zorzi (Ca’ Zorzi et al. 2009), the role of FDI in external financing was also high in other countries in Central and Eastern Europe: FDI funds accounted for over 100 per cent of the economy’s current account deficit in the Czech Republic and Bulgaria (based on average values between 2000 and 2007). In the Slovakian economy – in contrast to Poland – debt still played a significant role in the 1990s. Until the 2000s, debt-type liabilities — 174 —

3. Financing models from a macro perspective

were predominant within the external financing structure, which the corporate sector and the banking system both contributed to according to the sectoral breakdown available for other investments. The financing of corporate investments may therefore have partially relied on the banking system and partially on foreign borrowing. At the same time, debt financing in Poland remained quite low until 2007, with none of the sectors accessing any significant debt-type funding.

a percentage of GDP 15

Per cent

16.5

Inflow

0 –5

–5 –10.3

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

–10

Outflow

Slovakia Net Net Net Net Net

–10

Poland

external debt (including foreign reserves) portfolio equity FDI borrowing (based on financial account) borrowing (current and capital account)

Note: There is no IFS data available for 2001 in Slovakia. Source: IFS, WEO database, Eurostat, national central banks

The 2008 crisis hit both economies in a state of relatively sound external vulnerability: the external debt indicator was not high and thus neither was the gross financing need, nor were the net borrowing and the general government deficit. Thanks to the net borrowing, which was broadly subdued, and a government deficit that stabilised during the 2000s, no significant external debt was accumulated (Chart 3-17). — 175 —

Part I: International and national experiences in economic convergence

Net external debt (inclusive of intercompany loans) was around 20 per cent prior to the onset of the crisis. The net volume of FDI in Slovakia and Poland, however, was higher, reflecting the intensive influx of FDI characteristic of the convergence period. The net debt levels of 50–60 percent of GDP during the years leading up to the crisis were not salient in the Central and Eastern European region. Chart 3-17: External debt indicators in the countries of the region 70

Per cent

70 60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Slovakia

Poland

Net FDI stock Net external liabilities

Net external debt

Note: Stocks as a percentage of GDP. Intercompany loans are included in net external debt. In the case of Slovakia data were only available from 2008. Source: Eurostat

After the onset of the crisis, both the Slovakian and Polish economies underwent a slight external balance adjustment: the current account approached equilibrium, in conjunction with a moderate economic downturn. The crisis did not hit these economies particularly hard: Slovakia only experienced a significant economic downturn during one year, while Poland managed to sustain positive GDP growth throughout the crisis. The net lending underwent adjustment with — 176 —

3. Financing models from a macro perspective

rising net exports, while the external surplus was close to zero (in other words, the economy did not require any external funding). At the beginning of the crisis, net private sector savings rose substantially, along with waning investments and low consumption, but the budget position deteriorated. FDI-type financing decreased while corporate net lending turned positive, and the role of foreign borrowing grew in significance compared to earlier. Following net FDI influx of around 3–4 per cent before the crisis, the past two years saw an influx of 1–2 per cent, which is consistent with the decline in investments and the improvement in corporate net lending. At the same time, no significant debt-type funding was accessed during the initial years of the crisis.

3.3.4 Indebtedness and unsustainable convergence: Mediterranean countries

The international examples also include countries that joined the high-income countries based on GDP per capita, but did not achieve convergence based on durable factors. The following section presents the experiences of four of these countries (Greece, Portugal, Spain and Italy; Chart 3-18). In Greece, dynamic growth was achieved primarily through the substantial net borrowing accessed due to shrinking domestic savings, coupled with significant investments. Greece saw economic growth averaging 4 per cent between 1995 and 2007, which materialised with investments of around 25 per cent of GDP, predominantly financed by external funds. In parallel, savings within the economy during this period gradually decreased, accompanied by a rise in domestic consumption, and shrank to near 10 per cent of GDP by the end of the period. As a result of these developments, investments had to be financed through a current account deficit. The deficit already amounted

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to 5 per cent of GDP in 1997 and rose sharply from 2004, approaching 15 per cent of GDP by 2007. Similarly to Greece, Portugal saw the emergence of an increasing imbalance due to shrinking domestic savings. In Portugal as well, low domestic savings compared to investments led to an influx of external funds. While high investments strongly supported GDP growth, domestic savings only amounted to 15–20 percent of GDP, and therefore external funds were needed for financing. In the early 2000s, the volume of private sector debt led to a sort of adjustment, which thrust the country into recession due to a slump in domestic demand (European Commission 2004), but its current account deficit shrank slightly. From 2004, however, the deficit rose once again to nearly 15 per cent of GDP in the wake of an increase in domestic absorption and waning savings. In Spain, savings within the economy stood at a stable level, but were insufficient to fully finance increasing investment activity, so the current account balance exhibited a growing deficit. The country exhibited relatively lively growth between 1995 and 2007: investments rose higher than in Greece, over 30 per cent of GDP, however they were also not financed by a rise in domestic savings. Domestic savings fluctuated steadily between 22–24 percent of GDP (i.e. a quite elevated level). All of this led to significant net borrowing and a current account deficit of nearly 10 per cent by 2007. Italy was not characterised by the overheating observed in other Mediterranean countries, and therefore did not rely on significant external financing, but the government debt of over 100 per cent was a risk factor for the country. Over the same period, Italy’s problems differed from those of other countries. The relatively low investments (around 20 per cent) were almost entirely financed from domestic funding. As a result, growth fell short of other Mediterranean countries, coupled with a current account that was nearly balanced. It should be

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3. Financing models from a macro perspective

noted, however, that public sector debt was already elevated during this period, already exceeding 100 per cent of GDP in 1995. Chart 3-18: Investments, savings and the current account balance in Mediterranean countries and economic growth

Percentage of GDP

35 30

-5

–10

–15

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Greece

Portugal

Spain

GDP growth Savings (right-hand scale)

Italy

Investment (right-hand scale) Current account

Source: IMF

The available data reveal that the influx of funding was similar in Greece, Spain and Portugal, and exhibited a similar structure: the high current account deficit was financed by a rapid rise in external debt in all three countries. In the majority of Mediterranean countries, investments far exceeded the economy’s domestic savings, leading to a significant current account deficit. However, this deficit was not financed by FDI, but largely by foreign borrowing. The increase in external debt was over 10 per cent of GDP in certain years, but by the end of the period it had risen to nearly 5 per cent of GDP in Italy, which had the lowest net borrowing. It should also be noted that in Portugal, the inflow of debt funds were briefly replaced by the inflow of non-debt funds in the early 2000s, partly due to the adopted austerity measures. — 179 —

Part I: International and national experiences in economic convergence

In terms of the period under review, non-debt (mainly FDI) funds did not contribute to financing the economy, save for a few exceptions. Moreover, in many Mediterranean countries, a decline in net FDI can be observed, which led to an inflow of debt funding in excess of the net borrowing (Chart 3-19). According to the theories, the financing of the economy by debt funding can be expected, in parallel with a decline in the role of FDI (Komáromi 2007, Castejon–Wörz 2006), as confirmed by numerous examples among the countries examined earlier. Taking this into account, the indebtedness of Mediterranean countries was not necessarily a serious issue. At the same time, the economic crisis revealed that the enduring and substantial external indebtedness of Mediterranean countries in the early 2000s was not sustainable in the long run, and led to significant adjustment.

Percentage of GDP

Inflow 15

0 –5

–5 –10

Outflow

Greece

Portugal

Spain

Debt-type financing Non-debt type financing Source: Eurostat

— 180 —

Derivatives Net borrowing

Italy

–10

3. Financing models from a macro perspective

3.4 Summary of lessons learned from the international examples The experiences of successfully converging countries exhibit various patterns, but some general conclusions can nevertheless be drawn. The first is that domestic savings may enable a more stable convergence path over the longer run. External financing may accelerate the speed of convergence if it is channelled into productive investments – but as revealed by the crisis, the influx of foreign funds may also entail risks. The longer-term growth impacts of financing, whether from domestic savings or external funds, are primarily determined by the quality and effectiveness of the completed investments. In Southeast Asian countries, convergence was achieved in conjunction with elevated savings and relatively low external financing. Similarly, Austria’s economic convergence was also coupled with relatively low current account deficits. By contrast, Ireland and, to a slighter degree, Finland relied on a substantial influx of FDI for years, which reversed during the subsequent years – so the Visegrád countries under review are similar to these economies from this perspective. The role of FDI funding was only significant in the Visegrád Group (which is consistent with the theory that FDI funding plays a more important role during the initial phase of convergence), while high net borrowing materialised along with external indebtedness in Ireland and Finland. In the Visegrád countries (with the exception of Hungary) with lower external indebtedness, the impacts of the 2008 crisis were also moderate. Southern European countries converged against a backdrop of significant external imbalances, predominantly financed by foreign borrowing. These countries showed a gloomier picture in terms of both the investment ratio and FDI funding (Chart 3-20); this development proved unsustainable during the crisis and required significant adjustment. Finally, it is worth referencing a finding by Gerschenkron, who argued that for countries converging later, it is not worth looking at the growth trajectories of countries converging earlier, as they cannot follow the same path. Instead, they must seek

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Part I: International and national experiences in economic convergence

their own solutions and find their own path of convergence towards advanced status. Chart 3-20: Indicators as a percentage of GDP of successfully converging and Mediterranean countries

Current account Per cent

Investment rate Per cent

–8

0 –5

–16 1 2 3 4 5 6 7 8

Converging countries Clubmed average

Net FDI inflow Per cent

1 2 3 4 5 6 7 8

Average of converging countries

Note: The band and average of the investment ratio and the net FDI do not contain data for Austria and Finland due to a lack of data sources, while the net FDI average of the ClubMed group does not contain data for Italy. The data for the individual economies were taken into account based on different time horizons in function of the convergence period (see above). Source: IFS, WEO, Eurostat, national central banks

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Part I: International and national experiences in economic convergence Felipe, J. (2012): Tracking the Middle Income Trap: What is It, Who is in It, and Why? ADB Economics Working Paper, March 2012, No. 306. Fenz, G. – Scheider, M. (2006): Output fluctuations in Germany and Austria: comovement and shock transmission, OeNB Austria. Frank, M. Z. – Goyal, V. K. (2009): Capital structure decisions: which variables are reliably important? Financial Management No. 38, pp. 1–37. Ganioğlu, A. – Yalçın, C. (2013): Domestic Savings-Investment Gap and Growth: A Cross-Country Panel Study, Central Bank of the Republic of Turkey, Working Paper, No: 13/46. Gerschenkron, A. (1952): Economic backwardness in historical perspective. In The Progress of Underdeveloped Areas, ed. B. F. Hoselitz (University of Chicago Press). Ghazouani, T. (2013): The Capital Structure through the Trade-Off Theory: Evidence from Tunisian Firm, International Journal of Economics and Financial Issues, Vol. 3, No. 3, 2013, pp.625–636. Gorodnichenko, Y. – Svejnar, J. – Terrell, K. (2014): When does FDI have positive spillovers? Evidence from 17 transition economies, Journal of Comparative Economics No. 42 (2014) pp. 954–969. Halpern, L. – Muraközy B. (2005): Does distance matter in spillover? Centre for Economic Policy Research, Discussion Paper no. 4857, January 2005. Hochreiter, E – Knöbl, A. (1991): Exchange rate policy of Austria and Finland – Two examples of a peg, Bank of Finland, Discussion papers 12/91. Honohan, P. – Walsh, B. (2002): Catching Up with the Leaders: The Irish Hare, Brookings Papers on Economic Activity, (1) 2002, pp. 1–57. Huff, W. G. (1995): The Developmental State, Government, and Singapore’s Economic Development Since 1960; World Development, Vol. 23, No. 8, pp. 1421–1438. Jäntti, M. – Saari, J. – Vartiainen, J. (2006): Growth and Equity in Finland, World Institute for Development Economic Research (UNU-WIDER), WIDER Discussion Paper 2006/06. Kaldor, N. (1967): Strategic Factors in Economic Development, Cornell University, Ithaca, New York: New York State School of Industrial and Labor Relations. Kokkinen, A. – J. Jalava, M. – Hannikainen R. – Hjerppe: Catching-up in Europe: Finland’s convergence to Sweden and EU15, Scandinavian economic history review, 2007, No. 55, 2 pp. 153–171. Komáromi A. (2007): The structure of external financing: s there a reason to worry about financing through debt? MNB Bulletin, 2007 Kureger, A. O. (1990): Asian Trade and Growth Lessons, The American Economic Review, Vol. 80, No. 2, Papers and Proceedings of the Hundred and Second Annual Meeting of the American Economic Association (May, 1990), pp. 108–112. Lane, P. – Milesi-Ferretti, G. M. (2006): Capital Flows to Central and Eastern Europe, IMF Working Paper, No. 188.

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in growth Ádám Banai – Gábor Horváth – Balázs Vonnák

Financial intermediation plays a central role in economic growth both over the shorter and longer term. The role of lending and capital markets in fostering growth can be clearly established based on the literature. The bank-biased Continental European and the Anglo-Saxon model, which is characterised by more developed capital markets, are both able to create a funding environment conducive to prospering corporations. Several papers have concluded that both funding structures can be good, as both bank financing and capital market financing exert a positive impact on economic growth. They add that bank services are crucially important for developing countries. According to the literature, there is a threshold of financial deepening beyond which the banking system’s supporting role in growth loses impact. Above a certain level, lending might even have a slightly negative impact on growth, which is to be offset by an increasing performance of capital markets. Beyond the promotion of lending, developing the capital market in a country is also vital, as the latter typically only reaches a size where it no longer has a positive impact on growth at a later point in advanced economies. A comparative analysis of country groups confirms that the dominant channels of funding structure are not unequivocally decisive in terms of successful convergence. There are examples of the capital market playing a more prominent role (for instance in Southeast Asia) and of bank funding being dominant (for instance in Austria). The analysis has also shown that the convergence of countries with overly rapid financial deepening is more fragile compared to those with moderate growth in outstanding private loans. Finally,

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the stability and predictability of the legal system are also crucial to successful convergence.

4.1 Introduction The financial intermediary system plays a special role in the economy. Its operation enables economic actors in need of financing to access funds at the lowest possible cost. For economic agents in a net saving position, the system provides several opportunities for holding their wealth in the instruments which fits best their needs in the riskâ&#x20AC;&#x201C;return spectrum. The financial crisis, however, once again highlighted the fact that the financial intermediary system can not only function as the engine of economic growth: it can also be the starting point for a significant downturn. Nonetheless, it is difficult to establish when the financial intermediary system can still be considered healthy, and at what point it starts to hinder growth. It is challenging to determine this because there are various operating models in countries around the world, with successful examples in all cases. For example, continental European countries mainly have bank-based economies, but some have still been able to successfully converge with the developed countries (e.g. Finland), while some seem to be falling behind (e.g. Greece). As pointed out by Levine (2000), the main point is not the structure of the financial intermediary system, but rather ensuring an environment for all financial institutions in which they can provide reliable financial services. This chapter examines the impact of financial intermediation on economic growth and its role in the real economy. We primarily aim to present a theoretical overview, divided into three subchapters. First, we discuss the role of the financial system in supporting growth and the subtleties of this role. We then list the possible drawbacks that may be linked to excessive or overly rapid financial deepening. Finally, we

â&#x20AC;&#x201D; 187 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

touch upon some qualitative aspects of the structure and possible areas of further research.

The availability of adequate funds for various investments is of primary importance from the perspective of economic growth, and an institutional system performing this task is necessary for the adequate allocation of financial resources. This is because, at the individual level, savers face several risks that they typically cannot manage. Usually, they are not aware of the risks involved in production, and they also cannot assess the situation of the investor. Due to the lack of information, even risk-taking savers would not finance investments directly, and therefore even otherwise productive projects would not be realised without the financial intermediary system. This is further strengthened by the fact that savers generally prefer to keep their wealth in liquid instruments (Berthélemy and Varoudakis 1996). The role of financial intermediaries is to create long-term funds for investors in a way that simultaneously enables savers to hold their wealth in relatively liquid instruments. With the help of intermediaries, savers can ultimately finance a diversified portfolio which they do not have access to at the individual level. The link between the financial system and economic development is central in the influential book by Gerschenkron (1962), in which he discusses industrialisation as well as the financing of economic convergence in different eras. While the greatest providers of financing in the large investment projects of the English Industrial Revolution were the already relatively developed capital markets, the necessary funds for German industrialisation were channelled in by the banks, and in the case of Russia – in the absence of a well-functioning financial

— 188 —

system – the state provided the vast majority of funding. This underlines two points. First, that the development of the financial system and the performance of the real economy are interrelated, since the former supports the development of the latter, while economic growth enforces financial deepening. Second, the structure of the financial system (including the legal environment) is linked to the level of economic development, and depending on the latter the structure of the financial system which best supports long-term economic growth may vary. The development and deepening of the financial system can essentially contribute to increasing potential output via three channels (Berthélemy and Varoudakis 1996). Improving the efficiency of the payment system decreases transaction costs considerably, which enables the greater monetisation necessary for economic development and increasing the complexity of business relations. The deepening of financial intermediation fosters the development of more investmentintensive and productive technologies, which may in turn mobilise savings due to higher yields. Risk diversification by the intermediary system also increases the yields on savings and thereby the amount of available funds. The third channel is the more efficient allocation of savings. Within this, several mechanisms can be distinguished which increase the productivity of the economy through the realisation of more innovative and at the same time more risky and timeconsuming projects by diversifying shocks caused by more specialised technologies, alleviating liquidity shocks and reducing the average cost of distinguishing between good and bad projects. The first milestone in establishing the statistical link between economic growth and the deepening of the financial system was the analysis by Goldsmith (1969). Due to the quality and quantity of the data as well as the methodology employed, Goldsmith was only able to document the interrelated nature of the two processes without demonstrating the causality between them.

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Part I: International and national experiences in economic convergence

Later, using larger databases (involving more countries and longer time series) several studies were published that attempted to handle the potential endogeneity as well. Based on the database presented in the study by Demirgüç-Kunt and Levine (2001) as well as sector and company-level data, Beck et al. (2001) gauged the strength of the link between the financial system and economic development using three different methodologies (country-level, sector-level and company-level). Using data from 48, 36 and 33 countries, respectively, their sample basically covered 1980–1995. In relation to all three aspects, they concluded that the depth of the financial system had a significantly positive effect on economic growth. This effect, however, is not specifically linked to the banking system or the capital markets, but rather to the legal environment enabling the development of the financial system. As established by Beck et al. (2001), the structure of a country’s financial system is not decisive from the perspective of growth. In other words, bank-based and capital market-based economies are capable of the same development. In terms of economic growth, the legal environment is of primary importance. The study controlled for the legal environment using three different variables. The first measured the possibilities for the enforcement of collateral, i.e. how difficult it was for a creditor to obtain the collateral backing the claims. The second variable quantified the protection of minority rights. The third indicator measured legal certainty in general. Based on the results, all of the above-mentioned factors are crucial with respect to whether the financial system can support growth. Therefore in the context of a supportive legal environment, all funding structures may have a positive impact on growth. Levine (2000) also draws a similar conclusion. He demonstrates that the funding model considered advantageous by economists has changed considerably over time. The example of 19th century Germany is regarded by many to have shown that bank-based economies are better than market-based countries. This is supported by the fact that Germany gradually caught up with the United Kingdom and even surpassed it. The success of Japan over the United States in the — 190 —

20th century also justifies this view, but the downturn in the 1990s has raised doubts in this regard. In his study, Levine (2000) confirms that the main factor is not the funding model but the appropriate legal environment and the availability of high-quality financial services. From a decision-making perspective this also means that neither banks nor the capital market should be given priority: an appropriate, predictable environment should be created for both. This result is confirmed by Gambacorta et al. (2014). They find that both funding structures can be appropriate, as both bank and capital market financing have a positive effect on growth. They add that bank services are paramount for developing countries. Data from the period before the crisis also support this. Chart 4-1 shows that there is a significant difference between economies dominated by the banking system or the stock market, but there are successful countries in both cases.

Stock market capitalization to GDP (per cent)

Chart 4-1: Size of the banking system and the stock market between 2001 and 2008 250 CHE

200 ZAF LUX

150 USA

MYS FIN

100

AUS SWE

CHL ISR

IND

RUS ARG

KOR

NOR BRA HRV EST MEX TUR POL SVN BGRCZE HUN ROM LVA LTU SVK

GRC

GBR ISL

CAN ESP

FRA BEL CHN MLT EMU

ITA NZL

AUT

100

IRL DEU

NLD JPN DNK

PRT

150

Banks’ total assets to GDP (per cent) Source: GFDD

— 191 —

CYP

200

250

Part I: International and national experiences in economic convergence

The studies that found that the development of the financial system had a significantly positive impact on economic growth were typically written before the 2007–2008 crisis. This downturn has shed new light on the relationship between the financial system and the real economy. The former played a central role in the development of the bubbles that put the economies of several countries on an unsustainable path, which led to a significant recession and soaring unemployment during the years of the crisis. In line with this, more recent estimates also covering the period around the crisis attempt to establish whether there is a level of development at which the financial system’s conducive effect on growth is reversed and becomes negative. As soon as the observations made during the crisis, i.e. the credit expansion in developed countries and its unfavourable real economic impact, are included in the projections and analyses – not surprisingly – the earlier positive results become more elusive, and they are prone to suggest that financial growth can be less advantageous, and in certain cases harmful, above a certain level of development. Sahay et al. (2015) employ a comprehensive indicator of financial development constructed by them to examine the relationship between the financial sector and the real economy. According to them, the indicators and proxies (e.g. credit/GDP) used in the literature for estimating financial development only partially capture the aspects relevant from the perspective of economic growth. Their index also incorporates the size, accessibility and efficiency of financial institutions and financial markets. The analysis covering 128 countries and the 1980–2010 period also includes the square of the Financial Development Index, which helps Sahay et al. capture nonlinearities. According to their results, there is a maximum level for the positive relationship between financial development and economic growth, which approximately corresponds to Poland’s current level of development (based on the — 192 —

Financial Development Index created by them). Above this point the contribution of the expansion and improvement of the financial system to economic growth continues to be positive, but its effect gradually decreases: for example, one unit of improvement in the index bolsters economic growth in the USA by approximately two-thirds of the amount measured in Poland, which can be considered a moderately developed country (Chart 4-2). In very poorly developed countries, due to the nature of the quadratic function, the development of the financial system only has a limited impact on real economic convergence.

Per cent

Poland

Marokko

Effect on growth

Ireland

USA

95%-confidence band around the "turning point"

Ecuador 3

Japan

2 Gambia

1 0

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Financial Development Index Source: IMF

In their study, Sahay et al. give a detailed analysis of the reasons behind the decreasing contribution, and conclude that it is the impact on productivity – and not capital accumulation – that declines beyond a point in the Financial Development Index. Within this, the component that causes nonlinearity is the depth (size) of the financial

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Part I: International and national experiences in economic convergence

system, rather than its efficiency or accessibility. This result can be explained by the fact that the deepening of the financial system and the increasing volume of loans can impair the quality of fund allocation, and excessive lending can lead to the financing of bad projects. This is substantiated by the researchersâ&#x20AC;&#x2122; finding that the pace of deepening is linked to macroeconomic (and financial) stability: if the credit expansion is too rapid, it causes greater instability. There are also estimates claiming that the development and deepening of the financial system beyond a certain point contributes negatively to economic growth. Among these, the study by Cournede and Denk (2015) is one of the most recent. This paper also examines the period after the crisis, i.e. not only the golden age of the real economy and funding before the downturn. In some cases, the authors use very long time series for the years preceding the crisis as well. Their three estimates start in 1961, 1971 and 1989 and span until the end of 2011. The sample contains all the OECD and G20 countries, i.e. all the developed countries are included. The sample has special significance because when interpreting the findings with respect to the financial system, we must bear in mind that only countries with a mature financial system were analysed. In the panel estimates, GDP per capita growth was used as a dependent variable, while the explanatory variables included factors describing growth in general (e.g. investment rate, population growth, education) in addition to the key variables characterising the financial sector. Also various fixed effects (e.g. country, year) and dummies (e.g. crisis) were used as a control. One of their main findings was that the financial sector may exert a negative impact on growth, irrespective of whether the role of the sector was measured with loans extended to the private sector or with the value added of the financial sector. By contrast, a positive correlation was found between stock market capitalisation and growth. They also examined the threshold beyond which, according to the assumption, the positive correlation turns negative. They concluded that the value at which further activity is counterproductive should â&#x20AC;&#x201D; 194 â&#x20AC;&#x201D;

be around 100 per cent both in the case of the loans-to-GDP ratio and market capitalisation relative to GDP. The authors emphasised, however, that this figure may vary from country to country. Based on the above, one of their most significant conclusions from a policy perspective was that – in the case of bank-based economies with a mature banking system – a shift towards a market-based economy may bolster growth. Chart 4-3: The impact of funding channels on the growth of GDP per capita 3

Percentage point

1 0.8

2.5

0.6

0.4

1.5

0.2

0 –0.2

0.5

–0.4

–0.6

–0.5 –1

Percentage point

–0.8 30 40 50 60 70 80 90 100 110 120 130 140

–1

Lending to GDP

10 20 30 40 50 60 70 80 90 100 110 120 130 Stock market capitalization to GDP

Source: Cournede–Denk (2015)

Arcand et al. (2012) also concluded that the positive impact on growth may turn negative above a certain level of financial deepening. In their study, they examined a sample of more than 60 countries between 1960 and 2010, in several different periods. Their analysis also suggests that lending principally improves economic performance in the case of low and middle-income countries. Arcand et al. (2012) found

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Part I: International and national experiences in economic convergence

that the ratio of private sector lending relative to GDP does not have a significantly positive impact on growth above a level of approximately 80 per cent, and that the threshold beyond which the effect on growth becomes markedly negative may be around 100 per cent. One of the most important features of the research was that various periods were analysed in order to determine this threshold. In line with the above finding, the inclusion of the 2000s in the sample significantly reduced the threshold above which further deepening becomes counterproductive. For example, the estimate for 1960–1995 yielded 140 per cent for the threshold. This is especially significant because estimates including the 2000s take into account a historically unique credit expansion, which may significantly distort the resulting figure for the threshold.

One of the principal messages of Gerschenkron’s (1962) analysis is that capital accumulation may occur at different levels of economic development by exploiting different resources (capital market, banking system, state). Using a more comprehensive sample, Goldsmith (1969) revealed that in more developed countries the weight of non-bank financial intermediation and the equity market usually increased as compared to the banking system. Demirgüç-Kunt and Levine (2001) found a similar correlation in a very broad database: in the most developed countries, the role of non-bank financial intermediaries in lending was substantial in the 1990s. The size of equity and bond markets (market capitalisation) and the volume of trading have gradually increased since the 1970s. These markets can be considered dominant in the financial systems of more developed countries. Based on the same database, Beck et al. (2001) examined if the significantly positive correlation between the development of the financial system and economic growth varies depending on whether the banking system or the capital markets grow. Their analysis also — 196 —

produced the above-mentioned result that all elements of the financial system contributed to economic development in the same measure, i.e. there was no dominant strategy. Taking into account all of the above and the positive link between economic development and the relative weight of non-bank financial intermediation, we can conclude that the structure of the financial system does not explain economic development. It is important to emphasise that these findings were based on data from the period before the crisis. As we will see, the analyses incorporating the experiences gained during the crisis present a somewhat more complex picture. In their previously mentioned study, Sahay et al. (2015) found that – looking at the period of the crisis as well – while the relative growth contribution of the financial markets (e.g. equity and bond markets) was largely independent from the level of development, the expansion of financial institutions (including banks, insurance corporations, pension funds) resulted in decreasing returns. It follows from the above that beyond a certain level of financial development – roughly corresponding to that of Poland – the deepening of equity and bond markets should be fostered, and that – in relation to financial institutions – the widespread accessibility and the efficiency of services should be improved. Langfield and Pagano (2015) examine the size of the banking system relative to the capital market and its effect on the build-up of systemic risks as well as on economic growth, focusing on the role that banks’ dominance in financial intermediation plays in the weak economic performance of Europe. The explanatory variable in their estimate is the proportion of all of the assets of the banking system relative to the combined capitalisation of the equity and private bond markets. Examining 517 banks in 20 countries between 2000 and 2012, they find that systemic risks are more likely to arise in bankbased economies. They evaluate the impact on economic growth on a sample of 45 countries in 1988–2011. Their results also show that excessive dominance by banks is detrimental and may dampen — 197 —

Part I: International and national experiences in economic convergence

growth, especially in crisis situations when property prices decline significantly. They attribute this to the financial acceleration effect of the banking system. Chart 4-4: Predicted marginal effect of the bank-market ratio on GDP growth

Real GDP Growth

–2

–4 US

FR Estimated effect:

Housing market crisis

No crisis

Notes: The vertical axis shows the predicted yearly growth in real GDP per capita. Predicted GDP growth varies over (i) the occurrence of a housing crisis (shown by the black versus grey circles); and (ii) the bank-market ratio (shown over the horizontal axis). To illustrate the United States (with a bank-market ratio of 0.7 in 2011), France (3.5), the United Kingdom (4.1), Germany (5.7) and Italy (4.4).

The results of Langfield and Pagano (2015), however, seem to be in contradiction with the previously cited study by Cournede and Denk (2015), according to which in the case of capital markets the same phenomenon can be observed, namely that beyond a certain point they have a contractionary effect, and this point may also be around 100 per cent of GDP. This contradiction, however, can be resolved by — 198 —

adding that while in the samples used in the two studies the weight of the capital markets was typically below the level above which further expansion is harmful (the area below the horizontal line on the chart), “the overexpansion of banks” could be observed in several countries (countries to the right of the vertical line). Therefore, although the expansion of the banking system and the capital market may generally exert a similar effect on the real economy (in line with the results of Beck et al. (2001)), the negative impact of oversized banking systems is more prevalent in the present structures. Chart 4-5: Level of development of capital markets and banking systems in 2011 250

Stock market capitalization to GDP

ZAF

200 CHE

150

LUX CHL

GBR

CAN AUS

100

KOR

SWE

ISR IND FRA SAU RUS BRA NOR BEL OECD CHN IDN FIN DEU MEX POL AUT GRC SVN TUR CZE HUN ISL ITA ARG EST SVK

100

USA NLD JPN NZL

ESP DNK PRT IRL

150

200

250

Lending to GDP Source: Cournede–Denk (2015)

The relative importance of the stock market and the banking system is also examined by Owen and Temesváry (2012), who basically seek to ascertain whether the claim that increasing lending has a positive effect on economic performance holds in all cases. Using data from

— 199 —

Part I: International and national experiences in economic convergence

82 countries56 in 1985–2010, the study demonstrates the factors that determine whether funding has a positive effect, and if so, to what extent. The authors conclude that the strength of the legal framework, and the maturity of the stock market and the banking system both influence the impact of lending on growth. The study shows that a stronger legal framework is conducive to the banking system, and therefore lending results in better economic performance. However, in countries where the stock market plays a larger role, bank lending boosts growth to a lesser extent. Nevertheless, it follows from the methodology that there may be no causal relationship between the two. The model gives separate estimations for countries with more mature and less mature financial systems and thus does not uncover the real causative link. Another important finding of the study is that in countries with banking systems of varying degrees of development, the impact of foreign presence is also different. In underdeveloped countries, lending by foreign banks (cross-border lending and lending by foreign-owned banks) does not have a positive effect on growth. In developed countries, however, from a growth perspective, it does not matter whether domestic or foreignowned banks provide funding. The literature before the 2000s clearly emphasised that the financial system has a positive impact on economic growth, and therefore financial deepening is desirable. Nevertheless, the extent of the positive impact also depends on factors such as the legal environment, the enforceability of contracts and the maturity of capital markets. However, the analysis of the 2000s and especially the crisis give a more miscellaneous picture. And although estimates vary significantly, according to the literature, if the proportion of private sector lending relative to GDP exceeds 100–150 per cent, it may even have a negative effect on economic growth. Some studies analyse funding in a broader sense as well. Several researchers claim that stock market funding and 56

The study examined countries with widely differing levels of development, from undeveloped countries like Bangladesh to the most developed ones such as Switzerland and the USA.

— 200 —

bank funding are basically interchangeable. In both cases, the growth impact is positive, but there is an upper limit beyond which it does not unfold. In the majority of countries, however, the banking system is substantially larger than the capital market, and therefore the banking system reaches the upper threshold much sooner. This finding is especially important for decision-makers, because it also means that in the case of countries with overly large banking systems, supporting stock market funding might increase the growth potential considerably.

4.3 Growth characteristics of successfully converging country groups Countries that have successfully completed convergence provide vital international lessons on the role of funding in economic convergence. In the past few decades, countries in several regions have started convergence and entered on a sustainable, equilibrium path. These countries were typically able to escape from the middleincome trap, or they successfully approximated to their more developed peers in the region with respect to the level of their per capita output. Our comparative analysis involved countries from East Asia such as Korea (1988–1995), Singapore (1978–1988) and Taiwan (1986–1993); Western European countries such as Austria (1964–1976), Finland (1964–1979) and Ireland (1975–1990); and two countries from Eastern Europe: Slovakia (1998–2008) and Poland (1998–2008). The countries were analysed with respect to some key indicators. The following over-indebted economies from Southern Europe that failed in the convergence process were used as a control group: Spain, Portugal, Greece and Italy between 1998 and 2008. In these countries, the economic boom was based on a very fragile foundation and was only possible in conjunction with external vulnerability and substantially mounting debt. In the comparisons, we either analysed individual countries or the averages of groups, depending on whether the individual differences were meaningful.

— 201 —

Part I: International and national experiences in economic convergence

Table 4-1: Countries and country groups in the comparison and their convergence periods Country group East Asia

Western Europe

Eastern Europe Southern Europe: over-indebted countries, counterexamples

Country

Country code

Convergence period

Korea

KOR

1988–1995

Singapore

SGP

1978–1988

Taiwan

TWN

1986–1993

Austria

AUT

1964–1976

Finland

FIN

1964–1979

Ireland

IRL

1975–1990

Slovakia

SVK

1998–2008

Lengyelország

POL

1998–2008

Spain

ESP

1998–2008

Portugal

POR

1998–2008

Greece

GRC

1998–2008

Italy

ITA

1998–2008

The data serving as the basis for the comparison included the following indicators of financial depth, which were used in the studies for analysis and for uncovering the correlations, as described above in the summary of the literature: market capitalisation relative to GDP, the volume of private loans relative to GDP, the annualised growth rate of the volume of private loans in the convergence period, banking system concentration, the proportion of foreign-owned banks and changes in the loan-to-deposit ratio. Bank lending is traditionally the most widespread method for acquiring funding in an economy, but companies’ financing is not only possible via domestic bank loans, as they can also use foreign sources (loans, capital, subventions) and reinvested and repatriated profits. Companies in a supply chain provide each other temporary funding through trade credit, which is often essential in their liquidity management, especially in the context of ever stricter credit standards. Over the long term, however, this type of financing does not increase capacity or productivity. The study only examined the funding channels that contribute the most to growth, i.e. bank lending and the capital market. We can say that from the perspective of their financing structure the economies of the countries under review were not radically different — 202 —

from each other, irrespective of whether they successfully escaped from the middle-income trap or not. In each successfully converging country, the corporate sector mainly acquired external funding through the banking sector. Debt securities (bonds) only played a major role in the corporate sector of Korea. Eastern Europe was generally characterised by minimal bond issuance (1–2 per cent relative to GDP), which changed slightly after the crisis as a result of falling lending and the spread of alternative sources of financing. Chart 4-6: Stock market capitalisation 160

Percentage of GDP

160 140

120

100

Eastern-Europe Southern-Europe Eastern-Asia (Taiwan excluded)

T+9

T+8

T+7

T+6

T+5

T+4

T+3

T+2

T+1

T+10

140

Western-Europe Hungary

Note: The countries and country groups that were compared in their respective convergence periods are the following: Korea (1988–1995), Singapore (1978–1988) and Taiwan (1986–1993) from East Asia, Austria (1964–1976), Finland (1964–1979) and Ireland (1975–1990) from Western Europe, and Slovakia (1998–2008) and Poland (1998–2008) from Eastern Europe. There was no data for Western Europe in the period under review. Source: MNB data collection

The stock market plays vastly different roles in the various economies, and its dynamics are not straightforward (Chart 4-6). It is important to note, however, that the size of the stock market in itself does not necessarily indicate the financing opportunities of the domestic economy — 203 —

Part I: International and national experiences in economic convergence

(e.g. East Asian countries have large stock markets with lots of foreign market participants). In Eastern European countries, the stock markets are relatively small, and in Western Europe the stock exchange only became dominant in Finland – due to the expansion of ICT many years after the convergence period – while the Austrian and Irish stock markets are not large compared to their respective economies. There were substantial differences among East Asian economies as well, especially in the convergence period we examined. In Singapore and Taiwan, the stock market was relatively large even in the period under review, while in Korea this was untrue, although this could be attributed to the previously mentioned proportion of foreign actors. According to the literature, the capital market typically has a positive impact on growth. It can act as a sort of substitute for bank financing, thereby mitigating the risk of the banking sector growing too large. Nevertheless, experiences so far suggest that the significant strengthening of the stock market’s role is not a prerequisite for successful convergence. Chart 4-7: Total assets of banking system 200

Percentage of GDP

200

Hungary Southern-Europe Eastern-Asia (Taiwan excluded)

T+10

T+9

T+8

T+7

T+6

0 T+5

T+4

T+3

100

T+2

100

T+1

150

Western-Europe Taiwan Eastern-Europe

— 204 —

On the whole, bank financing plays a crucial role everywhere, and thus analysing the size and structure of the banking system was of primary importance. In successful countries, the credit-to-GDP ratio increased in the convergence period, albeit at a moderate pace (Chart 4-5). By contrast, for example in Southern European countries, the credit-to-GDP ratio rose considerably before the crisis and was not coupled with rapid economic growth. Thus, the data show that the growth threshold of financial development can be truly effective and suggest that convergence cannot be based solely on the expansion of the banking system. Chart 4-8: Annualised growth rate of private loans 12

Percentage of GDP

Percentage of GDP 10.4

9.9

8.3

7.0

5.7

4 2.6 1.4

12 10 8

6.7

10.2

6 4

3.1 0.8

1.2

1.9

–2

–4

KOR SGP TWN AUT FIN

IRL SVK POL ESP PRT GRC ITA HUN

–4

Annualised growth rate of private loan outstanding to GDP Note: CAGR (compound annual growth rate) calculated for the respective convergence periods of each country: Korea (1988–1995), Singapore (1978–1988) and Taiwan (1986–1993) from East Asia, Austria (1964–1976), Finland (1964–1979) and Ireland (1975–1990) from Western Europe, and Slovakia (2002–2008) and Poland (1998–2008) from Eastern Europe. Source: MNB data collection

— 205 —

Part I: International and national experiences in economic convergence

We used the annualised growth rate of the ratio of private loans relative to GDP to measure the pace of financial deepening in the various countries (Chart 4-8). With the exception of Taiwan, the countries converged with moderate credit growth. In the over-indebted southern countries, due to the rapid credit growth, the volume of non-performing loans increased substantially during the crisis. Managing the NPL (especially in the case of commercial property and household mortgage loans that is typical in Hungary as well) results in sacrifices in growth. Chart 4-9: European comparison of banking system concentration in 2014 100

Per cent

0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

GRC

FIN

PRT

SVK

ESP

HUN

IRL

POL

ITA

AUT

0.00

Share of top 5 banks (left-hand scale) Herfindahl–Hirschmann Index (right-hand scale) Note: Due to a lack of reliable data, the concentration in East Asia is not shown. Source: ECB

From the perspective of banking system concentration and ownership structure, the various countries also present a heterogeneous picture, irrespective of whether they belong to the successful or the unsuccessful group. The share of the five largest banks and the

— 206 —

Herfindahl–Hirschmann Indices of the banking systems were not available for the convergence periods in a comparable form; therefore we based our analysis on current concentration ratios (Chart 4-9). With respect to the data for Eastern Europe, it is worth mentioning that the ratio for Slovakia is much higher than in Hungary, while the Hungarian concentration is higher than in Poland. Chart 4-10: Share of foreign ownership in the banking system in 2007 100

Per cent

Per cent 92

100 90

80 70

15 10

10 0

AUT

ESP

FIN

GRC HUN

IRL

ITA

KOR

POL

PRT

SGP

SVK

TWN

10 0

Share of foreign ownership in banking system in 2007 Note: The earliest available data point that can be used in a comprehensive comparison is 2007. Source: MNB data collection, ECB CBD

The market share of foreign-owned banks also varies significantly. Among the successful countries, the market share of foreign banks is low for example in Korea, Austria and Taiwan, and high in Finland, Ireland and Singapore (Chart 4-10). Thus, based on our example, the role of ownership is not clear-cut. Both successful and unsuccessful countries are heterogeneous in this regard.

— 207 —

Part I: International and national experiences in economic convergence

Chart 4-11: Loan-to-deposit ratio in the convergence period 175

Per cent

175

Western-Europe Hungary Eastern-Asia (Taiwan excluded)

T+10

T+9

T+8

50 T+7

T+6

T+5

100

T+4

100

T+3

125

T+2

125

T+1

150

Eastern-Europe Southern-Europe

The structure of bank financing is also different in the various models. The proportion of external financing used to be high in the banking systems of Southeast Asia. However, it was largely scaled back before the crisis and reduced to below 100 per cent. By contrast, the banking systems of successful Western European countries relied on domestic funds in the convergence period. On the other hand, Southern European countries were characterised by a high loan-to-deposit ratio before the crisis (and by that time Ireland was in the same situation, but its convergence was based on domestic funds). Overall, the successful European convergence model hinged on domestic rather than external financing. We cannot say that the high loan-to-deposit ratio entails immediate problems, but over-reliance on external funding generates

— 208 —

substantial vulnerabilities in a banking system from a macroeconomic perspective, which is not desirable. In the successful Western European countries, the conditions for banking were typically looser, while in the Southeast Asian model the regulatory environment was stricter. Therefore, this factor does not provide an unequivocal explanation either as to why a country can successfully escape from the middle-income trap. The rigorousness of supervision is similar, although in Western Europe the Austrian supervision has exercised increasingly tight control since the end of the 1990s. From the perspective of the legal environment, however, Southern European countries with less efficient systems of legal enforcement lag behind the successful country groups. This confirms the hypothesis about the strength of the legal system put forward in the summary of the literature, according to which convergence requires a supportive, stable legal environment.

4.4 Conclusion The survey of the literature suggests that companies’ access to funding is of key importance in every country with respect to economic growth. The growth impact of lending is influenced by the stability of the legal environment, the structure of the banking system and the maturity of the capital market. Excessive credit expansion can lead to considerable risks, which may have a contractionary effect later on. There is an upper limit above which the role of lending in supporting growth fades, and it can even become counterproductive above a threshold of approximately 100–150 per cent of private loans relative to GDP. Accordingly, the development of the capital market is increasingly important for the corporate sector. The comparison of country groups shows that the convergence of countries with overly rapid financial deepening is more fragile

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compared to economies with moderate credit growth. The threshold of the growth impact of financial development may be truly effective, and countries cannot escape from the middle-income trap solely through the expansion of the banking system. According to our analysis, the ownership structure of the banking system is not decisive in the success of convergence. The successful European convergence model is based on domestic funds, since over-reliance on external funding can cause major vulnerability and may also entail risks. Furthermore, it is also important to note that the stability and strength of the legal system in a country is a condition sine qua non for successful convergence.

â&#x20AC;&#x201D; 210 â&#x20AC;&#x201D;

References Sahay, Ratna – Čihák M. – Papa N’Diaye – Barajas, A. – Ran Bi – Ayala, D. – Yuan Gao – Kyobe, A. – Lam N. – Saborowski, Ch. – Svirydzenka, K. – Seyed R. Y. (2015): Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note, May 2015. Arcand, J. L. – Berkes, E. – Panizza, U. (2012): Too much finance?, IMF Working Paper, WP/12/161 June 2012. Levine, Ross – Zervos, S. (1998): Stock market, banks, and economic growth, World Bank WP 1690. Beck, T. (2011): The role of finance in economic development: benefits, risks, and politics, European Banking Center Discussion Paper, No. 2011–038, May 2011 Cournede, B. – Denk, O. (2015): Finance and economic growth in OECD and G20 countries, OECD Economics Department Working Papers No. 1223. Owen, A. L. – Temesváry J. (2012): Foreign lending, local lending and economic growth, Hamilton College, June 2012. http://ssrn.com/abstract=2102637 Gerschenkron, A. (1962): Economic backwardness in historical perspective, a book of essays, Cambridge, Massachusetts: Belknap Press of Harvard University Press. Berthelemy, J. – Varoudakis, A. (1996): Models of financial development and growth, Financial Development and Economic Growth: theory and experiences from developing countries. London. Goldsmith, R. W. (1969): Financial Structure and Development, New Haven, CT: Yale University Press. Beck, T. – Demirguc-Kunt, A. – Levine, R. – Maksimovic, V. (2001): Financial structure and economic development: firm, industry, and country evidence, Financial Structure and Economic Growth: A Cross-country Comparison of Banks, Markets, and Development. MIT Press. Langfield, S. – Pagano, M. (2015): Bank bias in Europe: effects on systemic risk and growth, ECB WP No. 1797.

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converging countries Dániel Babos – Gergely Baksay – Márton Bókay

The impact of fiscal policy on economic growth is multifaceted. At the most aggregated level, it exerts an impact on the budget deficit and changes therein, and through government debt, thus primarily impacting economic stability and vulnerability over the medium term. In addition, it also has an impact through the structure of expenditures and revenues, such as expenditures shifting towards greater productivity aimed at improving physical infrastructure or human capital, or tax reforms that shift the emphasis to less distortionary taxes for economic activity, which can greatly contribute to a country’s competitiveness. Finally, it also matters a great deal how well-planned, effective and synergistic these expenditures and revenues are. This chapter examines several countries that have successfully converged over the past decades based on these criteria. One of the most important conclusions is that there is no one-size-fits-all solution for successful convergence. Each country must take into consideration its own resources and preferences to make the most of the opportunities. There are significant differences between the examined countries in the definition of the state’s role, its size and fiscal policy discipline. During periods of convergence, the fiscal balance as a percentage of GDP in the selected countries fluctuated in a wide range between -13 and +8 per cent. The beginnings of the periods were generally characterised by looser fiscal policy which stimulated the economy, and a lower deficit during more dynamic periods of growth, partly thanks to favourable cyclical developments. The budget balance

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therefore varied not only from country to country, but also over time. Hungary was characterised by looser fiscal policy at the beginning and at the middle of the selected period (1995–2015); it has managed to scale back its deficit to under 3 per cent in recent years. The declining government debt as a percentage of GDP started in every country as economic growth picked up, with major discrepancies in this indicator. Despite the relative decrease in the past few years the debt level is still high in Hungary compared to other successfully emerging countries. Chart 5-1: Development of the budget balance and the public debt in the studied countries and Hungary 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

Percentage of GDP

1 3 5 7 9 11 13 15 17 19

8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

100

Percentage of GDP

100

Budget balance of the studied countries Hungary's budget balance Average

1 3 5 7 9 11 13 15 17 19

Public debt of the studied countires Hungary's public debt Average

Note: The converging countries: Ireland, Austria, Finland, Korea, Slovakia and Poland. The start of the convergence period for different countries: 1985 for Ireland, 1964 for Austria, 1975 for Finland and Korea, and 1995 for Slovakia, Poland and Hungary. Source: OECD, Korea Development Institute, Youngsun Koh: Reforming the Fiscal Management System in Korea (2005), European Commission, IMF: Public Finances in Modern History

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Part I: International and national experiences in economic convergence

The size of the state and the redistribution rate also diverge between the selected countries (Chart 5-2). Experiences show that the degree of redistribution is less important than the structure of redistribution. According to the literature, the convergence process hinges upon the quality of education, but the analysis of education expenditure reveals significant differences across the various countries (Chart 5-2).The ratio of education expenditures to GDP in Hungary is relatively high compared to the examined countries, but in these countries, the financing of the private sector is more significant within education expenditures. Chart 5-2: Education expenditure and the redistribution rate in Hungary and in the studied countries

Percentage of GDP

3 2

2 1

Percentage of GDP

9 11 13 15

0 1 3 5 7 9 11 13 15 17 19

Expenditure on education in the studied countries Expenditure on education in Hungary Average

Redistribution rate in the studied countries Redistribution rate in Hungary Average

Note: The converging countires: Ireland, Austria, Finland , Korea, Slovakia and Poland. The start of the convergence period for different countries: 1985 for Ireland, 1964 for Austria (1970 for education spending), 1975 for Finland and Korea, and 1995 for Slovakia, Poland and Hungary. Source: OECD, Korea Development Institute, Youngsun Koh: Reforming the Fiscal Management System in Korea (2005), European Commission, IMF: Public Finances in Modern History

â&#x20AC;&#x201D; 214 â&#x20AC;&#x201D;

In addition to the differences between the examined countries during the convergence period, we can identify common traits as well. In several cases, broad educational reforms were implemented at the beginning of the period, leading to qualitative and quantitative progress in education. On the revenue side, there were major restructurings in the taxation structure, whereas on the expenditure side, an increase in productivity-boosting expenses can be observed, such as the reinforcement of physical infrastructure, the strengthening of human capital and social transfers.

5.1 Introduction In this study, we present the fiscal and economic policies of various converging countries, in search of the fiscal interventions, economic policy programmes and structural reforms that were decisive in these countries’ development. We attempted to select countries that followed different convergence models, in order to demonstrate that there is no uniform recipe: the countries have to use their own potential and opportunities to the best of their abilities. The convergence process of the various countries is shown in Chart 5-3, using Germany as a reference. The strongest convergence was exhibited by Ireland and Korea. As a result of its rapid economic growth, Ireland – once one of the least developed countries in the EU – first reached and then by the early 2000s even surpassed the benchmark level of German development. Korea started at quite a low level of development at the beginning of the period under review, but in recent years it reached the GDP per capita of the Southern European countries (Spain, Italy). Austria and Finland were able to keep up with the pace of German economic development, while in the CEE region Poland and Slovakia were the most successful.

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Part I: International and national experiences in economic convergence

Chart 5-3: Evolution of the GDP per capita, measured at purchasing-power parity, of the studied countries compared to Germany 140

Germany = 100

140 120

100

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

120

Finland Korea

Austria Ireland

Slovakia Poland

Source: OECD

5.2 South Korea In the second half of the 20th century, South Korea exhibited almost unrivalled economic convergence as it transformed from one of the poorest countries in the world into a member of the most developed ones. In the early 1960s, South Korean GDP per capita was lower than in India or Ethiopia, but by 2009 the figure amounted to 77 per cent of the German GDP. Moreover, the first half of this era coincided with the fastest period of growth in Germany’s economic history.

— 216 —

The history of South Korea’s economy can be divided into four phases since the country’s establishment. In the first phase, which spanned from the mid-1950s to 1961, the main focus was on import substitution, i.e. the country attempted to protect and stimulate its economy by an artificially strong exchange rate and protective tariffs. Implementing an efficient mix of an intentionally loose fiscal and monetary policy between 1961 and 1981, the “developmental state” achieved exceptional growth primarily driven by exports. From 1981, the focus was shifted from state intervention to market-friendly instruments and fiscal consolidation, but the economic growth did not slow down. The main thrust of economic policy did not change in the 2000s either, but the 1994–1995 Asian financial crisis was a dividing line. Nevertheless, it should be noted that South Korea was perhaps the quickest to recover from the crisis (Stiglitz 2002).

5.2.1 Fiscal policy

During its long convergence period, South Korea adjusted the tightness of its fiscal policy several times. The available data goes back until the 1970s. From the 1970s until the change of government in 1981, the country was characterised by a moderately loose fiscal policy with the central budget deficit fluctuating between 1.5 and 4.5 per cent (Chart 5-4). Fiscal policy generated substantial surplus demand in the economy, but due to the rapid economic growth this did not lead to a rise in the debt-to-GDP ratio. The new government that came to power in 1981, announced the new policy of a balanced budget, and 1986 was the first year when expenditure did not exceed revenue, i.e. the central budget deficit was reduced to zero. After this, the budget deficit hovered around zero until the East Asian financial crisis in the second half of the 1990s, even showing a surplus for several years.

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Part I: International and national experiences in economic convergence

Chart 5-4: Korea’s budget and central government balances (1970–2012) 5

Percentage of GDP

2012

2010

2008

–5

2006

–5

2004

–4 2002

–4 2000

–3

1998

–3

1996

–2

1994

–2

1992

–1

1990

–1

1988

1986

1984

1980

1982

1978

1976

1974

1970

1972

Budget balance Central government balance Source: OECD; Korea Development Institute, Youngsun Koh: Reforming the Fiscal Management System in Korea (2005)

Government debt posed few problems in South Korea as it fluctuated between 10 and 20 per cent of GDP during the convergence period. At the end of the Korean War, the country’s debt amounted to approximately 10 per cent of GDP, and then the debt ratio gradually increased to 20 per cent by the early 1980s. Despite the loose fiscal policy, this rise can be considered moderate over 20 years, which was primarily due to rapid economic growth. By the mid-1990s, owing to the balanced budgets characteristic of the 1980s, the debt ratio dropped again below 10 per cent. As a result, South Korea had an ample room for manoeuvre to dampen the effects of the Southeast Asian crisis. On account of the diminishing GDP and the anticyclical, simulative fiscal

— 218 —

policy, the debt ratio began to soar, reaching an unprecedented level of 25 per cent in GDP terms in the early 2000s (Chart 5-5). One recurring topic in discussing South Korean fiscal policy is that some elements of the government’s policies were not implemented directly through the budget, but rather through other instruments. It is important from the perspective of debt that the state not only assumed explicit debts but also provided substantial guarantees, for example for the loans taken out by public corporations. The value of the guarantees amounted to 3–10 per cent of GDP, approximating the amount of debt in certain years. During the financial crisis one of the tools was the expansion of state guarantees for restoring investor confidence in South Korean companies, and therefore the volume of such guarantees increased especially rapidly in these years (Koh 2007). Chart 5-5: Korea’s gross public debt (1958–2011) 40

Percentage of GDP

Public debt Source: IMF, Public Finances in Modern History

— 219 —

2010

2006

2002

1998

1994

1990

1986

1982

1978

1974

1970

1966

1962

1958

Part I: International and national experiences in economic convergence

Compared to the developed countries, the proportion of state redistribution and tax centralisation is one of the lowest in South Korea, and this characteristic of the country lasted for the entire convergence period (Chart 5-6). Between 1970 and 2000 – apart from the occasional surg – general government expenditure fluctuated around 15–20 per cent of GDP. Initially, revenue was below this, but it reached the same level in the period of the balanced budgets. The fiscal consolidation that started in 1981 was mainly achieved via spending cuts and thus in these years the revenue and expenditure hovered in the lower part of the above-mentioned range. The low redistribution rate was caused by two factors. First, as social security was significantly underdeveloped, the government’s social and welfare spending – including healthcare expenditure – were minimal until the end of the 1990s when they started to rise, albeit at a slow pace, but even then the Korean state only spent 3 per cent of the GDP on social benefits (OECD database). The other factor influencing the redistribution rate was that the economy was dominated by state corporations that were able to communicate the intentions of the government policy, thereby contributing to the effects of the budget. In the 1960s, state corporations produced 7–9 per cent of the GDP. Their main aim at that time was to build up the necessary infrastructure – i.e. practically to ensure the appropriate conditions – for companies in the private sector. Nonetheless, they also contributed directly to the expansion of GDP through investments, and they played a significant role in technology transfer (Kim 1991). Tax allowances were among the most important elements of the set of fiscal policy instruments, i.e. income stayed with the person who earned it, instead of the state collecting and redistributing it, which also contributed to the low rate of state redistribution. Despite the low redistribution rate, the state played a more dominant role in the economy than in the majority of the developed countries, because

— 220 —

state regulation and its direct (non-fiscal) interventions were more robust. From the start of the convergence period, Korea put considerable emphasis on education, and the related expenses constituted one of the largest items in the budget. The fact that Korea leads the OECD countries today with respect to the proportion of those holding a university degree was partly due to this, it also helped the country to become a world-class player in knowledge-intensive industries. Spending on human capital through the healthcare system seems to be low, but this is because the health insurance fund is not part of the budget statistics in Korea (Table 5-1). Regarding military expenditure, the make-up of the budget deviates from the structure that is considered ideal in the case of converging countries. This is understandable in South Korea’s geopolitical situation, but it has contributed little to increasing economic growth potential. It is noteworthy, however, that the country achieved exceptional growth despite such unfavourable circumstances. Table 5-1: South Korea’s central government expenditure as a percentage of GDP 1970

1980

1990

2000

General public services

3.9

0.8

0.7

1.1

Defense, public order and security

3.8

7.0

4.4

3.5

Education

2.8

2.9

3.0

3.3

Health

0.2

0.3

0.2

Social grants

0.8

1.1

1.4

3.3

Economic affairs

4.6

5.1

3.6

5.5

Other

0.9

2.7

4.4

5.0

Total

17.0

19.8

17.8

21.9

Note: The national healthcare fund is not part of the budget statistics. Source: Koh (2007)

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Part I: International and national experiences in economic convergence

Chart 5-6: Budget revenues and expenditure of Korea (1970–2012) 40

Percentage of GDP

Budget expenditure

2010

10 2006

2002

1998

1994

1990

1986

1982

1978

1974

1970

Budget revenues

Source: OECD

The budgetary system of Korea is fairly complex and includes the central budget as well as several other funds and special accounts (programmes; Koh 2007). These were created for fulfilling a special aim or task, and the majority of them have their own income to cover their expenses, while others receive funding from the central budget. The considerable independence of funds and special accounts is demonstrated by the fact that until the 2000s their own income and expenses were not even shown in cash flow terms on the consolidated accounts of the Korean budget. Budgetary and economic policy planning was hindered because the aims of the off-budget funds often overlapped (with each other and with those of the central budget as well). Korean economic policy was characterised by strong centralisation and central planning (despite the above-mentioned fragmentation of — 222 —

the budget). One of the most influential institutions in the country’s economic convergence in the 1970s and 1980s was the Economic Planning Board (EPB), which, despite its name, fulfilled the role of the most prominent ministry and its head also functioned as deputy prime minister. The EPB’s contribution was key in formulating the economic development plans as well as in planning and implementing the budget. While planning the budget, the EPB engaged in bilateral discussions with the other ministries, because in this manner it could get its way easier than at multilateral meetings. During the budget debate – partly due to the organisation of the state – the National Assembly had little say in the revenue and expenditure figures, for example it could not modify the budgetary aggregates (Koh 2007). If a certain programme or budgetary item exceeded its predetermined spending limit during implementation of the budget, the EPB could block or postpone payments. In addition to the EPB, there was a separate Ministry of Finance, which functioned partly as an enforcer of the EPB’s wishes. In the 1990s centralisation became even more pronounced, as the EPB and the Ministry of Finance merged and continued to operate as the Ministry of Finance and Economy (MOFE). This changed after the financial crisis at the end of the 1990s, when fiscal matters were once again assigned to another ministry.

5.2.2 Instruments of Korean economic policy

As pointed out in the introduction, South Korea was among the least developed countries in the world when it became independent. In the 1950’s, the government favoured the policy of import substitution, and its main elements of which were artificially strong exchange rate and high import tariffs. Fiscal policy also played a key role, since South Korea wished to finance its economic growth from domestic sources. In line with Gerschenkron’s (1984) theory, the necessary financial resources could not be provided by neither from private capital nor from bank source; therefore, the state took on a substantial and direct role in the economic development through large-scale investments. — 223 —

Part I: International and national experiences in economic convergence

The state’s aim with these investments was to rebuild and develop the physical infrastructure that was severely damaged during the war and to increase the capacity of the engineering and heavy industries. The distribution of government’s investments changed as economic convergence progressed. In the beginning, industrial (and mining) investments made up half of the government’s investments, while the other half was designated for infrastructure development. Later, the proportion of investment in infrastructure gradually increased: by the end of the 1970s it amounted to 75 per cent of all state investments, and therefore industrial investments were crowded out. The ratio of state investment relative to all investments fluctuated around 35–40 per cent in the 1960s and 1970s, following a slightly decreasing trend (Kim 1991). According to Kim, state corporations operated at a high technological level and at low prices and efficiently from the outset. They generally produced intermediate goods such as machinery for other industries. Data for this period are limited, but South Korea was characterised by a relatively high budget deficit as a result of the active investment policy, which also entailed a rise in government debt, despite the swift economic growth. Debt rose from 7 to 14 per cent relative to GDP between 1953 and 1960. In the early 1960s – after the president was toppled in a coup – economic policy changed fundamentally: import substitution was replaced by export promotion. The exchange rate policy was considered one of the main tools of the 1961’s economic reforms. The Korean won was overvalued until 1960 to support the economic policy of import substitution, but in 1961 the government devalued the currency from 65 won to the dollar to 130, and until 1965 the exchange rate was gradually raised to 251 won to the dollar (Yoo 2008). The other crucial area of the government’s policy was to control prices. The 1962 Price Control Act authorised the government to control the prices of public utilities and staple foodstuffs (Kim 1991). The government also exercised its influence in the exchange rate and the — 224 —

interest rate policy. According to estimates, in 1966, approximately 40 per cent of transactions were affected by the price controls. In 1961, the Korean Central Bank Act was amended to limit the independence of the Central Bank, and basically every commercial bank was nationalised (Yoo 2008). The government argued that this was necessitated by the lack of available capital. Korea wished to finance its development policy from predominantly domestic funds, and the government had to exert tighter control over the scant capital stock to achieve the plan. In this manner, the government was able to channel the available capital into the sectors of its choosing with preferential yields. The most widespread instrument for this was the preferential interest rate. Between 1960 and 1980 the interest rate of the so-called policy loans was, on average, half of the normal commercial loans, and by the end of the period, their volume exceeded by 10 per cent of the total volume of corporate loans. As a result of the economic turnaround in 1981, the interest rate of the policy loans was raised to the level of the market rates and they were gradually phased out. In addition, state banks were established to finance individual sectors that were not attractive to commercial banks (e.g. small enterprises, agriculture, exports and imports). The industrial development policy also used tools that could be classified among fiscal policy instruments. From the early 1960s, within the framework of export promotion, certain preferred industries, products and even corporations were chosen. A wide range of instruments were applied by the government for supporting them. These included corporate and personal tax allowances, tax and tariff concessions for importing the necessary commodities, accelerated amortisation, interest rate relief, and the provision of the necessary foreign currencies as well as export guarantees. According to Kim (1991), the most important of these proved to be the relief of interest rates. Companies producing for export were able to acquire loans at half of the market interest rate. Companies investing in domestically manufactured machinery received a 10 per cent investment grant. Until 1975 wages were artificially kept low, â&#x20AC;&#x201D; 225 â&#x20AC;&#x201D;

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however, after their annually rose by 17 per cent for 5 years. As a result, labour-intensive light industries lost some of their competitiveness and weight, while the significance of the capital-intensive heavy industry was heightened. After wages rose, a shift to a more modern structure was necessary to ensure sustainable growth. Yoo (2008) lists 8 tools of which the South Korean government employed to stimulate exports: 1. Exporting companies could retain their revenue in FX to cover their imports, despite the strict foreign currency management. 2. Exporting companies were exempt from import restrictions and tariffs. 3. State banks provided policy loans. 4. Tax allowances were introduced. 5. The state provided capital and current subsidies. 6. A crawling peg was adopted to prevent the appreciation of the real exchange rate. 7. The government announced goals that influenced the behaviour of companies even when they were not compulsory. 8. State prizes and awards were created. According to a comprehensive analysis, the Korean tax policy aimed at supporting companies that actually contributed little to the economic growth. Trela and Whalley believed that the tax policy facilitated rather than strengthened economic growth, and its actual annual contribution to the GDP growth amounted to merely 0.26 percentage points in 1962–1982 (Trela–Whalley 1992). Critics argue that when indirect effects are also taken into account, the role of tax allowances becomes clearer, but their impact was certainly less than that of policy loans (Yoo 2008). 1981 saw another momentous turnaround in economic policy, which was once again preceded by substantial political changes and disruptions. (The president who came to power in 1961 was assassinated, and in 1979 a coup was staged, which was followed by a bloody demonstration in — 226 —

1980. The president who came to office after the coup strengthened his grip on power in the elections of 1981.) The economic reforms were aimed at deregulation, fiscal consolidation, reducing the role of the state and allowing freer reign to market forces. Fiscal consolidation could be considered as a success, the budget balance improved rapidly as noted earlier, and until the outbreak of the financial crisis Korean policymakers were able to keep the budget relatively balanced. However, liberalisation progressed less rapidly (Koh 2007). This is illustrated by the fact that the floating exchange rate regime was introduced, which, in fact functioned as a fixed or a crawling peg exchange rate. The exchange rate was only allowed to truly float in the 1990s, after the crisis. From 1980, the government placed greater emphasis on incentives for manufacturing high-tech products. This was believed to require more intensive foreign direct investments and technology transfers than before. To this end, the government eased the restrictions on foreign investments. The pension fund introduced in 1988 initially contributed positively to the budget, as there were only contributions and no pay-outs. According to Koh (2007), the pension fund added the equivalent of 1â&#x20AC;&#x201C;3 per cent of the GDP to the budget balance annually. The basic items of the Korean budget and economic policies did not change significantly in the 1990s, but the financial crisis in 1998 caused a rift. The government reacted to the crisis with an expansionary fiscal policy, which manifested itself in support for the financial sector and the restructuring of exporting companies (Stiglitz 2002). The earlier disciplined fiscal policy provided a sound basis for this as at the onset of the crisis, the debt-to-GDP ratio only amounted to 8 per cent, which, however, soared to 18 per cent in three years. Stiglitz believes that Korea responded better to the crisis than its regional peers. The budgetary expenditure that increased during the crisis did not return to its previous level. Instead, the revenue was adjusted to â&#x20AC;&#x201D; 227 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

it. Therefore, the fiscal redistribution rate rose from the 25 per cent characteristic of the 1990’s to 32–34 per cent. This increase was mainly due to the expansion of welfare expenditure. As a result, the structure of the South Korean budget became much more similar to other developed countries, although the redistribution rate still lagged behind the European welfare states.

5.3 Ireland In 1950, Ireland was one of the least developed countries in Western Europe. Due to the protectionist economic policy, it was characterised by a low annual economic growth rate – approximately 2 per cent on average in the 1950’s – and it fell even further behind the countries on the continent. Therefore, at the end of the decade the government announced the policy of opening up, and the country joined several international organisations and signed bilateral free trade agreements. Many measures were introduced to encourage foreign investments, and the country achieved an economic growth rate of approximately 4 per cent in the 1960’s. However, in the decade of the oil crisis, Ireland piled up huge amounts of debt, which entailed a substantial interest burden. Thus, in the early 1980’s fiscal consolidation became necessary, but the tax increases were not able to halt the rise of the debt-to-GDP ratio. In 1987, the country was in dire economic straits and undertook radical reforms: it cut back state spending and transformed the tax system. After the structural reforms, it became one of the most popular investment targets for foreign companies. On the account of the financing received from European funds and the high rate of capital inflows, it exhibited a dynamic growth rate – sometimes as high as 9 per cent – in the 1990’s. By the 2000’s it had become one of the most developed countries in Europe. The economic policies of the years following the consolidation attracted widespread criticism, as for a long time in the 1990’s healthcare and education spending was not increased in line with the growing GDP. As the debt ratio surged after the 2008 financial crisis, today there is little leeway for bringing these expenditure items to the appropriate level. — 228 —

5.3.1 1950–1973: The decades of opening up

At the end of the 1950’s, the Irish government broke with its previous staunchly protectionist policy and sought to promote export-oriented growth instead. In 1957, the country became a member of the World Bank and the IMF, and in 1967 it joined the World Trade Organization as well. In 1965, the Anglo–Irish Free Trade Agreement was signed (Powell 2003). From the 1950s, the country attempted to attract more foreign direct investment by various allowances and incentives. One of the most influential measures was the introduction of tax allowances on profits made from exports in manufacturing, which amounted to 50 per cent from 1956 and to 100 per cent from 1958. Furthermore, almost all import tariffs were abolished, investment grants and preferential loans were provided to companies (for R&D and fixed capital) and industrial sites with state-owned infrastructure which were leased out at a low price (Hajós 2006). These made the country a more appealing target for foreign investors, but as pointed out by an OECD study at that time, skilled labour was still in short supply in this era (Dorgen 2006). The study led to an education reform in 1967, within the framework of which secondary education became free, and students’ free transportation to school was organised, which meant considerable progress in rural areas. By the 1960’s, as a result of the liberalisation of trade, GDP growth had doubled as compared to the approximately 2 per cent figure characteristic of the 1950’s.

5.3.2 1973–1986: The period of indebtedness

In the early 1970’s, Ireland continued the path of opening up and in 1973 it joined the European Community (EC), thereby becoming its least developed member. One of the main aims of the EC was to approximate — 229 —

Part I: International and national experiences in economic convergence

the Irish macroeconomic indicators to the community average. In 1973–1980, the country pursued a loose fiscal policy, which later led to a fiscal crisis. Following the oil crises in 1973 and 1979, the government sought to boost aggregate demand by increasing government spending. Between 1977 and 1981 state expenditure rose in all areas. State wages increased just like the number of people employed, the volume of social transfers and – due to to the large infrastructure investments – capital expenditures. As a result, by 1982 state redistribution grew by 17 percentage points to 56.7 per cent. After the oil crisis, international interest rates were already high, which, in Ireland’s case was coupled with a considerable risk premium (Powell 2003), and consequently interest expenses substantially restricted the country’s room for fiscal manoeuvre. The fiscal policy of the government became unsustainable by the end of the decade. Chart 5-7: Public debt and budget expenditures in Ireland (1960–2014) 140

Percentage of GDP

Budget expenditures (right-hand scale)

Public debt

Source: IMF, Public Finances in Modern History, European Commission

— 230 —

2012

2008

2004

20 2000

20 1996

1992

1988

1984

1980

1976

1972

1968

100

1964

1960

120

Thus, in the early 1980’s consolidation became inevitable, but tax increases were not enough to remedy the problems. The government attempted to lower the budget deficit by increasing taxes on labour and consumption (Dorgen 2006). The primary balance improved, but due to the high interest expenses, the debt-to-GDP ratio continued to rise. On account of the large budget deficit and the slow growth characteristic of the early 1980’s, by 1986, government debt had surged by 50 percentage points from its level in 1973, leaving the country in a difficult economic situation (Chart 5-7).

Owing to the successful structural reforms in 1987, the country managed to boost economic growth and consolidate the budget at the same time. The 1987 fiscal consolidation in Ireland was seen as a classic example of extensive consolidation because the austerity measures did not cause a substantial recession, not even in the short term, as the investment revitalization caused by the increasing credibility was able to offset the drop in domestic demand (i.e. non-Keynesian effects took hold). Yet, in recent years several studies challenged this claim, as many other favourable factors supported economic growth in the 1990’s (Healy et al. 2013). Still, it is fair to say say that these favourable circumstances were successfully exploited by the country, resulting to became Europe’s most dynamically growing economy. As the earlier revenue-side fiscal consolidation failed, the Programme for National Recovery was announced, in 1987 which included comprehensive economic policy reforms. As a member of the EMS, inflating away its debt was not an option for Ireland. The tax increases introduced in the 1980’s were not successful either, therefore the country decided to dramatically cut government’s spending. As part of the reform, the transfers and benefits were reduced along with capital expenses and the workforce in the state sector, i.e. the consolidation covered almost all areas (Honohan 1992). As a result, government — 231 —

Part I: International and national experiences in economic convergence

spending decreased from 53 to 42.5 per cent in GDP terms between 1986 and 1989. Chart 5-8: Budget balance in Ireland (1970–2014)

Percentage of GDP

–2

–4

–6

–8

–10

–12 –14

2010: –32,5 % 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

–12 –14

Budget balance

Source: IMF, Public Finances in Modern History, European Commission

This consolidation significantly improved the Irish fiscal indicators. The rise in the debt-to-GDP ratio was halted and it started to nosedive in 1995 (Chart 5-7). The budget deficit, which was typically around 10–12 per cent in the 1980’s, dropped to approximately 3 per cent by the first half of the 1990’s, and by the second half of the decade the budget showed a surplus (Chart 5-8). In parallel with the consolidation, the government continued its 1960’s policy of attracting capital and developing industries. In order to stimulate FDI inflows, a preferential 10 per cent tax rate was introduced in manufacturing (Walsch 2003). Changes have been made in the tax system as well. Taxes on personal — 232 —

income and on capital were reduced. In the same period, a wealth tax was introduced, and personal income tax and VAT were raised. The tax reform gave priority to turnover-, and wealth-type taxes over taxes on income. One aim of the reforms was to create a stable, competitive labour market. After joint negotiations, the government, the employers and trade unions agreed on a 2.5 per cent annual wage increase within the framework of the Programme for National Recovery.57 The trilateral agreement stabilised the labour market, the number of strikes dropped, business confidence improved and the unemployment rate started to offset by the aforementioned cut in the personal income tax rate.58 The labour market reforms also included the reduction of the unemployment benefits and the scope of those qualifying for it, which was intended to improve the participation rate. In addition to the successful reforms, the subsidies received from the European funds should also be mentioned. Between 1973 and 1996, 20 billion Irish pounds flowed into the economy, which amounted to 4 per cent of the country’s GDP annually. Effective utilisation of these funds contributed considerably to the country’s dynamic growth. When it joined the European Community, Ireland’s gross domestic product per capita at purchasing power parity corresponded to merely 60 per cent of the German figure. By the turn of the millennium, Ireland was in the vanguard of Europe in this respect as well, and it obviated both Germany and the United Kingdom. Due to the Programme for National Recovery and the efficient usage of the European funds, the country was able to achieve dynamic growth with a balanced budget Since 1987 launching programmes based on a public consensus has become a tradition in Ireland, which brought calmness and predictability to the private sector, and paved the way to keeping wages low, reducing taxes, curbing inflation and radically reducing unemployment. 58 In three steps until 2001, the general rate of the personal income tax was reduced from 35 to 22 per cent, while the upper rate was lowered from 58 to 44 per cent. 57

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Part I: International and national experiences in economic convergence

in the 1990’s. Nevertheless, the economic policy pursued after the consolidation in 1987 has received strong criticism in the recent years, since important government expenditure items (healthcare, education) were not increased sufficently at the time of the dynamic growth.

5.4 Austria Austria is one of the most developed countries in the European Union regarding to per capita GDP at purchasing power parity. As far as the size and role of the state are concerned, it is halfway between the continental and the Nordic models. The build-up of the welfare state started in the 1970’s, which led to the rise of debt. After the oil crisis, the government fixed the country’s currency to the German mark to import low inflation and embarked on fiscal expansion in order to raise aggregate demand. Despite the loose fiscal policy, the country’s growth rate did not exceed as in other Western European countries in the first half of the 1980’s. After the junction to the European Union, the budget deficit reached 4 per cent, but in line with the Maastricht criteria, fiscal consolidation was required. As a result of the 1995 budgetary adjustment, the deficit was reduced to 1–2 per cent of the GDP. At this time, the redistribution rate in the country was well above 50 per cent, but substanial reduction was achived in the second half of the 2000’s. Although the budget deficit was cut after the 2008 financial crisis, due to slow growth, the debt-toGDP ratio of the country continued to increase.

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5.4.1 The build-up of the welfare state

In the 1970’s, both the size and the goals of the budget changed significally, and the government aimed to create a welfare state, based on the Nordic model. The main characteristics of this era were the followings (Seidel 1982): • The primary aims were full employment and growth. • Expansive fiscal policy facilitating growth and increasing employment. Government investment programmes and extensive interest rate reliefs in order to raise private investments. • Strong currency that helped vanquish imported inflation. Bonding the schilling to the German mark led to the valorization of the Austrian currency, compared to other trading partners. • Sustained price and wage controls for fighting down inflation and preserving competitiveness. The budget balance deteriorated, and the surplus turned into a deficit of approximately 2–3 per cent. The debt level ascended to its record lows of around 10 per cent at the end of 1974, to 50 per cent of GDP by the mid-1980s. The new socialist government undertook sweeping reforms in 1970 and transformed the social security system and education, while undertaking several expansive fiscal policy interventions during the first oil crisis. One of the main aims of the political leadership was full employment, as they tried to avoid unemployment for political reasons. GDP growth was relatively stable around 4 per cent until the end of the 1970’s, but then fell considerably after the 1979 oil crisis. The global rise in interest rates following by the crisis led to an increase in interest expenses in relation to the GDP. In order to stabilise the economy, the government continued its expansive fiscal policy. The National Bank pegged the Austrian schilling to the German mark this time. This combination of monetary and fiscal policy that helped to mitigate the negative impacts of the global crisis on the country, is sometimes — 235 —

Part I: International and national experiences in economic convergence

referred to as Austro-Keynesianism (Seidel 1982). With the help of the measures, the Austrian leadership managed to increase the country’s economic growth rate to the level of the developed Western economies. Yet this meant that the economy expanded by merely about 2 per cent.

5.4.2 Consolidation and EU accession

In 1987 the government was formed by, the social democratic– conservative coalition, and one of their main objectives was fiscal consolidation. Austria applied for membership with the forerunner of the European Union in July, 1989. In 1992, as the time of accession approached, several fiscal measures became necessary. The marginal tax rate on labour was reduced by the government from (an excessively high) 62 per cent to 50 per cent (Katterl–Köhler-Töglhofer 2005). The taxes similar to value-added taxes were abolished, and certain services, such as healthcare services were made exempt from value-added tax. However, the excise duty was raised in the case of certain products. It was clear even before the accession that Austria, on account of its level of development, would be a net contributor to the EU budget, and in the first years these expenses amounted to 0.9–1.5 per cent of GDP. Partly due to this, the budget deficit rose to 5.7 per cent – well above the 3 per cent, which was required by the Maastricht criteria – in 1995, the year of the country’s accession (Chart 5-9). In 1995, the country failed to meet the Maastricht criteria not only in terms of the budget deficit, but also with respect to the debt-to-GDP ratio, which was above 60 per cent. In response to this, the government undertook fairly substantial budgetary adjustments. The austerity measures lasted for two years and amounted to 4 per cent of GDP. Two-thirds of the consolidation was performed on the expenditure side, with tax increases constituting the remaining share. As a result of the tightening, the disposable income of households dropped by 10 per

— 236 —

cent, and the measures hit wealthy households particularly hard. As part of the reforms on the expenditure side, the number of government employees was reduced, and a pension reform was implemented in 1997 (Katterl–Köhler-Töglhofer 2005). Chart 5-9: Budget balance in Austria (1970–2014) 3

Percentage of GDP

–4

–5

–6

2014

–3

2010

–3

2006

–2

2002

–2

1998

–1

1994

–1

1990

1986

1982

1978

1974

1970

Budget balance

Source: IMF, Public Finances in Modern History, European Commission

Furthermore, a privatisation programme was launched to reduce debt. The government sold its stakes in major banks (CreditanstaltBankverein, Bank Austria AG) and privatised several corporations, including the tobacco and the salt factory (Prammer 2004). The measures helped to reduce the debt-to-GDP ratio by around 4 percentage points by 1997, which thus approximated but did not meet the Maastricht reference value.

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Part I: International and national experiences in economic convergence

After the 1996–1997 consolidation the government abandoned the adjustment, despite the fact that the country had not fulfilled the Maastricht criteria and the favourable global economy environment would had supported it. In the election year, in 1999 the government announced that it would lower taxes, which amounted prior to an expansion of almost 1 per cent in GDP terms. The reform of family allowances imposed a further 0.25 per cent burden on the budget (Katterl–Köhler-Töglhofer 2005). Due to these measures, the debt-toGDP ratio started to rise again, albeit only slightly, and moved away from the 60 per cent target. Chart 5-10: The redistribution rate in the european countries (1999) 60

Percentage of GDP

60 50

Sweden Denmark France Austria Finnland Belgium Hungary Slovak Republic Germany Italy Norway Slovenia Netherlands Poland Portugal Malta Iceland Latvia Czech Republic Spain Luxembourg Bulgaria Romania United Kingdom Cyprus Ireland

Source: Eurostat

The redistribution rate of Austria was above 50 per cent at this time, which brought it on par with welfare states such as Denmark, Sweden or Finland (Chart 5-10). In these years, international organisations — 238 —

recommended shrinking the government sector, pushing ahead with privatisation, deregulating the electricity and gas markets as well as cutting spending to reduce the debt-to-GDP ratio (IMF 2000).

5.5 Finland Finland managed to catch up with the developed European countries, thanks to its dynamic growth from the 1960s to the 1980s. During this period, average GDP growth was close to 4.5 per cent. The fiscal position of the country was also favourable, as between the 1970s and 1991 the budget always showed a surplus. The debt-to-GDP ratio was also low: it fluctuated around 10 per cent (Chart 5-11). Chart 5-11: Budget balance, public debt and GDP growth in Finland (1961–2014)

Percentage of GDP

100

0 –20

–4

–40

–6

–60

–8

–80

–10

–100

1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

–2

GDP growth Public debt (right-hand scale) Source: European Commission

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Budget balance

Part I: International and national experiences in economic convergence

The country also implemented budgetary and structural reforms during the period under review. Among these the extensive education reform deserves special mention, as it improved both the access and the standard of the education. During the budgetary reforms, the structure of tax revenues was overhauled on the revenue side. Indirect taxes (turnover taxes, excise duties) received priority over income-type taxes. There were substantial changes on the expenditure side as well. In the early 1960’s, the build-up of the welfare state accelerated, and the volume of social spending relative to GDP tripled over 20 years. The central task from a foreign policy perspective was to prepare for the accession to the European integration. The free trade agreement between Finland and the European Community in 1973 was an important milestone in this process.

5.5.1 Education reform

The education reform which started in 1970 had three main goals: to ensure equal opportunities for students, to improve the quality of education and to increase the participation rate at all levels. In the early 1970’s, school performance was largely dependent on students’ social background. Children from low-income families fared worse than their peers from wealthy families, which was primarily due to the poorer standard of education in rural schools. In order to tackle the problem and to ensure the same quality of education for all students, school curricula were harmonised (Sahlberg 2009). As a long-term result of the harmonisation, the standard deviation of Finnish schools’ average score in the international PISA test – which measures the knowledge of primary school students – has been among the lowest in the OECD countries in recent years. In order to improve the quality of education, the training of primary school teachers was also overhauled. From the mid-1970’s the three-year teacher training programmes were replaced by 4–5 years of universitylevel courses. Over the long term, the reform has led to an improvement — 240 —

in quality, as Finnish students’ scores in the PISA tests are regularly among the best in the OECD. In order to raise the participation rate, primary education was made compulsory, and assistance was provided in getting to school (Sahlberg 2009). Furthermore, social assistance was given to families and students, and healthcare and dental services were provided to the children. As a result of the measures, the participation rate in primary education improved considerably in the mid-1970s (Chart 5-12). Following the reforms Finnish education spending increased significantly. In recent years, Finland was among the OECD countries that spent the most on education. In 2012, more than 7 per cent of GDP was allocated for this purpose. Chart 5-12: Enrollment ratio in the primary education (1971–1990)59 105

Per cent

105

1990

1989

1988

1986

1987

1985

1984

1983

1982

1981

1980

1979

1978

1976

1977

1975

1973

1974

1971

100

1972

100

Enrollment ratio in the primary education Note: The enrolment ratio can be greater than 100 per cent as a result of grade repetition and entry at ages younger or older than the typical age at that grade level. Source: World Bank

The indicator may exceed 100 per cent due to students who started school before the compulsory age and those who had to repeat a year.

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Part I: International and national experiences in economic convergence

5.5.2 Tax reforms

On account of the high inflation and in order to restore the external balance, both monetary and fiscal policy started to tighten in the mid1970’s. In parallel with the fiscal restraint, the tax system started to be restructured, and indirect taxes received priority over income-type taxes (OECD 1977). Within the framework of the tax reforms, the top marginal rate of the personal income tax was lowered from 70.75 per cent in 1976 to 51 per cent in 1979 (World Tax Database). As a result of the measures, the tax wedge on labour decreased from 41 to 36 per cent by the early 1980s (European Commission). The VAT rate was raised from 11 to 13 per cent, and later by an additional percentage point to 14 per cent (OECD 1977). By shifting the focus to turnover-type taxes, their share in the whole tax revenue increased at the end of the 1970s (Chart 5-13).60 Chart 5-13: Taxes on income and consumption (1965–1984) 50

Percentage of a total tax revenue

Taxes on consumption

1984

1983

1982

1981

1980

1979

1978

1977

1976*

1975

1974

1973

25 1972

1971

1970

1969

1968

1967

1966

1965

Taxes on income

Note: *Year of tax reforms Source: OECD

The processes are similar to the changes observed in Poland as discussed in the next subchapter.

— 242 —

The increase in indirect taxes was primarily disadvantageous for families with a higher marginal propensity to consume and lower income. It was attempted to offset this with a 15 per cent increase in child benefits.

5.5.3 Establishing the Nordic welfare model

The county took the first steps towards European integration in the 1960’s, which at that time was characterised by rapid industrialisation and changing political forces. The build-up of the Nordic welfare state started in this period. In the early 1960s, the foundations for the workplace pension and health insurance system were laid. Employers created independent funds where they paid a portion of employees’ wages. Later they financed employees’ pension and medical expenses from this fund. The latter’s weight considerably decreased when in the 1970’s state healthcare services were significantly expanded. During the decades of the welfare state’s establishment, the value of social spending relative to GDP increased continuously. In the early 1960’s, the volume of social spending was less than 10 per cent of GDP, but by the mid-1980’s it was close to 25 per cent, which corresponded to the Western European level (Kosonen 1993). The Nordic, Scandinavian model was different from the continental scheme. The Finnish welfare state was characterised by universality and redistribution, while the model employed in Western countries aimed to stabilise the economic situation of their citizens. The main difference is that in a universal welfare state every citizen is entitled to certain social benefits and basic services, whereas in continental welfare states these are usually linked to labour market status (unemployment benefit) or marital status (certain family benefits).

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Part I: International and national experiences in economic convergence

5.6 Poland In the two decades after the political transition, the Polish economy was a top performer among the Visegrád countries. Between 1992 and 2014 the country increased its gross domestic product by more than 4 per cent on average annually, thereby boosting it to 2.5 times its original volume. Poland’s budget balance fluctuated somewhere around the 3 per cent target set by the Maastricht criteria (Chart 5-14), Chart 5-14: Budget balance in Poland (1995–2014) 1

Percentage of GDP

Budget balance

2014

2013

2012

–8

2011

–8

2010

–7 2009

–7 2008

–6

2007

–6

2006

–5

2005

–5

2004

–4

2003

–4

2002

–3

2001

–3

2000

–2

1999

–2

1998

–1

1997

–1

1996

1995

Maastricht criteria

Source: European Commission

while the debt-to-GDP ratio was reduced from the 70 per cent observed in the early 1990s to 50 per cent. The structural reforms launched by the government in 1999 helped to maintain growth, and according to estimates by the International Monetary Fund, the GDP growth rate increased by 1.4 percentage points due to the reforms in the second half

— 244 —

of the 2000’s (IMF 2015). The success of the Polish economy was also facilitated by the fact that for a long time it specialised in relatively lowtech sectors, which entailed low labour costs ensuring a comparative advantage. It was almost the only European country that did not slide into recession after the 2008 crisis. In recent years, due to the earlier tight fiscal policy, it was possible to support economic growth through budgetary means and pursue a countercyclical fiscal policy. One of the reforms, the overhaul of the pension system, was partially reversed in order to reduce government debt and to boost budget revenues. After the dissolution of the Eastern bloc, Poland – just like other countries – faced enormous challenges. The transformation crisis caused a severe economic downturn in all Central and Eastern European countries. As the traditional export markets collapsed, the demand for the goods produced by the post-Soviet countries declined considerably, which later led to the reduction of capacities and high unemployment. However, in the years before the turn of the millennium, economic growth was solid at 5–7 per cent (Chart 5-15), and the budgetary situation also improved every year. The budget deficit was approximately 4 per cent of GDP, and the government debt was on a downward path and declined to below 40 per cent by the end of the 1990’s. In parallel with the shrinking debt, interest expenses relative to the GDP also diminished. Furthermore, the state also became smaller, and both the revenue and the expenditure side decreased by 4–5 percentage points in GDP terms. The good performance, however, concealed structural problems. Reforms were needed to tackle the excessive social spending and the complicated tax system containing countless loopholes (Kemme–Rapacki 2000).

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Part I: International and national experiences in economic convergence

Chart 5-15: GDP growth in Poland and in the V4 countries 12

Percentage of GDP

V4 countries (without Poland)

2014

–8

2013

–8

2012

–6 2011

–6 2010

–4

2009

–4

2008

–2

2007

–2

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

Poland's GDP growth

Source: European Commission

5.6.1 Tax reforms

The Polish government launched the structural reforms in 1999. One of the main aims of the tax reforms was the modernisation of the tax regime and the improvement of its efficiency by creating a simpler, more transparent and growth-friendly system. The most important task in reforming the tax system was shifting the focus of tax centralisation. In line with international recommendations, incometype taxes were to be given less weight while turnover-type taxes were to be increased. In the early 2000s, the tax wedge on labour was already high in Poland, which – together with the relatively inflexible

— 246 —

labour market – led to low employment levels and the expansion of the black economy. The tax wedge of employees with lower income was 42 per cent in 1999, which was the average among EU Member States. In order to address the problems, the top rate of the personal income tax was reduced by 1 percentage point in 1997 and by a further 4 percentage points in 1998 from 45 to 40 per cent, which was maintained until the onset of the 2008 financial crisis. In 2009, the top rate was cut by another 8 percentage points to 32 per cent. Thus in recent years there were only two rates: 18 per cent and 32 per cent. The bands were so broad that 97.5 per cent of taxpayers belonged to the lower one, i.e. there was basically a flat-rate tax system in the country (IMF 2015). In parallel with the reduction of the tax rate, several allowances were phased out, which yielded a simpler system and a broader tax base. As a result of the measures, the aforementioned tax wedge was reduced to 34.8 per cent, which is low even compared to other EU countires. The employment rate also rose, increasing from 55 to 62 per cent over ten years, and women’s employment received a particularly strong boost (OECD). In harmony with the requirements of the European Union, the range of goods subject to excise duty was expanded, and some related tax increases were implemented. Due in part to this, the implicit tax rate on consumption rose from 17.8 to 19.3 per cent in the period. The proportion of consumption taxes within the total tax revenue was 35 per cent in 1999, while the revenue of the taxes on income was around 44–45 per cent. As a result of the overhaul of the tax regime, however, the two tax types were aboutequal weight by the end of the 2000s (Chart 5-16).

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Part I: International and national experiences in economic convergence

Chart 5-16: Taxes on labour and consumption as a percentage of total taxation (1965â&#x20AC;&#x201C;1984) 46

Percentage of a total tax revenue

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Taxes on consumption

Taxes on labour

Source: Eurostat

Another important element of the growth-friendly tax system was the substantial reduction in the corporate tax rate. The top rate was cut in several steps from the 40 per cent in 1995 to 30 per cent in 2000, and in 2004 it was slashed yet again to 19 per cent (European Commission 2014). At the same time (just as in the case of the personal income tax) many allowances were abolished, and the rate of depreciation was changed as well. Thanks to the tax reductions, tax centralisation decreased from 41 to 38 per cent in GDP terms between 1999 and 2009.

5.6.2 Reforming the pension system and social spending

The pension reform introduced the three-pillar pension system by creating the second, funded pillar, which entailed considerable changeover costs. After the global financial crisis this reform process â&#x20AC;&#x201D; 248 â&#x20AC;&#x201D;

was reversed, as due in part to the recession and in part to the measures, the budget deficit increased by 1.5–2 percentage points. The weight of the second pillar was reduced in favour of the first in 2011. Until the changeover 7.3 per cent of gross income had to be paid into the second pillar, which was cut to 2.3 per cent, and the remaining 5 per cent was channelled back into the state budget (IMF 2014). In 2014, more than half of all private pension fund assets were nationalised, and the proceeds were partly spent on reducing the debt-to-GDP ratio. Reducing and better targeting social spending also posed a great challenge to the political leadership. The various, widespread, and in many instances overlapping (primarily means-tested) forms of social benefits were reduced and were clearly separated. Local governments took over the allocation of funds from the central government, thereby making the system more targeted. The system of unemployment benefits was differentiated, as the government also sought to manage the unemployment rate that surged to 20 per cent in the reform period. As a result, the volume of cash transfers dropped by 2.5 percentage points, and the amount of state benefits also decreased by approximately 0.5 percentage points in GDP terms (Table 5-2). Table 5-2: Government expenditures as a percentage of GDP 1995

2014

Difference

Government investment expenditures

2.7

4.5

1.7

Compensation of employees

11.2

10.1

–1.0

Social transfers

16.6

14.1

–2.4

Social transfers in kind

8.7

10.3

1.6

Subsidies

1.0

0.6

–0.4

Source: European Commission

5.6.3 Other structural measures

The goal of the healthcare reform was to modernise healthcare and to provide a solid financial background to that area. Therefore, regional health — 249 —

Part I: International and national experiences in economic convergence

insurance funds were set up that were financed through the national health insurance fund from patients’ supplementary and private contributions. Healthcare services were decentralised down to the county and province level, and the independence of healthcare providers was ensured. The reform of public administration aimed to improve the efficiency of public services. The government introduced a 3-level public administration, which functioned at the regional, the county and the local level. The newly created regions were larger and their ability of self-government were more robust, which facilitated the strengthening of democracy. Chart 5-17: PISA scores in OECD countries (2009–2012) 560

540

520

500

480

460

440

420

400

Mexico Chile Bulgaria Romania Turkey Greece Israel Croatia Hungary Sweden Lithuania USA Slovak Republic Spain Italy Portugal Norway Luxembourg Latvia Iceland OECD average Great-Britain France Czech Republic New Zealand Denmark Slovenia Ireland Australia Germany Belgium Poland Canada Finland Estonia Netherlands Switzerland Japan Republic of Korea

560

2009

2012

Source: OECD

Public education was also overhauled to enhance efficiency. The earlier 8+4-year system of primary and secondary education was replaced by a 6+3+3-year structure, in which primary school lasts for 6 years, and it is followed by a 3-year lower secondary school and a 3-year upper — 250 —

secondary school. An important element of the scheme is that students’ knowledge is assessed at the end of all three cycles. According to several studies, the impressive improvement in the PISA results – which helped the country catch up with Europe’s top performers – can be attributed to this (Chart 5-17).

5.7 Slovakia After Slovakia became independent on 1 January 1993, six years of economic instability ensued, and during this period the performance of the country lagged far behind the other members of the Visegrád Four. The budget deficit was 6 per cent on average annually (Chart 5-18), and the country was characterised by unsustainable growth in this period. In order to combat inflation, the loose fiscal policy was

Budget deficit

Maastricht criteria

Source: Eurostat

— 251 —

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Percentage of GDP

2000

1999

1998

1997

1996

Percentage of GDP

1995

2 1 0 –1 –2 –3 –4 –5 –6 –7 –8 –9 –10 –11 –12 –13

Part I: International and national experiences in economic convergence

counterbalanced by a stringent monetary policy. The government that came to power in 1998 undertook substantial reforms, which did not produce macroeconomic success in the first two years of governance but in the long term it proved effective in supporting convergence to the Western European average. The main aims between 1998 and 2002 were the stabilisation of the economy, the elimination of corruption and the acceleration of privatisation, while in 2002–2006 Slovakia implemented radical structural reforms in numerous areas.

The predictability of the macroeconomic environment was indispensable for putting the country on an economic growth path sustainable over the long term. This required a stable budget and the creation of a well-functioning institutional system. Budget planning was transformed, the three-year planning period was introduced, Chart 5-19: Slovakia’s gross public debt (1995–2014) 60

Percentage of GDP

Gross public debt of Slovakia Source: Eurostat

— 252 —

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

the analyses and decision-making processes became more transparent and strict fiscal rules were implemented (European Commission 1999, 2000, 2001). Regulating the budget more tightly was necessary because the level of Slovak government debt rose steeply after independence until 2000, reaching 49.6 per cent of the GDP (Chart 5-19). As a result of the successful reforms, government debt was continuously reduced until the onset of the 2008 economic crisis when it reached 28 per cent.

5.7.2 Tax reforms

The principal aims of the tax reform introduced in Slovakia in 2004 were to modernise the tax system and make it more competitive, while also reducing tax centralisation (Chart 5-20). The structure of the most important taxes were overhauled, allowances were phased out, tax base reducing items were scrapped and an attempt was made to abolish double taxation (Mikloš 2008). The former five-rate personal income tax – which varied between 10 and 38 per cent – was replaced by a flat-rate system with a 19 per cent tax rate. The flat rate VAT system was introduced, instead of the earlier reduced 14 per cent rate and the normal 20 per cent rate, the 19 per cent rate became universal here, too. There were many people againts the VAT system’s reform, since food, medication, the printed press and books all used to be taxed at the reduced rate. The former three-rate corporate tax system was also transformed, and a universal 19 per cent rate was introduced in this area as well. Moreover, the dividend tax, the gift tax, the inheritance tax and the real estate purchase tax were all eliminated.

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Part I: International and national experiences in economic convergence

Percentage of GDP

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

Fiscal revenues Source: Eurostat

5.7.3 Other structural measures

The pension system was reformed in 2005 with the aim of making it sustainable (Mikloš 2008). The three-pillar pension system was introduced, comprised of a mandatory state pension system, a mandatory second pillar financed by private pension funds and a voluntary private pension fund pillar. Joining the system became compulsory for all new employees, and it was decided that so-called Swiss indexation would be applied to pensions, taking into account inflation and changes in net wages. As a part of the reform, the retirement age was raised to 62 from 60 in the case of men, and from 57 in the case of women.

— 254 —

The main goals of transforming the healthcare system included the elimination of its inefficient operation, combating corruption and improving quality. Within the framework of the reforms, the state assumed the debt of healthcare institutions, performance-based funding was introduced, and health insurance enterprises were transformed into joint stock companies. The main goal of the labour market reform was to tackle the excessive unemployment and increase the low participation rate. As part of the reform, the labour code was made more flexible, taxes on labour were reduced, the employment of people with disabilities was subsidised and the process of hiring and firing became simpler.

5.8 Conclusion Fiscal policy may basically have four tasks in jumpstarting and maintaining economic growth. One of the most important of these is ensuring economic stability and cushioning the impact of macroeconomic cycles. The second and the third are providing the necessary volume of resources and the continuous improvement of the resourcesâ&#x20AC;&#x2122; quality. The fourth notable task is creating the institutional system necessary for the functioning of the economy and providing an adequate legal framework. However, there is no generally applicable recipe for all countries. Economies aspiring for convergence need to choose their fiscal and general economic policy based on their characteristics, external circumstances and preferences. The success of converging countries depends partly on how fiscal policy can exploit the potential of the given country or the favourable external processes on the global market. Some common features, however, can be deduced from the experiences of the countries under review. First, stability is the most essential condition of sustainable growth. Excessively loose fiscal policy sooner â&#x20AC;&#x201D; 255 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

or later leads to a crisis, in which all the gains of the previous years might be lost. As we have seen, fiscal stabilisation can be achieved in a fashion that stimulates economic growth even after a few years. On the other hand, convergence periods were usually preceded by structural reforms, i.e. active intervention is necessary to unlock the potential. This intervention included reform of the tax system in almost all cases, but also affected state redistribution, as well as transfers and incentives, and shifted the focus of the expenditure side of the budget onto productive items. Compared to successfully converging countries, fiscal equilibrium in Hungary has been unsatisfactory in the past 25 years, and it has only reached the adequate level in the past few years. Despite having declined in the past couple of years, government debt is still higher than in the countries under review. The Hungarian fiscal redistribution rate relative to GDP is also above the average, especially compared to similarly developed countries. From the perspective of human capital, spending on education as a percentage of GDP is noteworthy, as it is above the average in comparison with the countries under review. Nevertheless, the proportion of spending financed by the private sector within total education spending is more substantial elsewhere, and according to international surveys, the efficiency of education spending in Hungary still has room for improvement.

â&#x20AC;&#x201D; 256 â&#x20AC;&#x201D;

References Gerschenkron, A. (1984): A gazdasági elmaradottság történelmi távlatból (Economic Backwardness in Historical Perspective). Gondolat Könyvkiadó. Dorgan, S. (2006): How Ireland Become the Celtic Tiger, Backgrounder, No. 1945. Fiskális eszközök a növekedésorientált gazdaságpolitika szolgálatában Írország és Magyarország példáján (Fiscal instruments in the service of a growth-oriented economic policy through the example of Ireland and Hungary). PhD thesis. European Commission (1999): Regular Report on Slovakia’s Progress Towards Accession. European Commission (2000): Regular Report on Slovakia’s Progress Towards Accession. European Commission (2001): Regular Report on Slovakia’s Progress Towards Accession. European Commission (2014): Taxation trends in the European Union. Fischer, K. – R. Gönenç – R. W. Price (2011): Austria: Public Sector Inefficiencies Have Become Less Affordable, OECD Economics Department Working Papers, No. 897. Hajós R. Z. (2006): (The Irish miracle. Ireland’s economic development since its independence until today), Európai Honohan, P. (1992): Fiscal Adjustment in Ireland in the 1980s, The Economic and Social Review. Vol. 23, No. 3, April. IMF (2000): Austria: Staff Report for the 2000 Article IV Consultation. IMF (2001): Slovak Republic-Preliminary Conclusions of the Mission to Review the Staff-Monitored Program. IMF (2014): Fiscal Monitor, Public Expenditure Reform, Making Difficult Choices. IMF (2015): Fiscal Policy and Long-Term Growth, Policy Paper. Mikloš, I. (2008): Slovakia: A story of reforms. Growth versus security: old and new EU members’ quest for a new economic and social model. http://www.upms.sk/media/Slovakia_A_story_of_reforms. pdf Katterl, A. – Köhler-Töglhofer, W. (2005): The Impact of EU Accession on Austria’s Budget Policy, Monetary Policy & The Economy, Issue 2, pp. 101–116. Kemme, D. – Rapacki, R. (2000): Fiscal Reform, Policy, and Constraints during Transition in Poland, Post-Soviet Geography and Economics, No. 7, October–November; No. 8, December. Kim, Shin-Haing (2007): Finance and Growth of the Korean Economy from 1960 to 2004, Seoul Journal of Economics, Vol. 20, No. 4. Kim, K. S. (1991): The Korean Miracle (1962–1980) Revisited: Myths and Realities in Strategy and Development, University of Notre Dame, Working Paper 166.

— 257 —

Part I: International and national experiences in economic convergence Koh, Y. (2007): Reforming the Fiscal Management System in Korea, NBER-EASE, Vol. 16. Kosonen, P. (1993): The Finnish Model and the Welfare State in Crisis, Renvall Institute Publications, 5. pp. 45–66. OECD (1977): Economic Surveys: Finland. Park, Won-Am (1996): Financial Liberalization: The Korean Experience, NBER-EASE, Vol. 5. Powell, B. (2003): Economic Freedom and Growth: The Case of Celtic Tiger, Cato Journal, Vol. 22, No. 3. Prammer, D. (2004): Expansionary Fiscal Consolidations? An Appraisal of the Literature on NonKeynesian Effects of Fiscal Policy and a Case Study for Austria, Monetary Policy & The Economy, Issue 3, pp. 34–52. Sahlberg, P. (2009): A short history of educational reform in Finland. Seidel, H. (1982): Austro-Keynesianismus, Wirtschaftspolitische Blätter, 29, pp. 11–15. Stiglitz, J. (2002): Globalization and its discontents, W. W. Norton & Company. Trela, I. – Walsh, B. M. (2003): Taxation and foreign direct investment in Ireland, Fraser Institute. Yoo, I. (2008): Korea’s Economic Development: Lessons and Suggestions for Developing Countries, Korean Social Science Journal, Vol. 35, No. 1, pp. 31–63.

— 258 —

The current Hungarian situation

Convergence and equilibrium in Hungary since the political changeover Gábor Pellényi – Zsuzsa Kékesi – Géza Rippel – Balázs Sisak

Since the political changeover, Hungary has broadly converged to the development level of Western European countries, but this process has been uneven over time. The past 25 years have only seen short periods of sustainable and balanced convergence. Until the recession, Hungary’s economic growth trajectory varied between equilibrium and growth, and therefore balanced growth could only be achieved for short periods. The transformation period that followed the political changeover led to a sharp dip in GDP, which – coupled with the inherited high initial debt – disrupted the sustainability of external and internal debt. The adjustment improved the equilibrium position of the economy, but held back economic convergence until the second half of the 1990s. This was followed by a period of improving equilibrium indicators and rapid growth until the 2000s, also driven by deep structural reforms. While dynamic growth materialised between 1997 and 2001 in conjunction with sustainable external and internal balance and decreasing government debt, between 2002 and 2006 convergence was achieved with growing indebtedness and deteriorating macroeconomic equilibrium. The global economic crisis further hindered the correction of the unsustainable growth model, and thus until 2010 Hungary’s development level departed from developed economies. After the equilibrium position was stabilised, the convergence of the Hungarian economy resumed in 2013, largely driven by the utilisation of EU funds. Since 2013 the Hungarian economy has been expanding while maintaining macroeconomic equilibrium.

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Part I: International and national experiences in economic convergence

In the early 2000s, the expansionary fiscal policy substantially increased incomes, which directly fuelled consumption on the one hand, while also increased income expectations on the other hand. As a result, borrowing increased and did not subside despite the fiscal adjustment measures, because households compensated their lost incomes by borrowing. All of this led to the rapid indebtedness of households and the public sector, resulting in a rise in Hungary’s vulnerabilities. In order to attract external funds necessary for funding the substantial deficit, and due to the mounting inflationary pressure accompanying high consumption, the central bank pursued a strict monetary policy, resulting in a significant premium on forint yields. This led to an increasing shift to foreign currency borrowing by households, further boosting the risks for the Hungarian economy while conserving the elevated interest rates, due to the potential negative impacts of exchange rate depreciation. The challenges to economic policy were reflected in the lasting and increasingly unsustainable external imbalances, which could only be financed through external indebtedness. The price of the unsustainable growth model followed in the years leading up to the crisis was paid by the Hungarian economy in the form of a sluggish recovery from the recession. Broadly speaking, economic growth sustaining financial equilibrium would have allowed nearly 0.5 percentage point higher growth rates on average between 2002 and 2013. Worsening economic policy issues from 2002 to 2008, compromised the country’s solvency, pushing it to seek assistance from international institutions. As a result of the falling incomes due to the crisis and stricter lending, the private sector became a net saver, the general government deficit remained low, and thus the current account balance attained a surplus. In parallel, the volume of new deposits increased significantly, while private sector borrowing dropped, which allowed the repayment of foreign loans. Due to the revaluation caused by the depreciation of the exchange rate, external debt ratios and thus the country’s external vulnerability only declined significantly after 2011, which was supported to a great degree by the MNB’s self-financing scheme, the forint conversion of foreign currency loans and the Funding for Growth Scheme.

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6. Convergence and equilibrium in Hungary since the political changeover

6.1 Real economic convergence since the political transition 6.1.1 Introduction

Per capita gross domestic product (GDP) at purchasing power parity is the most widely used indicator for measuring economic development. In theory, the prosperity of the public would be more precisely shown by the amount of consumption, but value added indicates the performance of the economy as well, since it not only includes consumption but also goods produced for accumulation (and net exports). Over the long term, however, the two indicators typically follow a similar growth path. In line with this, the processes involved are, overall, robust for the choice of indicator, as per capita GDP and consumption exhibit similar trends. By using purchasing power parity, we seek to eliminate the price level differences across various countries, which may distort the comparison of values added calculated at current prices. The indicators used in the chapter are from the Penn World Table 8.1 database (PWT) published in April 2015 and from the World Development Indicators database (WDI) of the World Bank. The Hungarian economy suffered a serious downturn during the political transition, which was followed by a slow convergence to developed economies. According to WDI data, in 1991 the Hungarian economy’s level of development was 51 per cent relative to the average of the EU-15 countries (the “old” Member States from before 2004), and this had increased to 63 per cent by 2014. This 12-percentage point increase translates into a convergence of 0.5 percentage points annually. Based on Hungary’s initial position, current position and the convergence rate, the country shows average performance among the economies that joined the EU since 2004. In both 1991 and 2014, Hungary ranked seventh in per capita GDP among the former Easternbloc countries and successor states that joined the EU. Among Visegrád countries, Hungary exhibited the slowest convergence rate (Table 6-1).

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Part I: International and national experiences in economic convergence

Table 6-1: Evolution of GDP per capita in 1991 and 2014 in new EU member states comparing to old member states GDP per capita (1991)

GDP per capita (2014)

Average growth rate (1991-2014*)

Average rate of convergence (1991-2014) to EU15

Czech Republic

17577

28715

2.2

0.7

Slovenia

16518

28153

2.3

0.7

Estonia

14161

26612

2.3

0.9

Slovakia

12222

26471

3.3

1.2

Lithuania

13625

25813

1.3

0.9

Poland

9395

23976

3.9

1.4

Hungary

14968

23735

1.7

0.5

Latvia

13670

22076

1.1

0.4

Croatia

14115

20033

1.2

0.2

Romania

9822

19098

2.1

0.7

Bulgaria

8585

16363

1.5

0.6

Note: GDP per capita (PPS on current prices) * Volume of GDP on constant prices (not per capita). Source: World Development Indicators (World Bank), missing years added from Penn World Table 8.1

The economic convergence of Hungary has been uneven over time. After the shock-like political transition and the significant economic downturn, the bulk of convergence occurred in 1997â&#x20AC;&#x201C;2005. However, in the second half of this period, convergence only continued in the context of macroeconomic disequilibrium and over-indebtedness.61 In the second half of the 2000s, the convergence process stalled. By contrast, other countries in the CEE region were able to exhibit sustained convergence, in some cases stretching over more than a decade (e.g. Poland, Slovakia or the Baltic states). Four main phases should be distinguished in the convergence after the political transition. The first phase lasted until about 1995 and was characterised by a slump in economic performance and divergence from developed countries. 61

The relationship between Hungarian economic growth and macroeconomic balance is analysed in detail in Matolcsy (2015).

â&#x20AC;&#x201D; 264 â&#x20AC;&#x201D;

6. Convergence and equilibrium in Hungary since the political changeover

The second phase in the second half of the 1990s and the turn of the millennium was a period of successful, equilibrium convergence. This was followed by the third phase in the mid-2000s, i.e. the slowdown in convergence and macroeconomic disequilibrium. The fourth phase and renewed convergence started after the crisis management and the restoration of equilibrium. In the following, we describe the path that led here and the lessons that can be drawn from the experience. Chart 6-1: Evolution of GDP per capita in new EU member states comparing to old member states 80

Per cent

Czech Republic Hungary Poland Slovakia

Estonia Lithuania Latvia

1990 1993 1996 1999 2002 2005 2008 2011 2014

Per cent

Bulgaria Croatia Romania Slovenia

Note: Current prices (PPS). Source: World Development Indicators (World Bank), missing years added from Penn World Table 8.1

We obtain a more nuanced picture of economic convergence if we examine the development not only of gross domestic product (GDP) but also of gross national income (GNI). While GDP measures the â&#x20AC;&#x201D; 265 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

income produced by economic actors active in the territory of a country, GNI measures the income generated by Hungarian income earners. Thus, GNI does not take into account the capital income of foreignowned companies, but includes the labour and property income earned abroad by Hungarian nationals and companies (for more details see Box 3-2). Hungary’s relative level of development measured on the basis of gross national income is lower than the figure calculated from the GDP. The main reason for this is that foreign-owned companies play a key role in the Hungarian economy, and the gap between GNI and GDP was exceptional in the region in the 1990s and 2000s. Only the recent years have brought change in this respect, due to the increasing number of Hungarians working abroad (Chart 6-2). The WDI figures for GDP and GNI show a similar picture about the time course of convergence, as the difference between GNI and GDP was stable for much of the period. Nevertheless, different data sources show varying trajectories of convergence in GDP terms over time. This is due to the methodological differences of calculating purchasing power parity. According to Feenstra et al. (2013), using the Penn World Table (PWT) is better when analysing time series of longer periods. This is because the WDI only employs the 2011 price survey of the International Comparisons Program (ICP), and projects that to the other years. By contrast, the most recent version of the PWT also includes the earlier surveys of ICP (carried out every 3–5 years), and only interpolates the missing years. However, the course of the PWT time series seems less intuitive than the WDI data: for example, it shows divergence from the EU-15 at the end of the 1990s despite the rapid economic growth, but shows convergence with the EU-15 in 2008–2009 in spite of a considerable drop in Hungarian GDP. Therefore, despite the more favourable theoretical features of the PWT data, our study will be based on the WDI data, where possible.

— 266 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-2: Convergence based on GDP and GNI Per capita GDP and GNI at purchasing power parity compared to the EU15 countries 65

Per cent

65 60

40 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Based on GDP (WDI)

Based on GDP (PWT)

Based on GNI (WDI)

Difference between GNI and GDP in the Visegrád countries 2

Percentage of GDP

Czech Republic

Poland

Source: Penn World Table 8.1, World Development Indicators (World Bank)

— 267 —

2014

2013

2011

Hungary

2012

2010

2009

2007

2008

2006

–8 2005

–7

–8 2004

–6

–7 2003

–6

2001

–5

2002

–4

–5

2000

–4

1999

–3

1997

–2

–3

1998

–2

1996

–1

1995

–1

1994

1993

Slovakia

Part I: International and national experiences in economic convergence

6.1.2 Downturn after the political transition and the return to growth

The political transition caused a shock in the post-Soviet countries: GDP nosedived everywhere. In Hungary per capita GDP started to decrease as early as the late 1980s, then in 1990–1993 it plunged by 16 per cent. The scale of the recession was smaller in the Czech Republic and Poland, and larger in Slovakia. However, the recession in Hungary was drawn out for longer than in other countries: while in Hungary the first time the economy expanded was in 1994, Poland and Slovakia entered on a growth path in 1992 and 1993, respectively. In the end, Hungary was the slowest to return to its 1990 level of development (Table 6-2). Table 6-2: Decline in GDP per capita after the political changeover and the speed of recovery Czech Republic

Hungary

Poland

Slovakia

Decline after 1990 setback (%)

12.2

14.9

7.3

20.8

Year of regaining growth

1993

1994

1992

1993

Year of reaching 1990 level

1996

2000

1994

1998

4.6

2.9

4.4

5.3

Average growth in the recovery period (%)

Note: GDP per capita (constant prices). Source: Penn World Table 8.1

What caused the severe downturn in transition countries? What explains the relatively protracted Hungarian recession? There is no consensus in the literature about the reasons behind the recession (see, for example, Campos–Coricelli 2002), both supply and demand-side explanations can be found. 6.1.2.1 Role of demand-side factors

The fall in demand was influenced by the stringent fiscal and monetary policy pursued in order to achieve macroeconomic stability. Macroeconomic stability was attained relatively quickly in the Czech — 268 —

6. Convergence and equilibrium in Hungary since the political changeover

Republic and Poland, while it took more time in Hungary. In addition, the inherited debt burden of the Hungarian economy was higher as well. By contrast, the initial debt level was low in the Czech Republic, and Poland made an agreement with the Paris Club of sovereign creditors in 1991 about the rescheduling and partial forgiveness of its debt.62 As a result of the agreement, Polish external debt was reduced by one third, and the annual interest expenses were reduced by 3 per cent of GDP on account of the restructuring. Hungary did not request debt rescheduling, but chose instead to repay its whole debt as scheduled. Compared to the other Visegrád countries, this imposed a considerable extra burden on the budget. The other major demand-side channel was the collapse of the external trade with Comecon countries (mainly with the Soviet Union). The weight of this channel is demonstrated by the fact that Finland, which had a substantial export exposure towards the Soviet Union but functioned as a democratic market economy, experienced a recession similar to transition countries (see, for example, Gorodnichenko et al. 2012). The collapse of trade with Comecon meant that Hungary lost an export market where it had been able to sell moderately competitive products at relatively high prices. Already in this period, Hungary was considered open compared to other economies. Exports to Comecon countries comprised 41.4 per cent of total exports in 1989, which amounted to 13 per cent of GDP. By contrast, Comecon exports only accounted for 12 per cent of GDP in Czechoslovakia and 6 per cent in Poland. 6.1.2.2 Supply-side factors

One of the main reasons for the economic downturn on the supply side was the “creative destruction” that intensified with the transition to the market economy. The mass bankruptcy of uncompetitive, lossmaking state-owned enterprises led to the rapid disintegration of the 62

This was followed by an agreement with the London Club representing private creditors in 1994.

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Part I: International and national experiences in economic convergence

earlier economic structure. The newly created private companies, however, could only fill the void gradually. This also manifested itself in the fact that in most of the transition countries employment declined persistently, until the mid-1990s. The drop in the employment rate was the most dramatic in Hungary, but employment decreased significantly in Poland and Slovakia as well. On the other hand, labour productivity started rising rapidly after an initial dip, as the least efficient stateowned enterprises were forced out of the market and were replaced by more competitive private companies. The Czech economy followed a different pattern than the majority of the region. The transformation of state-owned enterprises progressed slowly in the Czech Republic.63 This helped to maintain the high level of employment, but labour productivity declined steadily and substantially. Nevertheless, the gradual reorganisation of state-owned enterprises was not a success overall, as in 1996 a bank crisis erupted in this country as well. In the years after the political transition Hungary found itself at a competitive disadvantage on the labour market and has not been able to fully offset this up to the present. In 1990–1995 approximately 1.3 million jobs were lost. The economic policy sought to mitigate the mass unemployment by facilitating the transition to inactivity. The options of early retirement and disability retirement also contributed to the fact that by 1995 the economically active population had decreased by 700,000 persons (15 per cent). Those that became inactive were unable to return to the labour market later on. No similar drop in participation was observed in any other Visegrád country. In Poland – where early retirement was also widespread – the economically active population decreased by 8 per cent, while it hardly changed at all in the Czech and Slovak economies (Chart 6-4). 63

The chosen method of privatisation may have contributed to the slow corporate reforms. As a result of the voucher privatisation, the enterprises were sold to small retail investors whose capacity to promote their own interest was too small for forcing the companies to operate more efficiently.

— 270 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-3: Decomposition of changes in GDP per capita (1990–1995) 20

Per cent

0 –10

–20

–30

1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995

–10

Czech Republic

Poland

Hungary

Labour productivity

Slovakia

Employment rate

Finland GDP per capita

Note: Based on National Accounts (constant prices). Source: Penn World Table 8.1

Chart 6-4: Decomposition of participation in Visegrád countries (1990–1995) 15

Per cent

5 0 –5

–10

–15

–20

–25

1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1994 1995

0 –5

Czech Republic Unemployed

Poland

Hungary

Employed

— 271 —

Slovakia

Labour market participation

Part I: International and national experiences in economic convergence

Furthermore, the economic downturn was exacerbated in several countries by the crisis of weak and underdeveloped financial systems. The bank crises were linked to the inefficient state-owned enterprises’ mounting debt: in many countries the persistently loss-making stateowned enterprises were kept alive by loans from the banking sector (which, in many cases, was also state-owned). Out of the Visegrád countries, bank crises erupted in Hungary and Poland in the early 1990s. The Hungarian crisis had more profound consequences, as the banking system’s credit-to-GDP ratio was almost triple the Polish figure. Similarly, the budgetary burden of bank bailouts was almost triple the Polish amount, and in 1991–1994 it amounted to around 10 per cent of GDP (Table 6-3). Table 6-3: Banking crises in CEE countries in the 1990s Systemic banking crisis (starting date)

Share of NPLs at peak (%)

Domestic credit provided by financial sector (% of GDP)

Romania

1990

30.0

79.7

0.6

Hungary

1991

23.0

98.0

10.0

Estonia

1992

7.0

Poland

1992

24.0

35.5

Slovenia

1992

Latvia

1995

20.0

11.7

Lithuania

1995

32.2

Bulgaria

1996

75.0

106.4

14.0

Czech Republic

1996

18.0

62.4

6.8

Croatia

1998

10.5

41.4

6.9

Slovak Republic

1998

35.0

60.3

Gross fiscal cost (% of GDP)

1.9 3.5 14.6 3.0 3.1

Source: Laeven-Valencia (2008), World Development Indicators (World Bank)

The Polish economy not only weathered the banking crisis with lower costs, it also recovered more rapidly from it. It may have helped that Poland had more success in managing banks’ non-performing portfolio. The recapitalisation of the banking system was conditional — 272 —

6. Convergence and equilibrium in Hungary since the political changeover

on the cleansing of the non-performing loan portfolios (reorganisation or liquidation of the debtor company), and therefore the banking system played a major role in the resolution of loss-making companies. In Hungary, the strict 1991 Bankruptcy Act led to a wave of bankruptcies, but banks played a rather passive role in bankruptcy proceedings, since they were less motivated to cleanse their portfolios (Baer–Gray 1996).

6.1.3 Convergence period

Per capita GDP started on a growth path after 1995 and exhibited a sustained growth of around 4 per cent until the mid-2000s. In this period Hungary’s average growth rate was the highest in the Visegrád region (Chart 6-5). Chart 6-5: Evolution of GDP per capita in Visegrád countries (1995–2011) 30

Thousand USD per capita (2005 PPS)

Annual change (per cent)

8 6

4 2

0 -2

-4 -6 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Czech Republic

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-8

Hungary

Poland

Slovakia

Note: Current prices (2005 PPS). Source: World Development Indicators (World Bank), missing years added from Penn World Table 8.1

— 273 —

Part I: International and national experiences in economic convergence

All factors of production contributed to the favourable growth performance. In the second half of the 1990s, the employment-topopulation ratio rose by almost 3 percentage points. In addition, labour productivity increased, which was primarily supported by the improving educational level, the slight rise in capital intensity and the productivity enhancement from other sources.64 According to the analysis by Badunenko et al. (2008), the growth in labour productivity between 1992 and 2000 was caused on the one hand by capital deepening, and on the other hand by the fact that the Hungarian economy’s level of technological development was able to grow at a similar rate as the global technological boundary. However, Hungary did not manage to join the global leaders in the efficiency of employing technology (Poland was the only Visegrád country that was able to get closer to the technological boundary). Compared to the Visegrád region, the employment rate developed favourably in the last third of the 1990s. While employment continued to decrease in other countries, employment rate rose by 2 percentage points in Hungary. Both supply and demand-side factors contributed to the expansion of employment. Demographic developments in this period resulted in increasing labour supply: more people with better skills (the so-called Ratkó grandchildren) entered the labour market than in previous generations (Kátay–Wolf 2008). Furthermore, the general upswing gained momentum, stimulating labour demand, which in turn supported the return of groups to the labour market that had become inactive (e.g. those that had stopped looking for a job, i.e. the discouraged unemployed). These favourable trends faded by the early 2000s, and by then Hungary’s performance in employment and the accumulation of human capital was on par with the region (Chart 6-6). 64

The decomposition of GDP growth into factors of production was performed with the help of the Penn World Table 8.1 database. In the calculations the compilers of the database assumed that an aggregate production function existed in which potential output was determined by the amount of labour, human capital, physical capital and total factor productivity (TFP). The strong theoretical assumptions required by this approach call into question the estimated contribution of growth factors. For more information on the issue see, for example, Felipe and Fisher 2003.

— 274 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-6: Employment rate and index of human capital per capita in Visegrád countries Employment rate 50

Human capital per worker

Per cent

3.6

Index

3.4

3.2 40 3.0 35

2.8

Czech Republic

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

2.6

Hungary

Poland

Slovakia

Note: Employment rate = employed in percent of total population. Source: AMECO, Eurostat, Penn World Table 8.1

The pattern of growth changed in the first half of the 2000s. The expansion of employment ended, rising capital intensity played a more central role, and the increase in total factor productivity intensified. In fact, capital intensity continued to grow even after the mid-2000s, despite the slowdown in the growth rate of investments. This may suggest that the growth issues originated, in large part, from the labour market, and the drop in investments was an endogenous reaction to the deteriorating labour market trends. The expansion of employment stopped as a result of the changes in the tax and transfer system that reduced the efficiency of labour market allocation, as well as the universally growing labour costs due to the rise in the minimum wage and public sector wages. These changes probably nudged companies towards a more capital-intensive production (Kátay–Wolf 2008). — 275 —

Part I: International and national experiences in economic convergence

Chart 6-7: Growth of capital stock per capita and total factor productivity in Visegrád countries Capital stock per worker Thousand USD per capita (2005 PPS)

150

140 130

120

110 100

–2

–4 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

70 60

Annual change (per cent)

Czech Republic

–6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

160

Total factor productivity

Hungary

Poland

Slovakia

Note: Current prices (2005 PPS). Total factor productivity contains cyclical movements of capacity utilisation. Source: Penn World Table 8.1

At the turn of the 1990s and the 2000s, potential growth rate of the Hungarian economy hovered around 4 per cent. Therefore, real economy convergence continued in this period in a sustainable manner, without upsetting the macroeconomic equilibrium. In these years economic growth was supported by capital accumulation and rapid productivity growth. Later the dynamics of productivity became subdued, which resulted in a drop in the potential growth rate. Thus, the developments in productivity played a pivotal role in the growth performance of the Hungarian economy. Deeper understanding of this process is fostered by the analysis of the economy’s structural changes (Chart 6-8).

— 276 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-8: Potential growth in the Hungarian economy 5

Percentage point

Growth contribution of capital Growth contribution of productivity

2014

2013

2012

2011

2010

2009

–2

2008

–2

2007

–1 2006

–1 2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

Growth contribution of labour Potential output growth (per cent)

Source: MNB

Structural changes in the economy considerably influenced the relatively high productivity growth of the Hungarian economy observed in the 1990s. Such changes included privatisation, the appearance of foreign investors, the increasing openness of the economy as well as the driving out of the least efficient companies from the market. In the following we analyse these processes. 6.1.3.1 Role of privatisation

The sale of state-owned enterprises to private owners (privatisation) and foreign direct investments through either privatisation or in the form of greenfield investments can be classified among the basic elements of the economic transformation after the political transition. The privatisation of state-owned enterprises in transition countries had a positive impact on the productivity of the reorganised companies (see e.g. Brown et al. 2006). When the private owner was a domestic agent, the — 277 —

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productivity of privatised companies increased by 8 per cent on average compared to non-privatised enterprises. A greater productivity increase – 23 per cent on average – could be detected when foreign owners took over at the helm of a company. In addition, the companies that came under foreign ownership were able to boost their productivity at a quicker pace than firms that came under domestic ownership (Estrin et al. 2009). The method of privatisation also influenced the result of the process (Brown et al. 2014). The comparison with the experiences of the CEE countries shows that the privatisation practice based on employee or management buy-out, which was relatively widespread in Hungary, created more efficient companies than either spontaneous or voucher privatisation. Privatisation to external agents who had had no previous interest in the operation of the company produced even more efficient and productive firms (Frydman et al. 1999). The process of privatisation also influenced the development of employment and wages. On the one hand, privatised companies were able to reduce employment and wages as part of their drive to improve efficiency. On the other hand, the new owners were often able to increase the sales revenue of companies, which in itself contributed to the expansion of employment and wages. In the case of privatisation to domestic owners the former effect was dominant, which resulted in a slight (but statistically insignificant) reduction in the workforce and wages on average. In the case of privatisation to foreign owners, however, the aggregate employment and wage effect was positive on average (Brown et al. 2010). The greater productivity growth achieved through foreign ownership may have been primarily linked to the fact that in such cases companies had easier access to advanced technologies, management practices, external markets, higher-quality foreign inputs and financing opportunities. Nevertheless, the assessment of the welfare impact of privatisation is difficult because its results depended on the regulation of the individual — 278 —

6. Convergence and equilibrium in Hungary since the political changeover

markets. If the sale of state-owned enterprises was not coupled with appropriate market regulation (as, for example, in the energy sector), companies could obtain a dominant position on the market that improved their profitability (and their productivity, which is derived from that), but placed an immense burden on consumers. 6.1.3.2 Role of foreign direct investment

The examination of the impact of foreign direct investment (FDI) is closely linked to the analysis of privatisation’s success. The papers discussing the results of privatisation (e.g. Estrin et al. 2009, Frydman et al. 1999) point out that in the case of companies privatised to foreign owners productivity, profitability, the number of employees and their wages exceeded those of companies under domestic ownership. From strictly this perspective, foreign capital had a positive impact on the economy of the host country as well. When assessing the economic impact of foreign capital, however, it is also important to examine the spillover effects on the domestic economy exerted by the companies privatised to foreign owners and the multinational corporations settling in Hungary through various portfolio or greenfield investments. International empirical evidence shows that positive spillover effects should not be taken for granted: the experiences of the CEE countries reflect significant differences (Hanousek et al. 2011, Gorodnichenko et al. 2014). According to analyses based on Hungarian data, knowledge spillovers within industries (horizontal) and across industries (vertical) only happened in industries in which foreign competitors played a great role (Schoors–Van Der Tol 2002). Positive spillover effects depend on the size of domestic companies and on the technology of the foreign company. Larger Hungarian companies were the main benefactors of multinational corporations’ impact, which remained subdued in the case of smaller firms (Békés et al. 2009). On the other hand, positive spillover effects could only be observed in the case of companies that transferred capital-intensive production to Hungary. By contrast, — 279 —

Part I: International and national experiences in economic convergence

companies that relocated labour-intensive production to Hungary to exploit cheap labour did not exert a substantial spillover effect on the country’s economic growth (Görg et al. 2009). At the macro level, foreign direct investments played a significant part in Hungarian economic growth. According to the estimate of Balatoni and Pitz (2012), since the mid-1990s FDI inflows have contributed 0.7–0.9 percentage points annually to the growth of the Hungarian economy, of which more than 0.5 percentage points were due to improved productivity. Nevertheless, on account of the subdued spillover effects, foreign direct investments may have strengthened the dual nature of the economy overall. Spurred on by the higher wages, skilled labour may have gravitated from domestic firms towards more capital-intensive foreign companies, thereby contributing to the lower productivity of domestic businesses. 6.1.3.3 Role of external trade

Foreign direct investment plays a substantial role in the export performance of the Visegrád countries. The growth of export market share after 1995 was closely linked to the amount of foreign capital that flowed into the economies. The countries in the region joined foreign (frequently German) production chains around this time, which led to a considerable increase in intra-industry trade and economic openness (Chart 6-9). Export performance affected productivity via two channels. First, the average productivity of export-oriented foreign companies that settled in the country was higher than the average. Second, the additional improvement in productivity could be observed in the case of companies newly engaging in exports, which was the result of learning by exporting (on Hungarian data see Rariga 2011). Productivity not only improves through exports but also through imports. Companies can enhance their operational efficiency by importing capital goods representing a higher technological level — 280 —

6. Convergence and equilibrium in Hungary since the political changeover

and better-quality intermediary goods. According to the calculations of Halpern et al. (2011), one-third of the productivity growth of manufacturing companies between 1992 and 2003 was due to the exploitation of imported inputs. This was partly a result of the more intensive utilisation of imported goods, and partly of the fact that foreign-owned companies, which imported more, were able to utilise these products more efficiently. Chart 6-9: Foreign direct investments and export performance in Visegrád countries between (1995–2013) 1.2

Export market share

1.2

PL 2013 1.0

1.0 CZ 2013

0.8

HU 2013

0.6

PL 1995 CZ 1995

0.4

SK 1995

0.4 HU 1995

0.2

SK 2013 0.0 0.0

0.2

0.4

0.6

0.8

1.0

0.0

Share of global FDI Czech Republic

Hungary

Poland

Slovakia

Note: Export market share based on exports of goods (in current prices) in percent of the world. Source: UNCTAD

6.1.3.4 Role of reallocation

Finally, transformation of the economic structure also resulted in the least efficient companies being driven out of the market, and the expansion of the market share of more productive companies. This creative destruction greatly supported productivity growth in the 1990s both in manufacturing (see, for example, Békés et al. 2011, Bartelsman et al. 2008, Brown and Earle 2008, Kátay and Wolf 2008) and — 281 —

Part I: International and national experiences in economic convergence

in services (Harasztosi 2011). In the case of services, the improvement in productivity was primarily due to the reallocation of labour, i.e. the decrease in the number of inefficient companies. Productivity growth resulting from reallocation mainly manifested itself in the individual industries. By contrast, the realignment across industries had a limited impact on aggregate productivity (Brown and Earle 2008). As the efficiency of allocating the factors of production improved, the resulting productivity growth slowed down by the 2000s. In countries where economic reforms progressed at a slower pace (e.g. Romania) greater differences in productivity developed between companies over the years. Owing to their weaker starting position, these countries experienced more intensive reallocation and thus sharper productivity growth in later years. By contrast, countries that undertook reforms more rapidly (such as Hungary) enjoyed greater intra-company productivity growth in this period (Brown and Earle 2008).

6.1.4 Macroeconomic disequilibrium and the slowdown in convergence from the early 2000s

Economic growth remained close to 4 per cent in the mid-2000s, but this performance concealed increasing macroeconomic imbalances and deepening structural weaknesses. The improvement in productivity resulting from the transformation of the economic structure gradually faded in the first half of the 2000s. Instead of introducing new reforms supporting long-term growth, economic policymakers sought to maintain the growth rate of the previous years by stimulating consumption. By contrast, in the VisegrĂĄd countries that initiated their reforms later, measures started to take effect at this time. As a result, the Hungarian economy dropped out of the vanguard of the region. On top of all of this, the consumption-fuelled growth path caused severe indebtedness in the country. There were attempts at correcting this even before the downturn, â&#x20AC;&#x201D; 282 â&#x20AC;&#x201D;

6. Convergence and equilibrium in Hungary since the political changeover

but the global financial crisis that erupted in the autumn of 2008 struck the Hungarian economy in a fragile, over-indebted state. Therefore, the crisis resulted in extremely large, protracted real economy sacrifices in Hungary. Thus, the slowdown in convergence in the 2000s is inseparably linked to macroeconomic disequilibrium. Accordingly, in order to understand the reasons that led to the weakening growth, we must first examine the developments in equilibrium. 6.1.4.1 Macroeconomic disequilibrium

For decades in Hungarian economic history, rapid economic growth could only be achieved through external indebtedness. This phenomenon was not new: from the 1970s until the 2008 crisis – except for some periods of varying length – the indebtedness of the private sector entailed rising levels of public debt. As a result, the Hungarian economy was characterised by a twin deficit in several periods (the 1970s, 1993–1995, 2002–2008) when both the general government and the current account balance were in negative ranges, and when the budget deficit was mainly financed through government bonds purchased by non-residents (MNB 2014) (Chart 6-10). Chart 6-10: Development of economic growth, external balance and budget balance

Source: HCSO, MNB

— 283 —

2014

2012

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

Current account balance (percentage of GDP) General government balance (percentage of GDP)

2010

Per cent

Fiscal balance in accordance with 2011 methodology

1980

1978

1976

Per cent

1974

8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

GDP growth

8 6 4 2 0 –2 –4 –6 –8 –10 –12 –14

Part I: International and national experiences in economic convergence

Due to the scarcity of domestic funds in small, open economies lacking capital such as Hungary, it is natural to use foreign funds as well when financing the investments necessary for economic growth. In theory, the productive capacities generated through investments can help the economy in paying back the loans taken out for the realisation of the projects. However, it is a recurring problem in Hungary that external funds are mainly used to finance consumption or less productive projects instead of productive investments, either through budgetary benefits or through direct borrowing by households. The recurrence of the twin deficit in the past was chiefly due to misguided economic policy. Amongst other things, the process was influenced by the weak control over fiscal policy as well as inadequate regulation of the financial system (MNB 2014). In the following we examine the role of two dominant factors, fiscal policy and household indebtedness, in macroeconomic disequilibrium. Fiscal policy

The gross debt of the budget increased by more than half between 2002 and 2010, and financing the general government became costly. The negative effect of the crisis was exacerbated by the short-sighted, procyclical fiscal policy of the previous years. The fiscal disequilibrium in the mid-2000s disrupted balance in other areas of the economy too (for more details, see Matolcsy 2015). Due to the country’s rising risk premium, monetary policymakers were forced to keep interest rates high, which contributed to the appreciation of the real exchange rate, eroded the competitiveness of domestic companies and thus also influenced the current account deficit. The high level of Hungarian interest rates was one of the main reasons why foreign currency lending became widespread.

— 284 —

6. Convergence and equilibrium in Hungary since the political changeover

After 2002, a significant income transfer from the general government to households was observed. The remuneration of public sector employees increased considerably, which was due on the one hand to the high inflation in the previous years, and on the other hand to the public sector’s deteriorating employee retention. However, statutory wage growth did not result in a substantial increase in productivity, which may be attributed to the lack of qualitative changes in performance requirements and the failure of organisational reforms. Social benefits were also overhauled. Despite the fact that the demographic outlook had been worsening for decades, the eligibility criteria for retirement benefits were slightly tightened along with an above-inflation pension increase, which entailed sustained growth in fiscal expenditure and a rise in the country’s implicit debt. As a result of various early retirement schemes, certain employees working in law enforcement, the army, the secret service, the railway or healthcare were able to retire from the labour market 15, 20 and in some cases 25 years earlier than the normal old-age pension age. In the 2000s, the system of entitlements did not change considerably, but after the 2008–2009 crisis the reform could not be postponed further. In the 2010s, most of the entitlements were scrapped, and the chance for women to retire after 40 years in employment appeared as a new element. The overall net impact of the changes to early retirement on the general government is positive. The old-age retirement age was changed in several steps. Within the framework of the 1997–1998 reform, men’s and women’s retirement age was raised to 62 years from the previous 60 and 57 years (Orbán–Palotai 2006), then in 2014–2021 the minimum retirement age will be gradually raised from 62 to 65 (Chart 6-11).

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Part I: International and national experiences in economic convergence

Chart 6-11: Old-age pension expenditures in percent

Per cent

2014

16 2013

16 2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

Source: AMECO, Eurostat

Although there were minor adjustments in 2004–2006, these cuts were not enough to prevent unfavourable developments. Financing the general government became unsustainable in its previous form by 2006– 2007, and more fundamental adjustments were necessary. The drastic, sometimes across-the-board cuts could be observed in the growth data as well: the Hungarian economy was in a recession even in 2007, i.e. before the global financial crisis. The negative impact of the 2008–2009 economic crisis hit the Hungarian economy more than neighbouring countries. The negative external shock aggravated domestic growth and equilibrium problems, which brought about a recession in 2009 that was considered extreme even in a European context. As a result of the deteriorating economic outlook, the high level of gross debt and the towering budget deficit, the international perception of the country gradually worsened, which resulted in a rise in the yield and risk premium of bonds.

— 286 —

6. Convergence and equilibrium in Hungary since the political changeover

Major fiscal adjustments were implemented in the years when the crisis erupted. The efficiency of the early attempts at consolidation was weakened by the fact that the reduction of budget expenditure received greater weight. Spending cuts in their own right directly reduced the GDP, and the austerity measures affecting households’ income hampered the repayment ability of indebted households. By contrast, the consolidation after 2010 was aimed at burden sharing among economic agents, and all in all it helped the debt reduction of households. Owing to the disciplined fiscal policy of the government, the balance of the government sector has steadily been below the 3 per cent Maastricht deficit target since 2012 (MNB 2014; Matolcsy 2015). Household indebtedness and growth

In the early 2000s, the loans with various state interest subsidies and guarantees stimulated the real estate market (too), but represented a long-term commitment for the budget. In the mid-2000s, as growth was interrupted and the budgetary position deteriorated, these preferential loans were phased out and were replaced by foreign currency loans. Widespread foreign currency lending was due to many reasons. After the phase-out of the aforementioned preferential forint loans, the high domestic interest rate level – as compared to US, European and Swiss rates – nudged both borrowers and lenders towards foreign currencies, none of whom took the potential exchange rate and interest rate risks into account. This was due to economic actors’ lack of financial awareness and to the inappropriate collection and provision of information, on the part of both borrowers and lenders. With respect to the regulatory issues, the government, the supervisory authority and the central bank all played important roles. The expansionary fiscal policy after 2002 directly boosted households’ income and indirectly stimulated borrowing by improving income expectations. Government debt started to rise as a result of the high budget deficit, which necessitated consolidation measures after — 287 —

Part I: International and national experiences in economic convergence

2006. The series of fiscal adjustments eroded households’ income, but continued to increase their loan demand due to the continued optimistic income expectations. Banks responded to the expanding loan demand by increasing their foreign currency loan supply, which led to a considerable increase in the volume of foreign currency loans (see Erhart et al. 2015). The spread of foreign currency loans is partly linked to EU membership (see, for example, Cuaresma et al. 2014). On account of the expectations surrounding the introduction of the euro and EU membership, the exchange rate stability perceived by economic agents gradually increased. Consequently, more and more borrowers were willing to take on exchange rate risk. As a result of the 2008–2009 economic crisis, the forint depreciated against the major foreign currencies (euro, dollar, Swiss franc) by 20–30 per cent, and consequently households’ net financial position deteriorated, and they were forced to deleverage. Households responded to the situation by curbing consumption and housing investments. Companies, adapting to the new market demand, reduced their production and investments. They started downsizing, which further exacerbated negative developments (Chart 6-12). The various rescue packages helping foreign currency borrowers (early repayment scheme, fixed exchange rate) did not always provide an effective solution to the problems. In the cases where the HUFdenominated amount of the foreign currency debt exceeded the value of the property serving as collateral (real estate, car), and a sale was implemented, the long-term obligations of the debtor with respect to the difference still have to be met.

— 288 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-12: Evolution of household loans 12,000

Billion HUF

12,000

10,000

8,000

6,000

4,000

2,000

2,000 0

Credit inst. loan (HUF) Other fin. corp. (HUF)

2013Q4

2011Q4

2009Q4

2007Q4

2005Q4

2003Q4

2001Q4

1999Q4

1997Q4

1995Q4

1993Q4

1991Q4

1989Q4

Credit inst. loan (FX) Other fin. corp. (FX)

Source: MNB

6.1.4.2 Growth impact of imbalances

Between 2002 and 2008, the expansion of the Hungarian economy exceeded its potential growth that would have preserved financial equilibrium, and the growth path was markedly influenced by the opening of the financial cycle at the time of a normal business cycle as well as by rapid indebtedness. Adjusting for this, the dynamics of the recovery after the crisis diverged from the rate ensuring sustainable growth due to the changes in behaviour and the various measures implemented to restore equilibrium (Chart 6-13). In 2002–2007, Hungary’s economy expanded by 0.4–0.5 per cent more on average annually than its potential long-term sustainable growth, whereas between 2009 and 2013 it exhibited an annual growth rate 1.2–1.5 per cent below potential, in order to address its vulnerability and adjust for the financial cycle (MNB 2014). The economic growth that unfolded over the past two years did not entail the deterioration — 289 —

Part I: International and national experiences in economic convergence

of equilibrium indicators. If domestic actors show a sustained change in their behaviour, this phenomenon may persist over the longer term.

Per cent

GDP

2015

2014

–8 2013

–8 2012

–6

2011

–6

2010

–4

2009

–4

2008

–2

2007

–2

2006

2005

2004

2003

2002

2001

Finance neutral potential output growth

Source: MNB (2014)

6.1.5 Structural changes since the political transition

The Hungarian economy has undergone fundamental structural changes since the political transition, which entailed a rise in productivity overall. At the same time, a deeper analysis of the structural changes sheds light on the ambiguous character of convergence. Although rapid productivity growth was observable in certain segments of the economy, it was not universal. In the following we present these processes in more detail. Two significant changes can be observed with respect to the sectoral composition of value added since the political transition: the increasing weight of services and the gradual decline in the importance of agriculture. By contrast, the share of industry has been — 290 —

6. Convergence and equilibrium in Hungary since the political changeover

relatively stable since the mid-1990s. The growing significance of services was characteristic of the other Visegrád countries as well, but in their case it was coupled with industry’s waning relevance. The share of industry in Hungary is average in a regional comparison. The weight of services was considered high in the 1990s, but regional countries have caught up since the turn of the millennium. Nonetheless, the region-wide proportion of services relative to GDP is below the share observed in more developed economies (e.g. Austria) (Chart 6-14). Chart 6-14: Sectoral composition of value added in Visegrád countries and Austria 70

Per cent

70 60

1991 1995 2000 2005 2010 2014 1991 1995 2000 2005 2010 2014 1992 1995 2000 2005 2010 2014 1993 1995 2000 2005 2010 2014 1990 1995 2000 2005 2010 2014

Hungary Agriculture

Czech Republic

Poland

Industry

Slovakia Construction

Austria Services

Source: OECD

6.1.5.1 Industry

Although the weight of industry has been relatively stable since the mid1990s, major realignments could be observed within the sector. With European economic integration and the elimination of the barriers to — 291 —

Part I: International and national experiences in economic convergence

external trade and capital flows, the Visegrád countries have become attractive targets for foreign investments. Their main advantages were low labour costs, appropriate infrastructure and the proximity to export markets. A large share of these investments in manufacturing was the result of outsourcing from Western European countries with higher labour costs. Thus, foreign-owned, export-oriented companies almost instantly joined the international production chains and engaged in intensive two-way external trade. Foreign-owned companies seemingly improved the technological level of both production and exports. Nominally, Hungary exhibited the highest technological level of exports in the region by the 2000s. High-tech exports amounted to 17–18 per cent of GDP, which was well above the average of the Visegrád countries. In addition, exported medium-tech products corresponded to 22–23 per cent of GDP, which was similar to the level observed in the Czech and Slovak economies. However, high-tech export products contained extremely low domestic value added. For example, the import content of the electronics industry’s exports was 77 per cent in 2005 (according to the input-output tables of the sector). Only tentative relations were established with domestic suppliers, and the Hungarian SME sector was barely able to profit from the export of high-tech goods. This also contributed to the enormous differences in productivity between large companies and the SME sector (Chart 6-15). Some high-tech exports linked to large companies did not prove durable in the face of the crisis. When certain electronics corporations were confronted with competitiveness issues at the global level, the assembly plants based on low local labour costs and tax advantages were not able to ensure a sustained competitive edge that would have guaranteed their survival after the crisis.

— 292 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-15: Exports by technological level in Visegrád countries 40

Percentage of GDP

Hungary High Low

Czech Republic Medium high Services

Poland

2013

2010

2005

2000

1997

2013

2010

5 2005

5 2000

1995

2013

2010

2005

2000

1995

2013

2010

2005

2000

1995

Slovakia Medium low

Source: OECD

On the other hand, the less technology-intensive sectors that would have enjoyed a comparative advantage in Hungary lost market share (for example, the food and textile industries). Most of the decline happened in 2001–2005. This was influenced by the deteriorating cost competitiveness caused by rising wages, the weak quality competitiveness resulting from postponed investments and technological improvements, and the increasingly intense competition on the market due to EU enlargement and the liberalisation of Chinese imports. This loss of market share, however, was not unavoidable, as can be seen from the Polish example: exports of low-tech products exploiting local competitive advantages have steadily increased since the mid-1990s.

— 293 —

Part I: International and national experiences in economic convergence

Chart 6-16: Yields of main cereals in Hungary and the Czech Republic* Wheat 6.0

Maize

Tons per hectare

5.5

Tons per hectare

5.0

4.5

4.0 5

3.5

3.0

2.0

2 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

2.5

Maize – CZ Maize – HU

Wheat – CZ Wheat – HU

Note: * Czechoslovakia before 1993. Source: FAO

6.1.5.2 Services

The performance of the Hungarian services sector is relatively favourable. The productivity gap between larger and medium-sized companies in the service industries is smaller than in manufacturing. This may be partly attributable to the fact that the capital intensity of the services sector is usually lower than in manufacturing. Consequently, larger companies can gain less advantage in productivity by increasing capital intensity. The performance of the services sector is also borne out by the fact that Hungarian services exports rose to 16 per cent of GDP by 2013, while the other Visegrád countries barely achieve the approximately 10 per cent characteristic of the 1990s. Moreover, services exports are — 294 —

6. Convergence and equilibrium in Hungary since the political changeover

relatively diversified, as in addition to tourism and transportation modern business services also play a key role. Nonetheless, substantial homogeneity can be observed within the services sector. The average level of productivity of exportable services (such as transportation, tourism, information and communications technology) is higher. This, however, does not necessarily translate into higher technical efficiency in production. One possible explanation for this is that in services export prices are higher than the domestic consumer price level (for example, because foreign consumers expect higher quality). 6.1.5.3 Agriculture

Among less important sectors, agriculture was hit hard by the political transition. This is indicated, inter alia, by the decline and increasing volatility of the main cereals’ average yields in the 1990s. Whereas until the 1990s the Hungarian and the Czech(oslovak) average yields moved in tandem, since 1990 Hungary has lagged behind the Czech Republic in productivity by 20 per cent. The reasons for deteriorating average yields include the fragmentation of farm structures, which led to weakly capitalised individual holdings. The mechanisation of agriculture has not changed since 1990. However, crop production techniques deteriorated: fertilisation showed a downward trend (it dropped to a third between the 1980s and 1991, and then it started to grow again), irrigation is rare (in 1991 only 70 per cent of irrigable areas was irrigated, while in 2000 this figure was merely 20 per cent). And finally, research and development in agriculture (e.g. plant breeding) has been subdued as well (Chart 6-17). The volatility of agricultural performance is aggravated by the relatively high weight of crop production in Hungary: at around 60 per cent, its proportion is 6–8 percentage points higher than in the majority of EU Member States. Conversely, the share of livestock breeding and services related to agriculture in the output of the sector is low.

— 295 —

Part I: International and national experiences in economic convergence

Chart 6-17: Labour productivity of Hungarian corporations in percent of similar sized German corporations in 2012 50

Per cent

1–9 employee 50–249 employee

10–19 employee above 250 employee

Administrative services

0 Professional, scientific services

Real estate

Information, communication

Accommodation

Transportation

Trade

Construction

Manufacturing

Mining

20–49 employee

Source: Eurostat

6.1.5.4 Construction

Since the political transition, the contribution of construction to the gross domestic product in Hungary has been steadily lower than in the Visegrád countries. In parallel with this subdued contribution, the productivity of the sector also considerably lags behind the construction industries of more developed countries (barely achieving one-fifth of the labour productivity of German construction companies in 2012). The informal economy, which is especially strong in the sector, may also contribute to the low productivity seen in the statistics. Furthermore, the proportion of owner-occupied homes is high in Hungary, and therefore the weight of home construction by households, which shows lower productivity, may be greater.

— 296 —

6. Convergence and equilibrium in Hungary since the political changeover

political transition Before the crisis, the Hungarian economy was characterised by a substantial current account deficit, which was primarily attributable to the high budget deficit and the diminishing net savings of households. The external indebtedness of the economy rose to an unsustainable level, and therefore a substantial adjustment was necessary after the crisis: the current account showed a surplus and external debt started to slowly decline. Based on the international examples, the successful convergence for Hungary may hinge on investment financing from domestic savings, which may be complemented by external borrowing for investment purposes. Currently, the volume of domestic savings is relatively high in Hungary, but this is coupled with a very low volume of investments. Thus, in the future investments necessary for convergence should be sought to be expanded, while maintaining the level of domestic savings (low deficit, steadily high household savings). At the current level of development of the Hungarian economy, the significance of FDI-type funds may gradually decline, but in the context of the relatively high external indebtedness, it would be favourable to maintain the present level.

6.2.1 Financing of the Hungarian economy before the crisis

In the ten years prior to the crisis, the gross savings of economic actors was persistently lower than the investment rate, which was reflected in the excessive current account deficit. If we approach the development of external imbalance from the relationship between savings and investments, then based on the data available before the crisis, investments relative to GDP exceeded domestic savings by far (Chart 6-18). This indicates that investments were realised with substantial external borrowing. The investment rate was 27–28 per cent relative to GDP in the late 1990s, while domestic savings were slightly above 20 per cent of GDP. This 6–8 percentage point difference — 297 —

Part I: International and national experiences in economic convergence

persisted during the 2000s, therefore the current account steadily showed a considerable deficit. The investment rate could be considered high in the period under review, and it continued to support economic growth, but as a result of the fiscal adjustments, growth fell, while the imbalances endured, due to the decrease in households’ savings. The massive budget deficit and the decreasing net lending of households resulted in a very high current account deficit. Substantial income-increasing measures (e.g. pension increase, 50 per cent wage hike, the tax exemption of the minimum wage) were introduced after 2002, which severely inflated the general government deficit. Rising income expectations and the deepening of the financial system led to a huge surge in retail lending. The introduction of subsidised forint lending also considerably increased households’ borrowing, which resulted in a rapid contraction of net savings. Households believed that the income-eroding effect of the fiscal adjustment measures implemented in 2006 were only temporary, and therefore they smoothed out their consumption by increasing borrowing. As a result, by 2008 households’ net lending in SNA terms was reduced to around 0 per cent of GDP.

Per cent

–5

–10

–15

Real GDP growth Gross savings Source: IMF WEO

— 298 —

Investments Current account

2008

–5

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

6. Convergence and equilibrium in Hungary since the political changeover

From the early 2000s, the rise in households’ consumption exceeded income growth, which dealt a blow to the trade balance. The income balance deficit also deteriorated, due to the income from foreign investments and the fact that Hungarians paid more and more interest abroad on account of the increasing external indebtedness. Overall, the country’s net borrowing became steadily high in the 2000s (Chart 6-19). Due to the easing of liquidity constraints, the mainly foreign currency-denominated retail lending picked up markedly, which was further fuelled by the buoyant income expectations about the path of real wages. As in the 2000s these expectations matched the projections for economic growth, and rising indebtedness seemed rational, since economic actors underestimated the mounting risks (Erhart et al. 2015). On the one hand, growing consumption undermined the balance of goods due to rising imports, and on the other hand, the interest payments on the expanding volume of state and retail debt substantially impaired the income balance. The deficit was significantly inflated by the profits paid for earlier capital investments. As a result, the net borrowing of the economy hovered around 6–8 per cent of GDP. Chart 6-19: Developments in the balance of payments relative to GDP 2

Per cent

–10

Transfer balance Balance of goods and services Income balance Source: MNB

— 299 —

Current account Net lending

2008

–10

2007

–8 2006

–8 2005

–6

2004

–6

2003

–4

2002

–4

2001

–2

2000

–2

1999

1998

Part I: International and national experiences in economic convergence

The structure of fund inflows gradually changed after the turn of the millennium, as the inflow of foreign direct investment was increasingly replaced by growing debt. In the late 1990s and early 2000s, the balance of payments deficit was chiefly financed by foreign direct investments (Chart 6-20). The structure of fund inflows changed substantially after 2002, as the proportion of debt inflows increased greatly (Komáromi 2007). From a sectoral point of view, both the general government and households – through the banks – contributed to the considerable expansion of external indebtedness. In the two years preceding the crisis, there were no net inflows of foreign direct investment, while debt liabilities increased by 10 per cent of GDP in both years.

Per cent

Non-debt type financing Transactions related to derivatives

2008

2007

2006

2005

2004

–6 2003

–6 2002

–4 2001

–4 2000

–2

1999

1998

0 –2

Debt-type financing Net borrowing

Source: MNB

The inflow of debt liabilities resulted in a rise in Hungary’s external indebtedness, which considerably increased the vulnerability of the economy. As households take out loans through banks as intermediary institutions, the financing of households with external funds is recorded — 300 —

6. Convergence and equilibrium in Hungary since the political changeover

in the balance of payments at the banking system (Antal 2006). The net external outstanding debt of the banking system increased from 3–4 per cent of GDP to around 30 per cent by 2008 (Chart 6-21). The expansion of government debt was partly financed by non-residents, which was reflected in the rise in the public sector’s external debt. Since part of the state’s external debt and the foreign currency loans were not financed in the local currency, the foreign currency ratio of the external debt also increased. The build-up of external debt and the steadily opening unsecured household foreign currency position resulted in the heightening of vulnerabilities, which also manifested itself in rising risk premiums. In addition, the high volume of debt led to ever longer maturities and rollover requirements, which would have made the Hungarian economy especially vulnerable in the case of a sudden stop. Chart 6-21: The structure of debt ratios 80

Percentage of GDP

2000

2001

2002

Banking sector Net external debt

2003

2004

2005

General government Public debt

2006

2007

2008

Corporate sector

Source: MNB

6.2.2 Crisis and adjustment

After the bankruptcy of Lehman Brothers the options for acquiring funds suddenly became limited, and the general government’s and the banking system’s access to funds became doubtful. Thus, over the — 301 —

Part I: International and national experiences in economic convergence

short term, the country was only able to avoid insolvency by availing itself of the EU–IMF loan (Hoffmann et al. 2013). Before the crisis, the net borrowing of the general government was significantly reduced as a result of the adjustment measures. However, the high rollover risks due to the persistently high volume of outstanding debt and the high foreign currency ratio within that prompted investors to sell off Hungarian government securities in great quantities in the autumn of 2008. Moreover, government securities auctions were unsuccessful, as ever fewer foreign market participants appeared as buyers (Chart 6-22). Banks experienced a strong squeeze on their foreign currency funds, and liquidity risks increased considerably. In this situation the Hungarian state turned to international organisations to keep the maturing debt and deficit financed. Thanks to the foreign currency loan extended by the EU and the IMF, the country was able to finance itself, but the foreign currency ratio of government debt jumped from 30 per cent to approximately 50 per cent. The external funds of the country were significantly curtailed, which exacerbated the risks. This considerably increased the foreign currency reserve requirement, the solution to which was once again provided by the foreign currency loan of the international organisations, which increased the foreign currency reserves of the central bank. The EU–IMF loan also helped the central bank in providing foreign currency liquidity to credit institutions through normal and extraordinary instruments, thereby maintaining their viability. Due to the drop in incomes and the ever stricter lending terms, households became increasingly cautious, consumption and investments plunged, and as a result, the current account balance turned into positive. As external financing dried up, the loan market became tighter, and due to this, as well as the growing unemployment and the deterioration of income prospects, the consumption of households dropped significantly. Therefore, in addition to the flagging external demand that decreased due to the global economic crisis, domestic demand also shrank, which led to a substantial reduction in the investment spending of companies. The sluggish domestic — 302 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-22: Issuance of long-term goverment securities (monthly data) 300

Billion HUF

300

200

100

0 –100

–200

–300

–400

–500

–600

Jan. 2006 Apr. 2006 July 2006 Oct. 2006 Jan. 2007 Apr. 2007 July 2007 Oct. 2007 Jan. 2008 Apr. 2008 July 2008 Oct. 2008 Jan. 2009 Apr. 2009 July 2009 Oct. 2009 Jan. 2010 Apr. 2010 July 2010 Oct. 2010 Jan. 2011 Apr. 2011 July 2011 Oct. 2011 Jan. 2012 Apr. 2012 July 2012 Oct. 2012

–100

Net issuance

Issuance

Source: MNB

Chart 6-23: Developments in net lending from the current and capital account’s side

Balance of goods and services Transfer balance Income balance Note: as a percentage of GDP. Source: MNB

— 303 —

Net lending Current account

2014

2013

2012

2011

2010

2009

2008

2007

2006

Per cent

2005

Per cent

2004

12 10 8 6 4 2 0 –2 –4 –6 –8 –10

Part I: International and national experiences in economic convergence

absorption resulted in the reduction of imports, which, despite the decreasing exports, led to a substantial trade surplus (Chart 6-23). The increase in net lending was also influenced by the drop in foreign companies’ profits as a result of the crisis, which was reflected in the reduction of the income balance deficit. The significant balance of payments surplus was also helped by the fact that in 2009 the utilisation of EU transfers accelerated, which led to a rise in the transfer balance surplus. The balance of services contributed more and more to the high trade surplus. The balance of services surplus started to rise after the crisis, and it comprises an increasingly large share of the trade balance, while the weight of services within total exports is lower (Chart 6-24). The improvement in the balance of services was primarily due to the subdued growth of services imports, and services exports also decreased less than the export of goods (MNB 2015). The balance of services surplus could be mainly attributed to tourism and transportation, but the expansion of contract work and other business services also played a part. Chart 6-24: Developments in the trade balance and its components 8

Percentage of GDP

–4

–6

Balance of goods

Balance of services

Source: MNB

— 304 —

2014

–4 2013

–2

2012

–2

2011

2010

2009

2008

2007

2006

2005

2004

Balance of foreign trade

6. Convergence and equilibrium in Hungary since the political changeover

The increasing precautionary motives in the private sector entailed a rise in new deposits and a steep decline in borrowing. The abundance of credit before the crisis diminished drastically by 2009, and the corporate and household sectors became net repayers of debt after the crisis (Chart 6-25). In addition to falling credit demand, the nosedive in credit supply by banks also contributed to the drop in lending. Credit institutions financed domestic lending partly from external funds, and therefore when external funds dried up, it naturally limited the provision of new loans. Moreover, since the risks of foreign currency lending had previously been underestimated, the proportion of nonperforming loans skyrocketed as the forint depreciated, prompting banks to reconsider their lending policies. The fact that the private sector became a net repayer of debt, and the increasing volume of new deposits due to the safer investment opportunities and the higher interest rates after the crisis enabled credit institutions to gradually shed their external debt. Chart 6-25: Net borrowing of the private sector 12

Percentage of GDP

Non-financial corporations Net borrowing of the private sector Note: as a percentage of GDP. Source: MNB

— 305 —

Household sector

2014

2013

2012

2011

2010

–6

2009

–6

2008

–4 2007

–4 2006

–2

2005

2004

0 –2

Part I: International and national experiences in economic convergence

The adjustment can be observed in the development of financial savings of the individual sectors. The general government maintained its low net borrowing, while the private sector increasingly became net saver. As a result of the fiscal adjustment measures, the net borrowing of the state considerably decreased in 2007 and then dropped to below 3 per cent of GDP by 2012 (Chart 6-26). Although a strict budget limited the outflow of income, households’ financial savings significantly increased as the precautionary motives intensified, and, as we have already shown, borrowing plunged, and the net lending of households also expanded considerably. In the context of the substantial EU transfer inflows and the drop in investment spending, companies also became net savers. The huge pre-crisis net borrowing turned into a modest net lending in 2009 and then increased to 7 per cent of GDP by 2014. Chart 6-26: Changes in net lending of the sectors in SNA terms 15

Percentage of GDP

–15

2014

–15

2013

–10 2012

–10 2011

–5

2010

–5

2009

2008

2007

2006

2005

2004

Corporate sector General government Household sector Net lending (from the financial account's side)

Note: General government: state budget, local governments, MNV Zrt., institutions private pension fund savings, therefore “Household sector” also includes this consistent data. Source: MNB

— 306 —

6. Convergence and equilibrium in Hungary since the political changeover

The process of indebtedness and adjustment can be followed easily from the perspective of financing as well: after the crisis, the country started to repay its foreign loans that had been taken out earlier. When foreign currency lending gained momentum, foreign borrowing prevailed. Before the crisis, external funds were acquired by the general government through foreign currency bonds, while the banking system obtained them in order to finance retail lending. As the possibilities for acquiring funds became limited, indebtedness stalled in 2009, in fact, in the years thereafter, debt gradually started to be repaid, which meant that a slow reduction of the country’s external debt began (Hoffmann et al. 2013). The reduction of debt also entailed a decrease in interest payments, which brought about the contraction of the income balance deficit. In parallel with this, the FDI inflow persisted after the crisis, albeit at a less intensive pace (Chart 6-27).

15 10

Billion Euro

th, grow s s able stain debtedne u s n U nal in exter

Net borrowing

–5 Net lending

–10

Bal a adj nce ust she me et nt

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Net FDI Debt-type financing Net lending (from the financial account's side)

Source: MNB

— 307 —

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Part I: International and national experiences in economic convergence

The rising volume of debt on account of the depreciation of the forint exchange rate, and the rise in short-term external debt hindered the reduction of external vulnerabilities. The sharp rise in external debt before the crisis considerably increased the country’s external vulnerability. The high foreign currency ratio of the debt and the rise in short-term external debt exacerbated the situation, which resulted in the heightening of rollover risks (Chart 6-28). The yield spread of long-term funds increased considerably during the crisis, and therefore banks were only able to roll over the maturing foreign currency debt at shorter maturities. Depreciation of the forint entailed the revaluation of foreign currency debt, and a significant expansion of the outstanding volume (Koroknai–Lénárt–Odorán 2012). Therefore, the reduction in debt only started in 2011, but then it was quite substantial: net external debt fell from its 2010 level of 55 per cent to 35 per cent in 2014. The deleveraging enabled the private sector to become a net debt repayer, but the state also supported the process through the selffinancing programme and the Funding for Growth Scheme (FGS). The net lending of the private sector started to rise considerably in 2009, and in 2014 it was around 10 per cent of GDP, which led to, first and foremost, the reduction of debt liabilities. The portfolio restructuring of households greatly helped the reduction of the state’s external debt, as households took on an increasing share from financing the government debt. The MNB’s self-financing programme also fostered the state’s increasing reliance on domestic funds, and the transformation of the central bank’s policy instruments also served this purpose. The portion of the FGS spent on foreign currency loan conversion also reduced the external vulnerability, as it slashed the foreign currency debt. The FGS provided to SMEs also compensated for banks’ dwindling supply of funds, and thus the FGS supported economic growth through financing the investments of SMEs.

— 308 —

6. Convergence and equilibrium in Hungary since the political changeover

Chart 6-28: Developments in net external debt and short-term external debt 70

Per cent

Billion Euro Crises: depreciation and shortening

60 50 40

rei

rre

u nc

Ba l ad ance jus sh tm ee en t t

ing

d len

Corporate sector General government Banking sector

2014

2013

2012

2011

2010

2009

10 2008

10 2007

2006

2005

2004

Net external debt Short-term external debt (right-hand scale)

Note: As a percentage of GDP, billion euro. Source: MNB

Foreign currency lending considerably opened up the foreign currency position of the private sector, which, at the sector level, was closed once again by the conversion into forint and the settlement, thereby reducing the country’s external vulnerability. As a result of the steady build-up of foreign currency debt, the foreign currency loans of the private sector exceeded foreign currency assets, and consequently the depreciation of the forint exchange rate entailed a substantial drop in disposable income through an increase in repayment instalments (Erhart et al. 2015). Due to the conversion into forint of foreign currency loans and the settlement of unfair interest rate increases, the foreign currency assets of the private sector once again exceeded foreign currency loans,

— 309 —

Part I: International and national experiences in economic convergence

and, at the sector level, the risks associated with a potential depreciation of the forint abated drastically. However, the foreign currency exposure is now indirectly transferred to the consolidated general government, as foreign currency reserves have fallen significantly over a prolonged period due to the foreign currency liquidity provided to banks. Thus, a potential exchange rate depreciation reduces the net wealth of the consolidated government more on account of the lower level of foreign currency reserves. The debts of the general government are not affected by the forint conversion, and as a consequence, the impact of exchange rate depreciation on the repayment of maturing foreign currency loans is the same as before the forint conversion. In addition, the balance sheet foreign currency exposure of the banking system also diminishes with the forint conversion, which is favourable from the perspective of the countryâ&#x20AC;&#x2122;s vulnerability and contributes to a lower risk premium.

6.2.3 What can Hungary learn from successfully converging countries?

In East Asian countries, the investment expenses of economic agents during the convergence period were mostly covered by domestic savings, while in the majority of countries under review external funds had to be acquired. In East Asian countries such as Korea and Singapore, the substantial investment rate amounting to about 40 per cent of GDP on average was also financed from domestic savings at the time of the convergence. Although in Taiwan the investment rate was lower than that, domestic savings exceeded this level by far. Therefore the Taiwanese economy was in a net saving position even during the convergence period. In European countries, the investment rate was typically higher than savings relative to GDP. This is not necessarily a problem, since external borrowing may

â&#x20AC;&#x201D; 310 â&#x20AC;&#x201D;

6. Convergence and equilibrium in Hungary since the political changeover

enable a higher investment rate. This may accelerate convergence as in the case of Austria and Finland, for example. It should also be noted though that in Mediterranean countries external borrowing did not entail sustainable growth, which made these countries more vulnerable during the crisis. Similar to Central and Eastern European countries, Hungary acquired substantial external financing during the convergence, but its investment rate was below that of Slovakia, Finland and Austria, which were characterised by higher levels of domestic savings. The example of these countries provides a lesson: an increase in the domestic savings rate would enable a higher investment rate in Hungary, which may be complemented by the inflow of external funds. During the convergence period, Hungary had a relatively high investment rate but low domestic savings, which was reflected in the massive current account deficit. After the crisis, the net lending of the private sector showed a surplus, which entailed a large rise in domestic savings (Chart 6-29). In order to speed up Hungary’s convergence, investments should be boosted; domestic savings provide adequate funds for this in the present situation. As companies are currently in a net saving position, a surge in the investment rate may entail a fall in domestic savings. The preservation of households’ high net saving position and the further reduction of the budget deficit (net borrowing) may be necessary to prevent a significant decrease in domestic savings. The latter might also help to prevent the funding of the state from draining off domestic savings, so that surplus savings can reach companies through the banking system.

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Part I: International and national experiences in economic convergence

Chart 6-29: Role of domestic savings in the convergence period* 45

Gross savings as a percentage of GDP

Taiwan Province of China

Taivan

Singapore

Austria

30 Hungary 2014

Spain Italy

Poland

Ireland

Finland Slovak Republic Hungary Greece Portugal

10 5 0 0

Total investment as a percentage of GDP Note: For the description of the periods, see the chapter on converging countries. Source: IMF, WEO

Foreign direct investment was typically significant in the CEE countries during the convergence period. According to the literature on convergence, the inflow of foreign direct investment is mainly characteristic of the early period. In line with this, out of the countries under review, average FDI inflows exceeding 3 per cent of GDP during convergence were mainly typical of the Central and Eastern European countries that started out at a relatively low level of development (Chart 6-30). As in the Eastern European region relatively little capital was accumulated (compared to, for example, Austria or Finland), FDI investments promised higher returns. Consequently, in the CEE countries and especially in Hungary, FDI inflow was relatively high (based on the annual average of Hungary and the regional countries â&#x20AC;&#x201D; 312 â&#x20AC;&#x201D;

6. Convergence and equilibrium in Hungary since the political changeover

in 1995–2007). Yet, due to constant development, the significance of FDI in financing investments may wane, as shown by the examples of Ireland, Finland and Austria. Accordingly, the importance of the inflow of foreign direct investments may gradually decline in Hungarian convergence. This may be supported by the fact that recent greenfield investments were partly financed through foreign borrowing. In successfully converging countries, the inflow of FDI was typically high, while the inflow of debt was typically low. Ireland represented an exception, because there high economic growth reduced debt ratios, and a considerable debt reduction was implemented after the convergence period. In Mediterranean countries, huge amounts of debt liabilities flowed in without adjustment, and therefore their volume ballooned to an unsustainable level.

Per cent

Non-debt type financing

— 313 —

Spain

Italy

Greece

Debt-type financing

Note: In the period of convergence, as a percentage of GDP. Source: IFS, IMF

Portugal

Taiwan

Austria

–8 Korea

–8

Ireland

–6

Finland

–4

–6

Poland

–4

Hungary

–2

Slovak Republic

Singapore

0 –2

Part I: International and national experiences in economic convergence

External indebtedness may also support the convergence process if borrowing chiefly finances investments. Investment funded from debt may help convergence, as companies’ revenue increases due to investments, which may provide coverage for part of the increasing debt service. By contrast, state or household consumption financed from debt does not generate income directly, and hence the repayment of debt may reduce disposable income. Due to their high propensity to save, East Asian countries did not even increase their external indebtedness during the crisis. In fact, Singapore and Taiwan provided substantial funds to external economic actors (Chart 6-31). From this perspective, the earlier Hungarian convergence resembled the Mediterranean countries the most, where the investment rate was low compared to Slovakia or Finland, but average debt financing was high. Slovakia and Finland should again be mentioned here as good examples.

a percentage of GDP 10

Average debt-type external financing as percentage of GDP Spain

8 Greece

Italy

Ireland Ireland

Portugal

Finland Slovak Poland Republic Austria Korea

2 0 –2 –4 –6

Singapore

Hungary 2014 Taiwan Province of China

–8 –10

Average investment as percentage of GDP in the period of convergence Note: In the period of convergence as a percentage of GDP. Source: IFS, IMF

— 314 —

6. Convergence and equilibrium in Hungary since the political changeover

There was no substantial debt-type financing in these countries, but the investment rate was exceptional. The example of the Mediterranean countries shows that acquiring further debt financing in the context of high indebtedness may bog down the convergence process.

6.3 Conclusion Since the political transition, the development level of the Hungarian economy has slowly converged to Western European countries. Based on the gross domestic product per capita figure for Hungary at purchasing power parity, the average annual convergence amounted to roughly 0.5 percentage points. Convergence has been uneven over time. Convergence can mainly be linked to the second half of the 1990s and the early 2000s. The examination of the equilibrium indicators of the economy shows that Hungary only exhibited a sustainable, equilibrium convergence path in 1997–2001 and in the period after 2013. Earlier years were characterised by economic downturn following the political transition, and then in the second half of the 2000s intensifying macroeconomic imbalances impeded the growth performance. The period since the political transition provides several lessons for current economic policy: • The extent and persistence of the downturn after the political transition was linked to the debt problems of the Hungarian economy. The repayment burden of the considerable external debt necessitated a restrictive fiscal and monetary policy, which dampened domestic demand for a long time. The shock transition caused permanent losses on the labour market. In addition, the institutional system did not create enough incentives for banks’

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Part I: International and national experiences in economic convergence

portfolio cleansing, and therefore the defaults on loans extended to loss-making state-owned enterprises resulted in costly and protracted bank restructuring. • The rapid growth that unfolded in the second half of the 1990s was basically linked to the structural transformation of the economy. The expansion of higher education after 1990 supported the accumulation of human capital. Privatisation, the emergence of foreign investors and the integration into world trade boosted the productivity of the corporate sector. However, productivity growth from structural changes lifted the growth rate only temporarily, and as the reforms were terminated in the second half of the 2000s, the dynamics of labour productivity weakened. • Macroeconomic stability is vital for real economy convergence. The combined indebtedness of households and the state in the second half of the 2000s led to grave debt problems. Debt-financed consumption was able to maintain the growth rate of the previous years only temporarily, and the model lost momentum even before the global financial crisis. • Productivity growth was uneven across the various segments of the economy. There were extreme differences in productivity between large and smaller companies. Foreign-owned, export-oriented companies formed few ties with suppliers, and did not sufficiently drive the convergence of Hungarian small and medium-sized enterprises. Overall, the domestic SME sector did not possess the capacities necessary for improving productivity. A deeper analysis of this is beyond the scope of our study.

— 316 —

6. Convergence and equilibrium in Hungary since the political changeover

• Thus, for Hungary the key to successful convergence may be investment financing from domestic savings. External funds may speed up convergence even more if they are primarily used for financing investments. Due to the decreasing but still high level of indebtedness, Hungary can only involve a limited amount of debt liabilities in financing investment, therefore FDI-type fund inflows may continue be more favourable in the future.

— 317 —

Part I: International and national experiences in economic convergence

References Antal J. (2006):

, MNB Occasional Papers (MT 51).

Baer, H. L. – Gray, C. W. (1996): Debt as a Control Device in Transitional Economies: The Experiences of Hungary and Poland, World Bank Policy Research Working Paper, No. 1480, The World Bank, Washington D. C. Badunenko, O. – Henderson, D. J. – Zelenyuk, V. (2008): Technological Change and Transition: Relative Contributions to Worldwide Growth During the 1990s, Oxford Bulletin of Economics and Statistics, 70 (4), pp. 461–492. Balatoni, A. – Pitz, M. (2012): effect of direct investment on Hungary’s gross national income), Közgazdasági Szemle, 59(1), pp. 1–30. Bartelsman, E. – Haltiwanger, J. – Scarpetta, S. (2008): Cross Country Differences in Productivity: The Role of Allocative Efficiency, manuscript, http://web.stanford.edu/group/SITE/archive/SITE_2008/ segment_9/papers/bartelsman_alloc_eff_july3108.pdf Békés G. – Halpern L. – Muraközy B. (2011): alakulásában Magyarországon (The role of creative destruction in productivity growth in Hungary), Közgazdasági Szemle, 58, pp. 111–132. Békés G. – Kleinert J. – Toubal, F. (2009): Spillovers from multinationals to heterogeneous domestic firms: Evidence from Hungary, The World Economy, 32(10), pp. 1408–1433. Brown, J. D. – Earle, J. S. – Telegdy Á. (2014): Where Does Privatization Work? Understanding the Heterogeneity in Estimated Firm Performance Effects, GMU School of Public Policy Research Paper No. 15–6. Available at: http://ssrn.com/abstract=2547819 Brown, J. D. – Earle, J. S. – Telegdy Á. (2010): Employment and Wage Effects of Privatisation: Evidence from Hungary, Romania, Russia and Ukraine, The Economic Journal, 120 (545), pp. 683–708. Brown, J. D. – Earle, J. S. – Telegdy Á. (2006): The productivity effects of privatization: Longitudinal estimates from Hungary, Romania, Russia, and Ukraine, Journal of Political Economy, 114(1), pp. 61–99. Brown, J. D. – Earle, J. S. (2008): Understanding the Contributions of Reallocation to Productivity Growth: Lessons from a Comparative Firm-Level Analysis, IZA Discussion Paper No. 3683, Institue for the Study of Labor, Bonn. Campos, N. F. – Coricelli, F. (2002): Growth in Transition: What We Know, What We Don’t and What We Should, Journal of Economic Literature, 40, pp. 793–836. Cuaresma, J. C. – Fidrmuc, J. – Hake, M. (2014): Determinants of Foreign Currency Loans in CESEE Countries: A Meta-Analysis, Focus on European economic integration Q4/11, Österreichische Nationalbank.

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6. Convergence and equilibrium in Hungary since the political changeover Erhart Sz. – Kékesi Zs. – Koroknai P. – Kóczián B. – Matolcsy Gy. – Palotai D. – Sisak B. (2015): A devizahitelezés makrogazdasági hatásai és a gazdaságpolitika válasza (The macroeconomic effects of foreign currency lending and the economic policy response), A devizahitelezés nagy kézikönyve. Nemzeti Közszolgálati és Tankönyv Kiadó. Budapest, pp. 121–158. The effects of privatization and ownership in transition economies, Journal of Economic Literature, 47(3), pp. 699–728. Feenstra, R. C. – Inklaar, R. – Timmer, M. P. (2013): The Next Generation of the Penn World Table, NBER Working Paper No. 19255, National Bureau of Economic Research, Cambridge, MA. Felipe, J. – Fisher, F. M. (2003): Aggregation in Production Functions: What Applied Economists Should Know, Metroeconomica, 54, pp. 208–262. Frydman, R. – Gray, C. – Hessel, M. – Rapaczynski, A. (1999): When does privatization work? The impact of private ownership on corporate performance in the transition economies, Quarterly Journal of Economics, 114(4), pp. 1153–1191. Görg, H. – Hijzen, A. – Muraközy B. (2009): The role of production technology for productivity spillovers from multinationals: Firm-level evidence for Hungary, Kiel Working Papers, No. 1482. Gorodnichenko, Y. – Mendoza, E. G. – Tesar, L. L. (2012): The Finnish Great Depression: From Russia with Love, American Economic Review, 102(4), pp. 1619–1643. Gorodnichenko, Y. – J Svejnar, J. – Terrell, K. (2014): When does FDI have positive spillovers? Evidence from 17 transition market economies, Journal of Comparative Economics, 42(4), pp. 954–969. Halpern, L. – Koren, M. – Szeidl Á. (2011): Imported Inputs and Productivity, CeFiG Working Papers No. 8, Center for Firms in the Global Economy. Harasztosi P. (2011): Growth in Hungary 1994–2008: The role of capital, labour, productivity and reallocation, MNB Working Paper 2011/12, Magyar Nemzeti Bank. Direct and indirect effects of FDI in emerging European markets: A survey and meta-analysis, Economic Systems, 35(3), pp. 301–322. Hoffmann M. – Kóczián B. – Koroknai P. (2013): eladósodás és alkalmazkodás (Developments in the external balance of the Hungarian economy: indebtedness and adjustment), MNB Bulletin. Kátay, G. – Wolf, Z. (2008): Driving factors of growth in Hungary – a decomposition exercise, MNB Working Paper 2008/6, Magyar Nemzeti Bank. Komáromi A. (2007): (The structure of external financing: Is there a reason to worry about financing through debt?), MNB Bulletin. Kónya I. (2011): Növekedés és felzárkózás Magyarországon, 1995–2009 (Growth and convergence in Hungary, 1995–2009), Közgazdasági Szemle, 58, pp. 393–411.

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Part I: International and national experiences in economic convergence Koroknai P. – Lénárt-Odorán R. (2012): (Developments in external borrowing by individual sectors), MNB Bulletin. Matolcsy Gy. (2015): Egyensúly és növekedés (Balance and Growth), Kairosz Kiadó. MNB (2014): Growth Report 2014, Magyar Nemzeti Bank. MNB (2015): Report on the Balance of Payments, Magyar Nemzeti Bank, June 2015. Orbán G. – Palotai D. (2006): (Economic policy and demographic challenges in the Hungarian pension system), Közgazdasági Szemle, 53, pp. 583–603. Rariga J. (2011): Processing Trade and Firm Performance: The Case of Hungary, MA thesis, Central European University, Department of Economics, Budapest. Available at: http://www.etd.ceu. hu/2011/rariga_erzsebet-judit.pdf Schoors, K. – Van Der Tol, B. (2002): Foreign direct investment spillovers within and between sectors: Evidence from Hungarian data. Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium, 2002/157.

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Regional differences in economic growth in Hungary Géza Salamin – Imre Lengyel65 – Júlia Gutpintér

The empirical observations of global economic processes and the Nobel Prize awarded to Paul Krugman in 2008 highlighted the fact that the economy is functioning in space and is shaped by strong concentration processes, and that even the various regions of countries exhibit different development trajectories. Understanding the regional economic specificities and the spatial dimension is particularly important in the case of Hungary, as the country is characterised by significant spatial disparities despite its small size, and its geographic location within Europe results in various opportunities for forging regional links. In Central and Eastern Europe, and specifically within Hungary, the transition to a market economy also led to a sharp increase in geographic disparities. This was mainly caused by the strong selectivity of FDI-funded investments which were a major driver of development, as a result of which only a small number of regions were able to intensely connect to the competition of the integrated common European market. In the wake of market liberalisation, many of Hungary’s regions first faced the loss of their Eastern markets and then their domestic markets as well. The geographic concentration of the Hungarian economy ground to a halt at the level of the counties after 2009, and a moderate levelling-out dynamic has even been perceived in recent years. This is due to a smaller extent to the reinforcement of less advanced regions, and to a larger extent to the temporary slowing of economic dynamics in more advanced regions, and to the more sustained slowdown in the dynamics in Budapest. A territorial analysis of GDP, employment and other parameters reveals that the Hungarian growth trajectory is not uniform; instead, 3-4 territory types 65

Prof. Dr. Imre Lengyel head of institute, University of Szeged Faculty of Economics and Business Administration

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Part I: International and national experiences in economic convergence

characterised by significantly different development paths can be identified, which can be effectively incentivised using different strategies, with integrated interventions. Budapest and its vicinity have become globally integrated, Komárom-Esztergom, Fejér, Vas, and more recently Bács-Kiskun county) have become integral parts of the European economy through the subsidiaries of multinational manufacturing firms. Since 2011, Hungarian economic growth has largely depended on the performance of these regions. Every county in Hungary was able to improve its GDP until 2006, but 2007 brought significant setbacks. After 2009, only 3-4 FDI-driven manufacturing regions were capable of growing and improving their labour productivity dynamically and significantly. From 2011, economic growth resumed in all counties, albeit slowly at first, and mainly as a result of improving employment. At the same time, the country’s northeastern and southwestern regions remain economically only moderately active, also limiting the opportunities of macrolevel output. At present, the regional disparities and economic spatial structure are no longer just a question of fairness, but may also be one of the bases of or even limits on growth. The country’s excessively monocentric economic spatial structure, its excessively Budapest-centric transportation network and weak transversal links and the disproportionalities of the settlement network hinder the economic development of rural regions. Meanwhile, beyond a certain point this structure does not benefit the capital and holds back the entire country’s economic growth. The spatial economies of scale stemming from the concentration of labour, demand and economic agents in Hungary, in other words agglomeration advantages are present only in the Budapest region mainly due to the historically induced nature of the urban network in Hungary. In order to strengthen the urban nodes needed to reach the critical mass necessary for agglomeration advantages outside the agglomeration of Budapest, larger rural towns could engage in cross-border agglomeration with nearby large cities in the Carpathian Basin to form joint economic regions. At the same time, this calls for an economic policy that offers opportunities in less urbanised regions with no export potential by creating employment opportunities, strengthening their domestic market presence, deepening urbanrural relationships and by applying a local economic development approach. — 322 —

7. Regional differences in economic growth in Hungary

The appreciation of spatial agglomeration advantages and the presence of lagging regions that are barely active economically underscores the fact that it is possible to tap into growth reserves for the national economy by understanding geographically diverse development and the regional dynamics of the economy, and by reinforcing the regional foundations of economic growth in an integrated manner using strategies tailored to specific regional characteristics. This chapter analyses the development of regional differences in Hungary’s economic development and growth and provides a Central and Eastern European outlook as well. It evaluates the changing contribution of the different counties to the country’s economic performance over time. In addition to this, it reveals how and to what extent certain factors, such as labour productivity, employment and changes of the number of individuals of working age shaped economic growth in different counties. The spatial features of the determinants of the status of human resources are analysed as a special topic in the chapter, and the summary attempts to identify certain spatial conditions for economic growth.

7.1 The changing approaches to the examination of regional economic growth A national economy should not be considered a unified whole, as there are significant differences between the regions within a country with respect to growth potential. This notion has gained increasing acceptance among those examining the economy, thanks, among other factors, to the new economic geography approach linked to the name of Paul Krugman. Due to the impact of globalisation, the operation of societies and thus economies has been greatly transformed. Factors that were previously unknown or regarded as less important have gained in importance, and new processes are under way. As globalisation has gained momentum, socio-economic conditions have changed, and the neoclassical approaches have been unable to appropriately describe their impact. A dual spatial process has been observed in the operation of the economy: in parallel with the geographic spread of economic activities, local tendencies — 323 —

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have strengthened. The economic role of spatial concentration has acquired new significance, while ties between remote business partners may also become stronger. Companies in global industries plan for country groups with respect to product markets and sales, while they plan for subnational regions, usually cities and the surrounding areas, when organising input markets and production. Companies competing globally have realised that the sources of their competitive advantages are concentrated spatially, therefore they need to strive to strengthen them locally. Due to this competition within industries, regions and territorial units gained in economic importance, which manifests itself in rivalry among regions, i.e. the unique competition of cities on the one hand, and in businesses’ increasing utilisation of the agglomeration advantages (basically spatial external economies of scale) resulting from spatial concentration on the other hand. Owing to the above-mentioned trends, several basic tenets of economics should be revisited, such as territorial competition and the interpretation of economic growth and development – that are closely linked to competition – as well as the concepts of economic policy and development employed in the face of the new challenges. The economic approaches based on different principles have interpreted the economic growth of regions differently (Abreu 2014; Armstrong– Taylor 2000; Ács–Varga 2000; Capello 2007a; Capello–Nijkamp 2009; Lengyel 2010a; McCann–Van Oort 2009; Pike et al. 2006). Until the 1970s, the principal method was the spatial application of Keynes’ ideas, while it was accepted that the negative effects of market cycles can be mitigated by economic policy interventions. The main aim was to increase incomes and employment, which was sought to be achieved in the regions through stimulating demand (consumption, investments, public spending). As a result of the socio-economic changes happening in the background, the drawbacks of the Keynesian economic policy became obvious by the early 1970s. Inflation rose, while at the same time the economy stagnated, and instruments that were useful earlier did not work in regional development. — 324 —

7. Regional differences in economic growth in Hungary

Neoclassical approaches became dominant in the 1970s. Neoclassical exogenous growth theories assume that self-regulating market mechanisms operate efficiently, and that the results of technological change basically spread as externalities. If factors of production (capital, labour force) and technology can flow freely among regions, economic growth can achieve equilibrium in spatial terms as well: capital flows from developed regions to underdeveloped ones as greater returns can be achieved there, while the labour force moves from less developed regions to the developed ones in hope of higher wages. In this approach, development was primarily sought to be achieved by creating the underlying conditions facilitating the flow of the production factors in space (mainly through the establishment of the technical infrastructure and transportation links), and thereby achieving the goal, i.e. evenly rising productivity and living standards and convergence among regions. In the 1980s, the neoclassical endogenous growth theories gained prominence, since hardly any spatial levelling-out could be observed, mainly due to the limited flow of production factors between regions. Economic growth and the increase in productivity and living standards were expected from technological progress corresponding to the requirements of economic agents, effective innovation policy and the improving quality of human capital. In line with this expectation, one should not interfere with market forces, but the factors providing the qualitative underlying conditions beyond companies should be strengthened. As globalisation gained momentum in the 1990s, underlying socioeconomic conditions changed fundamentally. As a result, various heterodox approaches became popular, which were recently replaced by the endogenous, place-based regional growth approaches that expect increased competitiveness on the global stage from the improving competitiveness of the region and the utilisation of its unique competitive advantages. Technology and knowledge are considered endogenous within the region. Therefore, a unique growth path is charted in each region based on the given local features, and this â&#x20AC;&#x201D; 325 â&#x20AC;&#x201D;

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growth path can be stimulated by a unique economic development “competition strategy”. Table 7.1: Major economic approaches to regional economic growth Theoretical aspects Period

Keynesian theory 1960s, 1970s

Neoclassical (exogenous) theory

Neoclassical (endogenous) theory

Heterodox theory

Regional theory

1960s, 1970s

1980s, 1990s

1990s, 2000s

Interpretation of Growth of economic growth incomes and employment

Improvement of productivity and quality of life

Improvement of competitiveness

Factors of Demand economic growth (consumption, investments, public spending)

Factor endowment and productivity

Endogenous mechanisms of productivity growth (technological development)

Non-conventional Endogenous factor regional factors endowment (infrastructure, innovation, accessibility)

Theoretical basis Export base Flow of factors theory, of production cumulative between regions causation theory

Macroeconomical Growth potential Endogenous endogenous theories subregional growth theories growth theories

Source: Lengyel (2010a) p. 40

The chronology of the above-mentioned approaches clearly shows that regional growth used to be interpreted as the “late print” of macroeconomic growth theories, e.g. by adapting the results of the Keynesian (export-base) or neoclassical (technical progress) approaches (Lengyel–Rechnitzer 2004). In addition, the growth of each region was thought to happen based on similar conditions or “templates”. Recently, it has become obvious that in a global context growth is based on regionspecific, endogenous place-based factors, and several growth paths can be observed due to the intense global competition, and the regionspecific inclusion in the international division of labour due to the varying underlying natural, social and economic conditions. The most widespread are now territorial approaches based on endogenous territorial elements that form an independent theoretical system by spatially applying the main results of endogenous growth theories. In the case of exogenous neoclassical approaches, we can apply the same model anywhere, — 326 —

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i.e. space is considered passive, whereas in the case of endogenous approaches space plays an active role, as all regions are unique due to the differences in geographical location, accessibility, neighbourhood and settlement patterns (being one of the sources of agglomeration advantages) (Capello 2008; Lengyel 2010a). This approach revisits the basic concept of geography and has become generally accepted. With the introduction of the place-based principle, the approach has also emerged in the European Union’s 2014–2020 regional policy and provides the theoretical basis for economic development subsidies as well. Competitive advantages have clearly gained priority over comparative advantages (Lengyel 2010a; Porter 1990). A conceptual change has also occurred, competitiveness as the “ability” for growth and development under the conditions of territorial competition (see Box text) has clearly become the key concept in the interpretation of regional economic growth. Consequently, although the central government’s (postKeynesian) interventions are necessary, in addition to these, unique, bottom-up economic development strategies based on endogenous features and integrating several sectors need to be developed in each region in order to improve competitiveness, which basically means the enhancement of regional competitiveness. Accordingly, not only moderately developed regions should be supported in their convergence but also developed urban regions, as the latter compete on the international level. The type of support should be vastly different: while the economies of moderately developed regions should be stimulated by “hard” instruments (e.g. developing infrastructure, facilitating investments, establishing new business facilities), developed regions should be invigorated by the development policy using “soft” instruments (the introduction of the results of R&D into business life, the implementation of technology transfer, fostering cooperation and trust). According to empirical analyses in the international literature, the agglomeration advantages, without which companies start out in the international competition with an almost insurmountable disadvantage, depend on city size. The business advantages stemming from spatial — 327 —

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concentration enable, inter alia, the reduction of transaction costs, the sharing of services, the emergence of externalities and efficient input substitution. Box 7-1: New economic geography and competition among regions

According to the new economic geography theory of Nobel laureate Paul Krugman (2000, 2003), the general equilibrium theory describing the new conditions can only be formulated by taking into account spatial dimension. Economies operating under the new conditions can be characterised by the reduction of unit transport costs, the growing importance of the economies of scale, the role of increasing returns to scale in global industries, monopolistic (and oligopolistic) spatial competition and agglomeration externalities. According to the new economic geography, the centripetal forces leading to spatial concentration and the centrifugal forces entailing spatial dispersion stem from these effects, and the two opposing forces result in spatial equilibrium. The increasing importance of spatial concentration, i.e. metropolitan economies – which serve as “hubs” in the global economy – follows from the theory. The examination of the competition among countries and regions has become one of the central issues in economics and regional studies, generating lively debates. In his earlier, well-known opinion, Krugman (1994) disputed that there was any competition among countries (and thus regions) similar to the business sector (for example, the success of a country does not necessarily entail the marginalisation of its competitors). In fact, Krugman considered the initial use of the concept of competitiveness dangerous, as the international division of labour based on comparative advantages benefits every country, since living standards rise everywhere. Therefore, the economic growth of every region is automatic, provided that they specialise in line with their comparative advantages. According to Porter (2008), however, competition among regions can, in fact, be observed, and comparative advantages cannot be utilised. Instead,

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7. Regional differences in economic growth in Hungary

competitive, i.e. absolute advantages have become important, similar to competition among industries. Porter asserts that in regional competition “competitiveness depends on the productivity i.e. how human capital and natural resources are utilised locally. Productivity sets the sustainable standard of living” (Porter 2008 p. 3). Therefore, economic growth is not automatic. In competition among regions, win-lose situations can also occur, and therefore programmes based on strategic planning should be fostered in economic development (Porter believes that cluster-based organisations can take part in the global competition). In regional economics and economic geography, it seems to be established that regions do compete, but the features of this competition are unlike those between companies or countries (Batey-Friedrich 2000; Chesire 2003; Malecki 2002). As Capello (2007a) put it: “regions compete on the basis of absolute rather than comparative advantages”. The consequences of competition between regions are similar to the results of competition among countries: for example, in successfully competing regions incomes increase, the standard of living and employment improves, new investments emerge, and talented and creative young people and businessmen gravitate towards such regions (Malecki 2004; Polenske 2004). Another factor fundamentally determining regional development is the fact that competition between regions is not simply for capital, but for activities with various levels of value added, i.e. the levels of the increasingly global value chains representing higher value added (Parrilli et al. 2013). The key to the global economic success of regions and countries is increasingly their ability to attract the higher levels of these economic value chains (e.g. R&D, knowledge-intensive industries, design), and how well they can “anchor” these activities and avoid their relocation, for example with an exceptional knowledge base, synergy ties or an environment fostering innovation. The majority of the conditions for forming links with value chains can be created in individual regions or metropolitan areas, therefore in addition to the increasing importance of agglomeration advantages, this also boosts the significance of regionalism and urbanisation.

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Part I: International and national experiences in economic convergence

7.2 Developments in the inherited spatial structure and regional disparities 7.2.1 Certain consequences of the transition on regional development in Central and Eastern Europe and Hungary

In the economies of the Central and Eastern European countries transitioning from the socialist planned economy to a market economy, gradually in the 1980s and at an increasing pace from the 1990s, foreign direct investment became the engine of the economy and growth. The substantial inflow of capital into Central and Eastern European that started in the early 1990s was stimulated by higher yield prospects, stronger growth rates, the exceptionally cheap but still relatively skilled labour and the expanding demand on these markets. Typically, the export base created through foreign direct investments became the main driver of growth in the economies of the region, which also contributed to the fact that these countries became exceptionally open economies. However, only a limited number of regions were able to profit from this, as the inflow of capital proved to be highly selective by region, preferring only a smaller part of these countries, mainly the regions around the capital and closer to the Western market. Just like most of the regions in Hungary, a significant share of Poland’s and Slovakia’s regions were unable to join the export production representing the new model, while their earlier economic role eroded during the unavoidable structural transformation. As the 2014 analysis by the European Commission points out, in contrast to the EU-15, in the EU-13 the spillover effects of the developed capitals did not take hold, or hardly took hold in their broader regions (European Commission 2014). The eastern part of the European Union is less urbanised than the vast majority of the older Member States, which in today’s competition between regions is already a disadvantage from the perspective of the now increasingly important external economies of scale (agglomeration economies, Vas–Lengyel–Szakálné Kanó 2015). While the proportion — 330 —

7. Regional differences in economic growth in Hungary

of urban population in the EU-15 is 79 per cent, it amounts to merely 62 per cent in the post-Soviet EU Member States (UN 2014), and the share of those enjoying a quality urban lifestyle is even lower. Just like the heavy industry crisis areas, most of the rural regions were unable to establish their position on the competitive market that became unified on account of the market liberalisation and the EU integration, and they lost a significant portion of their domestic market share – for example in certain sectors of the food industry or the light industry – due to the increasing imports in the 1990s. As the weight of the agricultural sector in the national economy and especially its role in employment diminished, this sector did not provide a substantial economic base in these regions. Yet the factor mobility of the regional theories based on neoclassical ideas was not realised either, according to which labour shifts to regions providing higher yields, i.e. only a moderate portion of the labour force moved to the urban centres and western regions that were more economically dynamic. As a consequence, a substantial share of human capital “lies fallow” due to the lack of the economic opportunities and capacities of the region. The special treatment of the moderately economically active regions is therefore key from the perspective of the regions’ economic growth and employment prospects. The answers given to the problems of rural areas in Hungary have mostly manifested themselves in the rural development policy and the convergence efforts of the regional development policy, with relatively limited success. The 2011 introduction of the public employment programme was an important step, but it does not provide a permanent solution in this area. However, the economic crisis hit rural regions less hard, and therefore in the EU-13 the relative position of the rural regions improved, albeit only slightly (European Commission 2014). One direct consequence of the above is that while in the past 15 years the Visegrád Group exhibited a perceptible convergence with the European Union at the national level – although this convergence has slowed down since 2008 or was disrupted – there is considerable regional divergence within the individual countries (Chart 7-1). Actually, with the exception of — 331 —

Part I: International and national experiences in economic convergence

the Czech Republic, vastly different courses of development can be seen behind the growth paths of the Visegrád Group, and certain successful metropolitan regions (primarily around the capital) and western regions are neighboured by economically hardly active regions that are typically rural or burdened by the challenges of structural transformation from the former heavy industry, which results in considerable economic disparities among the regions overall (Chart 7-2). Chart 7-1: Changes in regional concentration of GDP within countries (2004–2011) 3.3

3.3

3.1

2.9

2.7

2.5

2.3

2.1

1.9

1.7 2004

2005 Hungary Eurozone

2006

2007 V4 EU

2008

2009

V4 and Romania V3 (CZ, SK, PL)

2010

1.7 2011

Club Med

Note: The ratio of the GDP per capita of a given country’s most developed and least developed NUTS 2 regions. In the case of country groups, the unweighted average of the ratios, excluding overseas regions and countries consist of one region. The characteristics of statistical regions should be taken into account. In the case of all countries of the Visegrád Group, the most developed region is the one containing the capital, which, however, contains only the capital in the case of the Czech Republic and Slovakia, the capital and its nearby surroundings in the case of Romania, and the capital and its broader surroundings in the case of Hungary and Poland. Source: EUROSTAT

— 332 —

7. Regional differences in economic growth in Hungary

Chart 7-2: GDP per capita in the NUTS 2 regions of the Visegrád Group (2013)

97 72

82 159

108

93 70

112 73

210

104

84 81

79 245

94 60

GDP/capita, 2013 (EUR, at current prices) 6117.5–7515.0 7514.1–10271.1 10271.2–13289.9 13290.0–16413.2 16413.3–33286.2

101

162

GDP/capita as a 81: percentage of country average, 2013

Source: EUROSTAT

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Part I: International and national experiences in economic convergence

The disparities between the regions not only clearly widen within countries, but also across the Visegrád Group. Examining the total number of NUTS 3-level territorial units of the Visegrád Group (considering the capitals and the counties “carrying” their agglomeration one metropolitan unit), it can be seen that the economic growth of more developed counties was more dynamic between 2009 and 2013. According to data from 2013, the disparities within these regions are quite large: the upper decile’s average is three time as high as the lower decile. Out of the last five counties of the Visegrád Group, three are found in Hungary (see Chart 7-17). However, it can also be seen that during the economic crisis, i.e. from 2008 to 2011, the largest slump was observed in the capital city regions of the EU-13, and the second-tier metropolitan regions fared better, while in the case of the EU-15 there were no disparities of this type or extent between the different urban regions (Table 7-2). Table 7-2: Changes in GDP per capita, productivity and employment by urban region types in 2000–2008 and 2008–2011 in the EU-13 2000–2008 GDP/ capita

2008–2011

Productivity Employment

GDP/ capita

Productivity Employment

Capital city metropolitan regions

5.5

3.6

1.9

–0.3

–1.3

Second-tier metropolitan regions

4.9

4.1

0.8

1.4

1.3

0.1

Smaller metropolitan regions

3.7

3.6

0.1

1.4

1.2

0.2

Non–metropolitan regions

4.5

4.4

0.6

1.7

–1.1

Total

4.9

4.3

0.6

0.7

1.4

–0.8

Source: European Commission 2014

From the perspective of the spatial development of the Central and Eastern European regions, the dangers of certain dependences need to be pointed out. The dominance of foreign capital “prone to” relocation in development creates a sort of vulnerability in these — 334 —

7. Regional differences in economic growth in Hungary

Chart 7-3: GDP per capita in the NUTS 2 regions of the EU, and real GDP growth in the Member States (2013, 2014) GDP/capita, 2013 (EUR, at current prices) 3803.2–14251.6 14251.7–22282.8 22282.9–29366.5 29366.6–38235.0 38235.1–52687.4 52687.5–83097.2 83097.3–179711.5

Real GDP-growth 1.6 rate, 2014

-0.4 2.3 2.9 2.9

1.3

5.2

2.4 3.0

1.0 1.3 3.3

1.6

0.2

2.0

4.1 0.4

2.4 3.7

0.9

3.0

1.4

2.9

–0.4

-0.4

1.5 0.7

-2.5

Cyprus

Data of the German NUTS 2 regions is for 2012 except for those which are NUTS 1 regions as well

4.1

Note: Data for Hungary, Finland and Croatia are preliminary. With respect to the GDP growth rate only Greece, Spain, Cyprus, the Netherlands, Romania and Portugal have preliminary data. Source: EUROSTAT

countries, especially at the regional level, where the economy of the regions depends largely on one or two multinational corporations. In the future, the risk of migration by the skilled and active labour force — 335 —

Part I: International and national experiences in economic convergence

may cause greater vulnerabilities in the development of Central and Eastern European regions, for which a steady motivation is provided by the major differences in wages between the eastern and western parts of the EU. This migration motivated by the substantial differences in wages between the East and the West and based on the free flow of labour within the EU may also significantly impact Hungary’s most developed regions, where employers in segments requiring higher skills are already struggling with acute labour shortages (see Chapter 7.4.3).

Hungarian economy

Hungary’s regional development was fundamentally determined by certain features that can be traced back to the period before the transition. In terms of the spatial structure, we should mention two legacies of the period before 1990 which are still dominant today. The industrialisation policy implemented from the early 1950s played a central role in the spatiality of the domestic economy. As a result, mostly due to the forced industrialisation which later caused severe problems in the economic structure, the economy expanded considerably in the following regions: the axis formed by the North Hungarian Mountains and the Transdanubian Mountains (stretching from Veszprém County to BorsodAbaúj-Zemplén County), the industrial zone along the river Danube and a few additional commodity-based industrial regions (Komló– supply and centred around block flats also followed these regional preferences in industrial development. The one-sided, commodityintensive, heavy industry economic base of the socialist cities that were constructed almost as “greenfield” investments during this period, such as Dunaújváros, Komló, Kazincbarcika, Ajka, Oroszlány, and partly Salgótarján and Ózd, still represents an economic burden. However, the significance of the – not only politically, but also economically – greatly divisive borders created after the 1920 Treaty — 336 —

7. Regional differences in economic growth in Hungary

of Trianon is perhaps even greater in today’s economic spatial structure, as the Treaty severed off two-thirds of the territory of the country and all of the large cities which played a regional role, while Budapest, which used to be the capital of a previously substantially larger territory, became the “swollen head” of the country due to the lack of regional centres (Chart 7-4). According to the literature, to some extent the excessive weight of Budapest could already be observed earlier (Beluszky 2007). Between the two World Wars and in the early 1950s, 50–60 per cent of the industrial production was concentrated in the capital. The population of Budapest continued to rise from the 1949 level of 1,590,000, reaching 2,059,000 by 1980.66 Meanwhile, the agglomeration of the capital also expanded its territory and population Chart 7-4: Share of Budapest and Pest County in certain socio-economic indicators *Number of employees in the ICT-sector (2013)

-1.25

R&D expenditure (2014)

-5.76

Stock of foreign capital (2012)

-0.46

R&D staff number (2014)

+2.70

GDP (2014)

+2.21

Number of active corporations (2013) Number of tourism nights (2014)

+1.42 +1.37

*Investments (2014)

-6.41

Industrial production (2013)

-4.14

Population (2015)

+1.02 0%

Budapest

20% Pest county

40%

60%

80%

Rest of the country

+1.02 Change of the share of Budapest in the last 10 years (percentage point) *Change in the last 10 years

Source: HCSO

Growth includes the expansion due to the creation of Greater Budapest.

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Part I: International and national experiences in economic convergence

at a rapid pace. In the 1960s the growth of Budapest’s industry was restricted with administrative measures: the city’s proportion from the country’s industrial workers dropped to around 20 per cent by the end of the socialist era, however, its weight in the metropolitan segment of the increasingly important tertiary sector, i.e. social and economic governance, was preserved (Beluszky, 2007). Although the government’s plans for regional development67 (1971, 1998, 2005) almost always sought to strengthen large cities’ regional centre functions, the multi-polarisation of the country did not make substantial progress (Chart 7-4 ). According to the literature, in Hungary the advantages from economies of scale and agglomeration stemming from spatial concentration, which is gaining increasing importance in terms of competitiveness, can only be observed in Budapest. Due to their small size, the other Hungarian urban areas can only provide conditions, i.e. localisation agglomeration advantages, which enable the companies to compete successfully on the international stage, for only one or two industries or business lines. The agglomeration of the capital could be expanded towards the inner circle of medium-sized cities (Kecskemét, Szolnok, Hatvan, Salgótarján, Tatabánya, Veszprém, Székesfehérvár and Dunaújváros) with the appropriate transportation links, cooperation and governance instruments, as foreseen by the 2014 National Development and Regional Development Plan (Salamin et al. 2014). Larger rural cities, however, are on the periphery of the country’s territory, i.e. close to the border.

7.2.3 Regional polarisation as the consequence of the transition

Initially, the majority of foreign direct investments in Hungary served privatisation purposes, and then from 1997 the sources of foreign capital investments were reinvested incomes and greenfield investments, and after the turn of the millennium investments increasingly flowed towards manufacturing (HCSO 2015a). Foreign direct investments mostly 67

1971: National Settlement Network Development Plan; 1998, 2005: National Regional Development Plan.

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7. Regional differences in economic growth in Hungary

targeted the capital and its nearby surroundings, as well as Western Transdanubia and Central Transdanubia, and market-based investments typically preferred facilities in metropolitan regions. Meanwhile, as agriculture lost its significance in the economy, and the role of the dominant agricultural regions diminished, especially on the Great Hungarian Plain. In addition, the crisis of most of the aforementioned “socialist industrial regions” still poses a growth problem today, primarily in the previously heavy industrial regions of counties BorsodAbaúj-Zemplén, Nógrád and Baranya. As a consequence of the abovementioned developments, regional disparities within the country have almost continuously increased since the mid-1990s. The main regional dimensions and trends of the Hungarian disparities are the significant differences in the level of development between the capital and the rural areas and between the eastern and western parts of the country, as well as the fact that the regions without a significant city lag far behind. The differentiation continued almost uninterruptedly after Hungary’s accession to the European Union, up until 2009. In 2012, the three most developed regions with 24 per cent of the population, i.e. Central Hungary, Western Transdanubia and Central Transdanubia, generated two-thirds of the GDP, and 89 per cent of the foreign direct investment linked to the area was also concentrated in the companies headquartered in these regions. Compared to the average of the EU27, and especially to the small size of Hungary, the internal regional disparities are still excessively huge in the country: based on 2011 data, Hungary ranked second after Bulgaria with respect to the differences at the county level (European Commission 2014). The literature points out that the increasing regional differences since 1990 have, in a certain sense, been a natural consequence of the market economy transition. According to Nemes Nagy (2009), the relative parity of the Soviet countries was not based on real factors, i.e. it did not have an enduring real basis. While in modern market economies the basic precondition for convergence was the tertiarisation of the economy, — 339 —

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i.e. the increasing dominance of the sectors linked much more to the population proportions than the primary or the secondary sectors, in socialist countries convergence was primarily based on the oversubsidised productive sectors (heavy industry), mass production and the levelling of wages and incomes. According to Nemes Nagy, the political transition not only marked a return to the market economy, but also, as an unavoidable consequence, a return to trend of regional disparities characteristic of market economies (see Box 7-2). Nevertheless, it must be noted that while Hungary still performs relatively well with respect to the social and income inequalities “kept” at a low level in socialist countries – the country’s so-called Gini index measuring income inequalities is lower than in 17 EU Member States - the economic disparities in regional terms are much higher than in the majority of the EU15. Box 7-2: Relationship between growth and regional disparities68

In the literature, the classic basis for the empirical analysis of regional disparities within countries is considered the 1965 study by J. G. Williamson. The so-called Williamson Hypothesis is basically the territorial equivalent of Kuznets’ model for economic growth and social inequalities, according to which the relationship between national economic growth and the internal territorial division of the country can be described with an inverted U-curve. Economic growth typically entails an increase in regional differences, which start to diminish after a certain point that cannot be determined exactly. According to Nemes Nagy, the curve can be described the following way: in its first phase, the universal dominance of agriculture keeps regional disparities low. In the second phase, capitalism and the capitalist manufacturing industry starts to take hold, the operation of which takes place in a spatially much more concentrated manner. In the third phase, services appear in the economic structure in increasing proportion, thereby mitigating the “marked duality of the economic structure” and regional disparities. The fourth is basically the

Based on Nemes Nagy 2009, pp. 319–329.

— 340 —

7. Regional differences in economic growth in Hungary

continuation of the third, which is supplemented with a top-down regional policy aimed at convergence, which reduces regional differences even further. The original model was not designed to forecast economic and regional trends, and therefore had to be adjusted later on. The 1988 model by Amos can be regarded as one of the most important contributions to the original, in which two possible appendages were added to the inverted U-curve. The first indicates a balanced and hardly changing spatial structure, while the second signals the resuming increase in disparities. As the possibilities of empirical studies expanded, several additions were made, and several attempts were made at confirming or refuting the curve’s validity. The Williamson Hypothesis is one of the few theoretical models used for describing and forecasting territorial processes. Nonetheless – due to the nature of models – it generalises and mixes several growth paths; therefore, the course of development of individual countries cannot be inferred from it. The development of Hungary, similar post-Soviet countries and their spatial structure is a good example for this, as the artificial equality created by socialism considerably diverted them from the paths projected by the models. With the strong differentiation that started with the political transition and lasted until recently, disparities returned to the trend line typical of market economies. The results projected by the model show considerable differences between developed and less developed countries. In the latter, regional (and social) disparities have stabilised at a high level. In developed countries, for example in Western Europe, (regional) differences in the level of development are smaller, and they followed Williamson’s model closely until the 1970s. However, in the 1970s, as a manifestation of the developments in the economy, the levelling-out observed since World War II came to an end. These changes transformed the previous situation and features of the regions. Both developed and moderately developed countries have been characterised by an unstable, fluctuating growth path since the 1970s, but these developments have had no fundamental influence on the fact that the spatial structure of the most developed countries is much more balanced than in less developed countries.

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Part I: International and national experiences in economic convergence

While Hungary’s economy showed a converging trend between EU accession and 2008, in regional terms we can see that the national figures are based on widely varying regional paths. Of the seven Hungarian regions, Central Hungary improved its position considerably until 2011, while Western Transdanubia did so to a lesser extent, but five of the country’s regions slid down 7-8 places with respect to per capita gross domestic product. Compared to the average of the EU28, all Hungarian regions reached their trough in 2007. On account of the downturn in 2012, Central Hungary’s position weakened considerably, and it was ranked 17 places lower than previously, which was closely linked to the macro-level slowdown at that time (Table 7-3). Table 7-3: Position of the Hungarian regions in the ranking of the EU28’s 272* regions based on GDP per capita Region

2004

2011

GDP/capita PPS EU28=100

Rank

GDP/capita PPS EU28=100

Central Hungary

101

124

Western Transdanubia

225

Central Transdanubia

Southern Transdanubia Southern Great Plain

2012

2013*

Rank

GDP/capita PPS EU28=100

110

105

108

218

216

233

241

238

251

259

260

261

252

260

261

262

Northern Great Plain

256

263

Northern Hungary

257

265

266

Rank

GDP/capita PPS Rank** EU28=100

data table published by EUROSTAT contains only 272 regions. It does not contain Mayotte and **The 2013 data for Hungary, Croatia and Finland are estimates. When creating the ranking, due to the lack of 2013 data for 29 German regions, 2012 data were taken into consideration at 2013 prices. Source: EUROSTAT

— 342 —

7. Regional differences in economic growth in Hungary

Domestic regional development policy and the availability of substantial European Union funds after EU accession had a minor impact on the levelling-out of regional development, or at least its results could not be seen until 2010. Although strategies for the use of funds and programmes considered the aspect of regional convergence, and territory-based programmes (regional operational programmes) were launched, in reality, more developed regions were able to access more economic development funds, which were mainly allocated in an application system. Although the territory-based regional operational programmes achieved considerable success in the development of settlements and rapid fund absorption in general, they were mostly unable to use the opportunity for aligning with the different features of the individual regions (which would have been one of their main advantages). They remained uniform and were typically unable to Chart 7-5: Value of the EU’s economic and enterprise development funds disbursed per resident, by the location of the projects 90 80 70 60 50 40 30 20 10 0

Zala

Tolna

Békés

Nógrád SzabolcsSzatmár-Bereg Somogy

Fejér Jász-NagykunSzolnok Borsod-AbaújZemplén Baranya

Vas

Hajdú-Bihar

Hungary

Thousand HUF

Heves KomáromEsztergom Veszprém

Sopron Bács-Kiskun

Thousand HUF

Csongrád CentralHungary

90 80 70 60 50 40 30 20 10 0

National Development Plan Economy and Competitiveness OP New Hungary Development Plan Economic Development OP New Széchenyi Plan Enterprise Development Breakout Point Note: The National Development Plan (NDP) includes the Economic Competitiveness OP (ECOP), the New Hungary Development Plan (NHDP) includes the Economic Development OP (EDOP), while the New Széchenyi Plan (NSP) includes the Business Development Breakthrough Point,

Source: EMIR, accessed: 12 January 2016

— 343 —

Part I: International and national experiences in economic convergence

realise improvements that would have substantially boosted regions’ economic development and enhanced corporate value added and employment (Salamin et al. 2014). This was coupled with the low share of funds in domestic operational programmes dedicated to economic development within the structural funds. Transportation developments, especially motorway developments, did not have the expected huge economic benefit in rural regions. No improving economic dynamics can be observed in the disadvantaged regions accessible from the expanded M3 and M6 motorways (counties Baranya, Borsod-Abaúj-Zemplén and Hajdú-Bihar), in fact, the Budapest-centric large-scale infrastructure developments may have improved the agglomeration advantages of the capital city region against rural regions (Lengyel 2013). In the new 2014–2020 cohesion policy cycle, Hungarian operational programmes focus on economic development in the service of innovation and employment, and the opportunity for regional economic programmes has also emerged (Péti 2014).

7.2.4 Emergence of levelling-out dynamics

The trend of differentiation between Hungarian counties that started in the 1990s and was only interrupted temporarily after 2000 came to an end after the 2008–2009 economic crisis; in fact, there has been a levelling-out in recent years with respect to the output of the individual counties (Chart 7-6). Three processes drive these dynamics of levelling-out. On the one hand, the economic crisis around 2009 eroded the growth Esztergom, Vas, Fejér and Budapest the most, albeit only temporarily. The proportion of foreign direct investments was the highest in these regions, and their output was the most exposed to the contraction in world trade as well as in household consumption and investment demand, which was partly financed from credit. This slump was only temporary, however, as after 2012 and 2014 the stronger-than-average — 344 —

7. Regional differences in economic growth in Hungary

upswing returned to these counties, with the exception of KomáromEsztergom County, the growth of which is less dynamic, probably due to NOKIA’s discontinuing production. Chart 7-6: Regional disparities in GDP at the county level based on the Hoover index (1994–2014)

2014

2013

14 2012

14 2011

2010

2009

2008

2007

2006

2005

2004

2003

2001

2002

2000

1999

1998

1997

1996

1995

1994

Note: The index measures the difference between the territorial distribution of GDP and population. Range: 1–100 (1 = no regional difference).69 The methodology for calculating GDP data published by the HCSO. Source: Based on HCSO data

On the other hand, increasing economic dynamism in certain less developed regions can also be observed: for example, between 2010 and 2014 the second strongest growth was recorded in Bács-Kiskun, while the counties Borsod-Abaúj-Zemplén, Tolna, Békés and JászNagykun-Szolnok were also characterised by substantially higher-than69

Methodology based on Nemes N. 2009.

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Part I: International and national experiences in economic convergence

average growth. (On the role of the counties in growth, see Chapter 7-3) The spatial distribution of investments, which contracted by one fifth between 2008 and 2012 at the country level70 and has increased considerably since 2013, showed a unique realignment and exhibited signs indicating the possibility of regional levelling-out, as in this period investments gained momentum first in Bács-Kiskun County, then in the Northern Great Plain Region, especially Jász-Nagykun-Szolnok County. Overall, investments have considerably expanded in the counties in the eastern part of the country, while in Budapest they have relatively declined (for details, see Chapter 7.3.2). However, the levelling-out within the country was also due to the unfavourable fact that the economic dynamics of Budapest decelerated. GDP per capita dropped by almost 12 percentage points between 2010 and 2014 as compared to the national average, although it was still 210 per cent. While between 2011 and 2013 the capital was ranked ever lower among the counties with respect to the volume of per capita investment, in 2014 it was able to improve its position once again, and Sopron and Jász-Nagykun-Szolnok. Capitals stand out in all four countries of the Visegrád Group, however Budapest and its surroundings lag behind them with respect to GDP per capita. The capital city regions in Slovakia and Poland (when analysed together with the counties in their surroundings) exhibits greater per capita GDP figures by 26 per cent, while the Czech Republic’s advantage in this respect is 14 per cent. Based on 2013 data, in addition to the three capital city regions, one Polish county (Trójmiejski and its agglomeration) was ranked higher than Budapest taken together with Pest County (Chart 7-17). It should be noted, however, that this difference is also due to the varying divisions of statistical regions, as the relatively underdeveloped Pest County distorts the figures for Budapest. Based on 2013 data, when only the capital cities (as NUTS 3 units) are examined without the surrounding counties, Budapest and Warsaw are 70

Measured at constant prices.

— 346 —

7. Regional differences in economic growth in Hungary

on the same level below Bratislava and Prague, with respect to market size and population size, which are key agglomeration features, the region of Budapest comes second behind Warsaw, and with respect to patents it ranks higher than all the other three capitals (Table 7-4). Table 7-4: Position of Budapest and its agglomeration among the capital regions of the Visegrád Group Population 2013 (million)

Life Share of Employment Number of GDP/capita. expectancy population rate 2013 2013 (PPS) EPO at birth with higher (%) patents/ 100 000 2013 education inhabitants (years) degree 2011-20122013 (%) 2013

GDP/ Investments employee as a 2012 (PPS) percentage of GDP 2011-20122013 (%)

Prague

2.54

78.9

74.2

5.8

32284.6

63963.2

Budapest

2.95

76.6

25.5

62.7

9.2

28358.8

65902.3

15.7

Warsaw

3.28

33.7

78.2

6.1

36360.5

71299

13.6

Bratislava

1.17

77.1

25.6

68.8

4.1

35929.9

71238.1

26.9

Note: All capital cities’ agglomeration are included.

However, manufacturing-oriented counties that depend predominantly on foreign direct investments are not only in a favourable position, they are also vulnerable to some extent due to the fact that their whole economy hinges on relatively few large enterprises. This is attested by the substantial local downturns after the termination of a factory’s production. An example for the regional dependence on one enterprise in Hungary brought great prosperity. In the early 2000s, IBM’s withdrawal from Székesfehérvár, and recently the termination of NOKIA’s production in Komárom caused economic shocks in the affected regions. With respect to the spatial dimension of the turnaround in growth after 2012, we can say that Northern Hungary and Western Transdanubia contributed the most to the upswing in 2013–2014, followed by the Southern Great Plain and Central Transdanubia. The regional data on employment (see Chapter 4.1) and the uptick — 347 —

Part I: International and national experiences in economic convergence

in investments in 2013–2014 both show that growth was not driven by Budapest but primarily by certain rural areas, which may also contribute to the dynamics of levelling-out. If we attempt to map growth and potential growth, we can see that the growing zone of the north-western part of the country and the developed zone of the capital may form a sort of growth centre that expands in a south-eastern direction through Kecskemét towards Szeged and Csongrád. Debrecen with Hajdú-Bihar County is an insular addition to the north-western, south-eastern axis. The north-eastern part of the country, where some signs of convergence can be observed, and Southern Transdanubia, which increasingly lags behind, are the areas that may hinder the growth of the national economy due to the lack of their resources’ economic utilisation (Chart 7-7). Chart 7-7: GDP per capita in absolute terms and relative to the EU average in Hungarian counties (2013, 2014)

42.3% 28.4%

35.7%

45.6% 80.2%

67.4%

141.4% 47.6%

64%

55.3% 43.6%

64.3%

47.1%

Zala 52.8%

38.5% 41.6%

51.2%

48.4% 44% 1429.5–1773.6 1773.7–2109.5

43.6%

2109.6–2757.0 64.3%

Source: HCSO STADAT

— 348 —

2757.1–4068.0 4068.1–6842.5

7. Regional differences in economic growth in Hungary

The lack of the spatial spillover effect of economic dynamics can be vividly seen in the striking difference between Budapest and Pest County, and in the case of Nógrád County, which is close to the capital but still increasingly lags behind. The trends of spatial concentration and the burden of the inherited heavy industry continues to hamper growth in Nógrád, which is characterised by a very low level of urbanisation, and which, despite its proximity to the capital, increasingly lags behind the other counties with respect to GDP per capita. Nevertheless, employment figures have clearly improved in recent years, which shows that in addition to the impact of public employment, the county may also profit from its proximity to Budapest. Out of the resource-intensive heavy industry regions, Tatabánya and its surroundings and KomáromEsztergom County in general were able to exhibit dynamic growth after tackling their crises, thanks to their strengthening geographical position (M1 motorway, Vienna–Budapest axis) and the inflow of foreign direct investments.

7.3 Varying contribution of counties to growth This chapter analyses the economic growth of Hungarian counties since 2000, and from the 2009 trough until 2013, with special regard to each county’s contribution to output. Also, the individual subfactors of growth are analysed through decomposition. In this examination of Hungarian counties, Budapest and Pest County will be considered as one unit, since the vicinity of the capital, i.e. the metropolitan group (agglomeration) comprises 86 per cent of the population in the Central Hungary region, which is made up of these two units. Although GDP per capita has increased in the majority of the counties since 2000, growth dynamics have been widely diverging (Chart 7-8). a Hungarian context, the counties Komárom-Esztergom, Fejér and Vas and partly Zala have also been characterised by this process. We can also see that one huge investment — 349 —

Part I: International and national experiences in economic convergence

Moson-Sopron, only boosts GDP over the short term, and does not have a lasting impact on growth, and no regional multiplier effects can be seen either, i.e. counties manage to take one step forward but after that economic growth decelerates. The economic growth of the other 13 counties is very similar, they develop almost as “one group”. Most of them can be found in the lowest 10 per cent among the counties in the EU28 Member States. As we have pointed out, Nógrád County clearly lags behind, but both the counties Szabolcs-Szatmár-Bereg and Békés develop at a slow pace. Chart 7-8: GDP per capita in Hungary between 2000 and 201471 6,000

Thousand HUF

2,000

1,500

1,000

Csongrád

Vas Fejér Tolna Zala

Heves Baranya

Source: HCSO STADAT

At 2014 prices.

— 350 —

2014

2,000

2013

2,500

2012

2,500

2011

3,000

2010

3,000

2009

3,500

2008

3,500

2007

4,000

2006

4,000

2005

4,500

2004

4,500

2003

5,000

2002

5,000

2001

5,500

2000

5,500

Central Hungary

6,000

7. Regional differences in economic growth in Hungary

Sopron were able to considerably improve their position in PPS terms since 2005 as compared to the EU27 average, and to exceed 75 per cent (which is a “mythical threshold” in the EU’s regional policy, see table 7-5). However, Fejér, Vas, Tolna, Jász-Nagykun-Szolnok and Bács-Kiskun counties all converged with the EU average by at least three percentage points. The other 12 counties were unable to improve their position, despite the substantial subsidies from the EU’s development funds. In fact, several counties, such as KomáromEsztergom, Baranya and Nógrád slid back as compared to 2005, i.e. their economic growth lags behind the EU average. Table 7-5: GDP per capita at purchasing power parity as a percentage of the EU27 average 2005

2010

2012

2013

Percentage point difference 2013-2005

Central Hungary

100.6

107.0

105.0

105.9

5.3

69.0

77.8

74.7

80.2

11.2

Komárom-Esztergom

71.5

66.8

65.5

67.4

–4.1

Fejér

59.6

56.7

60.5

64.3

4.7

Vas

58.6

55.5

60.8

64.0

5.4

Zala

54.1

53.2

54.9

52.8

–1.3

Tolna

42.2

47.6

50.0

51.2

9.0

Csongrád

48.3

47.3

48.3

48.9

0.6

Bács-Kiskun

42.2

41.8

45.1

48.4

6.2

Hajdú-Bihar

46.6

48.1

47.6

1.0

Veszprém

46.6

47.2

45.6

47.1

0.5

Heves

43.6

44.9

42.3

45.6

2.0

Baranya

45.1

43.4

42.4

43.6

–1.5

Jász-Nagykun-Szolnok

38.5

39.8

41.6

43.6

5.1

Borsod-Abaúj-Zemplén

42.7

39.4

39.9

42.3

–0.4

Somogy

40.9

41.5

40.9

41.6

0.7

Békés

37.7

36.2

36.6

38.5

0.8

Szabolcs-Szatmár-Bereg

34.2

35.2

35.0

35.7

1.5

Nógrád

31.8

29.1

28.3

28.4

–3.4

Hungary (total)

62.1

64.8

64.5

66.2

4.1

Source: HCSO (2015)

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Part I: International and national experiences in economic convergence

7.3.1 Changing role of counties in the growth path of the country

The data above show that the pace of economic growth varies greatly across the counties. We should examine how individual counties contributed to the economic growth of the country, and which county boosted or hampered growth of the country and when. The country’s GDP can also be conceived as the sum of the GDP of the 19 territorial units (counties). The examination of territorial time series always poses difficulties in measurement, and this study based its comparison of counties’ economic growth on the country’s volume index of GDP. In measuring counties’ 2013 GDP in 2000 real terms, the difference between the 2000 and the 2013 figures shows how much individual counties increased the country’s output in this period (Chart 7-9). In absolute terms, Central Hungary stands out markedly, as it Chart 7-9: Contribution of the counties to the country’s GDP growth between 2000 and 2013 (at 2000 prices) 2,400,000

Million HUF

2,400,000

1,900,000

1,400,000

–100,000

Nógrád

–100,000

Tolna Vas Baranya

400,000

Heves Zala Csongrád

400,000

Bács-Kiskun Hajdú-Bihar

900,000

Central Hungary Komárom-Esztergom

900,000

Note: The data from HCSO STADAT 6.3.1.1, corrected based on the country’s volume indices of GDP. Source: HCSO STADAT (Analysis concluded: 31 December 2015)

— 352 —

7. Regional differences in economic growth in Hungary

generated 68 per cent of the increase in the country’s output, while the other counties grew at a much slower pace. On account of its population of almost 3 million, the comparison with this county probably does not show a realistic picture, but the figure per thousand inhabitants is also the highest here, and it is more than double the national average (Chart 7-10). In addition to Central Hungary, the counties Komárom-Esztergom much more subdued growth compared to 2000. The data also show that in two cases, in Nógrád and Békés, output has declined in real terms since 2000, i.e. these counties lowered the country’s economic growth, and Veszprém and Baranya were also unable to make considerable progress in 13 years. Chart 7-10: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2000 and 2013 (at 2000 prices)

800

Million HUF

800

700

600

500

400

300

200

100

the country’s volume indices of GDP. Source: HCSO STADAT (Analysis concluded: 31 December 2015)

— 353 —

Nógrád

Baranya

Vas

Csongrád

Tolna

Zala

Heves

Bács-Kiskun

Hajdú-Bihar

Komárom-Esztergom

Central Hungary

–100

0 –100

Part I: International and national experiences in economic convergence

In 2000–2008, steady, exceptional economic growth was observed, with an average annual growth rate of 4 per cent. In this period, it was once again Central Hungary which contributed the most to the country’s output, accounting for around 60 per cent of the country’s increase, and based on the data calculated per thousand inhabitants, economic growth was seen in all countries. The expansion was exceptionally strong in the capital city region as well as in Komárom-Esztergom (Chart 7-11). In territorial terms, the economy expanded fairly evenly until 2008, and all counties were able to improve their output as compared to 2000, but Nógrád and Vas counties showed the least improvement. Chart 7-11: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2000–2008 and 2009–2013 (at 2000 prices) 100

Million HUF

100

2000–2008 annual average

Source: HCSO STADAT (Analysis concluded: 31 December 2015)

Vas

Nógrád

Fejér

2009–2013 annual average

Note: Data corrected based on the country’s volume indices of GDP.

— 354 —

Békés

Tolna

Veszprém

Csongrád

Szabolcs-Szatmár-Bereg

Somogy

Baranya

Bács-Kiskun

Jász-Nagykun-Szolnok

Borsod-Abaúj-Zemplén

Heves

–60

Hajdú-Bihar

–60

Zala

–40 Hungary

–40 Komárom-Esztergom

–20

Central Hungary

–20

7. Regional differences in economic growth in Hungary

Country-wide economic growth came to a halt in 2009. Based on the counties’ GDP change in 2009–2013 in real terms at 2000 prices, the counties split into two groups in this period. Economic growth was seen in 4 counties, while the other 15 experienced a downturn. According to data calculated per thousand inhabitants, the counties Vas, output of the capital city region declined considerably. Therefore, the country’s stagnant economic growth between 2009 and 2013 was mainly attributable to further decline of the capital city region. Chart 7-12: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2011 and 2013 (annual average, at 2000 prices) 60

Million HUF

Hajdú-Bihar

Nógrád

Somogy

Zala

Central Hungary

Komárom-Esztergom

Veszprém

Szabolcs-Szatmár-Bereg

Hungary

Baranya

Csongrád

Heves

Jász-Nagykun-Szolnok

Tolna

–30

Békés

–30

Borsod-Abaúj-Zemplén

–20 Fejér

–20 Bács-Kiskun

–10

Vas

–10

Note: Data corrected based on the country’s volume indices of GDP. Source: HCSO STADAT (Analysis concluded: 31 December 2015)

In examining the recent past, GDP growth in real terms can be observed in the majority of the counties since 2011. Per capita figures show that relative to their population, Vas, Bács-Kiskun and Fejér have played — 355 —

Part I: International and national experiences in economic convergence

a central role in boosting growth since 2012 (Chart 7-12). A turnaround could be observed in the majority of counties that previously experienced a downturn. It seems that they have reached their trough and that their GDP has increased. It should be noted that according Table 7-5, 18 counties improved their position relative to the EU27 average in 2013 as compared to 2012, i.e. the convergence process resumed everywhere.

7.3.2 Changing position of counties with respect to investments

In the field of investments, a sort of relative realignment was witnessed in favour of the eastern part of the country, which entailed a slight and temporary decrease in the weight of the capital. The contribution of the individual counties to investments, which stagnated and dropped between 2008 and 2012 and then expanded in 2013 and 2014, varied significantly every year, reflecting the bigger investment projects of large enterprises. Compared to the situation in 2008, an improving trend can be observed in both the Southern Great Plain and the Northern Great Plain, where the investment rate relative to GDP, which used to be 15 per cent, reached 17–27 per cent by 2014. In general, we can say that between 2008 and 2014 only a handful of Hungarian counties were able to (temporarily) achieve the ideal investment rate of around 25 per cent relative to GDP: these were Nagykun-Szolnok and Békés in 2014 (Chart 7-13). Between 2008 and 2011 the first significant surge in the investment rate relative to GDP was observed in the south, i.e. in the counties Tolna, Bács-Kiskun, Csongrád and Baranya, and then from 2012 this positive trend became typical of the eastern counties such as Jász-Nagykun-Szolnok, Békés and Szabolcs-Szatmár-Bereg. The 2008–2010 performance of Fejér and Tolna declined, and their prominent position was gradually taken over under review, Nógrád and Zala were mainly characterised by a low investment rate relative to GDP. The former has been the “permanent loser” of investments since 2008. — 356 —

7. Regional differences in economic growth in Hungary

Chart 7-13: Changes in the value of investments relative to GDP in the counties between 2008 and 2013 2008

2009

2010

2011

2012

2013

2014 Investments as a percentage of GDP >12 12–18,5 18,5–25 25<

Source: HCSO STADAT

Based on the per capita values of the investments flowing into the counties, the top position that was secured by Budapest in 2008–2010 — 357 —

Part I: International and national experiences in economic convergence

2013 Komárom-Esztergom also surpassed the capital. In 2014, Budapest Sopron and Jász-Nagykun-Szolnok (Chart 7-14). In addition to the good certain counties in the eastern part of the country (Békés, Jász-NagykunSzolnok and Heves) have also risen considerably, which may contribute to convergence. Chart 7-14: Value of investments per capita in Hungarian counties (2008, 2011, 2014) 900 800 700 600 500 400 300 200 100 0

900 800 700 600 500 400 300 200 100 0

2008

2011

Source: HCSO STADAT

— 358 —

2014

7. Regional differences in economic growth in Hungary

7.3.3 Growth factors of the counties

Analysing the economic growth of the counties between 2000 and 2013 at 2000 prices through decomposition,72 it can be seen that for almost one and half decades the main source of growth was labour productivity everywhere, and the more developed a county was, the Chart 7-15: Impact of the major factors of economic growth (2000–2013) 700

Million HUF

700

600

500

400

300

200

100

100 0

Nógrád

Baranya

Tolna

Hajdú-Bihar

Csongrád

Vas

Heves

Bács-Kiskun

Zala

Hungary

Central Hungary

-100

Komárom-Esztergom

-100

Number of individuals in active age

Note: GDP was calculated at 2000 prices based on the country’s volume index (KSH STADAT Table 3.1.1), and the list of the counties follows the order based on 2013 GDP per inhabitant Source: Calculation of the authors based on HCSO STADAT (Analysis concluded: 31 December 2015)

As is widely known, economic growth can be decomposed, since GDP per inhabitant can be given as the product of three factors: GDP inhabitants

GDP employees

employees × working-age population

working-age population inhabitants

The above formula means that GDP per inhabitant equals the product of labour productivity (lp), employment rate (er) and the proportion of the active population (ap). It has to be noted that by definition labour productivity means the output per one hour worked; therefore, we only use an approximation here. In short, the formula is: y=lp*er*ap When comparing two periods, the increase in real GDP terms can be decomposed: y1-y0=(lp1-lp0)*er0*ap0+(er1-er0)*lp1*ap0+(ap1-ap0)*lp1*er

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Part I: International and national experiences in economic convergence

more marked this effect was (Chart 7-15). Compared to the starting year of 2000, labour productivity growth in Central Hungary and KomáromEsztergom was above the national average, and these counties were Moson-Sopron, Bács-Kiskun, Vas and Heves. In two counties, Békés and Szabolcs-Szatmár-Bereg, however, labour productivity decreased, and compared to 2000 it also hardly improved in Fejér County. In the counties Békés and Szabolcs-Szatmár-Bereg, the main driver of economic growth was the employment rate, but employment also contributed to economic growth in Komárom-Esztergom and BorsodAbaúj-Zemplén as well as in Central Hungary, while the presumed labour shortage hindered growth in Vas and Zala. The improvement in the proportion of the active population within the total population enhanced the situation in Szabolcs-Szatmár-Bereg, Hajdú-Bihar and Borsod-Abaúj-Zemplén, while in Central Hungary the demographic change was negative. In 2009–2013, after the trough of the global crisis, employment gained priority in the economic growth of the counties (Chart 7-16). In 15 counties – surprisingly also in Central Hungary – it played a more important role than labour productivity. The improvement in labour Fejér, Vas and Bács-Kiskun. A drop in the proportion of working age population was observed in several counties, partly due to ageing and partly to the considerable share of employees working abroad. Komárom-Esztergom this had a negative impact on economic growth.

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Chart 7-16: Impact of the major factors of economic growth (2009–2013) 350

Million HUF

350

300

250

200

150

100

–100

Tolna

–50 Zala

–50

Note: GDP was calculated at 2009 prices based on the country’s volume index (KSH STADAT Table 3.1.1), and the list of the counties follows the order based on 2013 GDP per inhabitant. Source: Calculation of the authors based on HCSO STADAT (Analysis concluded: 31 December 2015)

Comparison with the regions of the Visegrád Group

In assessing their performance compared to the NUTS 3 regions (counties) of the Visegrád Group, it can be seen that the growth rate in most of the Hungarian counties has been slowed since 2009, i.e. the the other countries of the Visegrád Group and their regions are growing more rapidly, and in the case of the Czech economy, they stagnate at a higher level. Based on the 2013 GDP figures, among the 93 NUTS 3-level territorial units of the Visegrád Group, three Hungarian ones are included in

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dynamic growth. The growth rate of Budapest and its vicinity as well as Komárom-Esztergom is slow. Two other counties (Vas, Fejér) have average economies, while the remaining 14 maintain weak economies, and their level of development is below the counties’ average. Out of the latter, only Bács-Kiskun’s growth has become dynamic (probably on account of the investment by Daimler AG). In addition to the capital city regions already mentioned, two Czech, 3 regions are among the 15 most developed counties (Chart 7-17). Chart 7-17: GDP/capita PPS in 2009 and the growth until 2013 in the NUTS 3 regions of the Visegrád Group 40,000

35,000

30,000

Bp.+Pest

40,000

30,000

20,000 Zala

15,000

Heves

20,000

Tolna

25,000

Vas

25,000

15,000

10,000

5,000

5,000 0

Note: Capital cities and the metropolitan Polish urban regions are considered one metropolitan unit with the counties surrounding them.

7.3.4 Three types of county growth paths

We believe that, based on the county-level indicators of economic growth and other empirical analyses (Lengyel B. – Szanyi 2011; Lengyel I. — 362 —

7. Regional differences in economic growth in Hungary

– Szakálné Kanó 2012; Vas et al. 2015), three types of growth paths can be charted in Hungary: Budapest and its agglomeration (its commuter zone, which in many cases extends beyond regional and county boundaries): this area is integrated into the global economy; before the crisis, i.e. until 2007 it showed dynamic growth, generating a substantial share (60 per cent) of Hungarian GDP growth. However, during and after the crisis its growth became subdued, and it has lagged more and more behind the capitals of the Visegrád Group. According to per capita data, it slid lower in Hungary as well, moving to the fourth place among the counties. After 2009 its labour productivity also declined. With a skilled population of almost 3 million and high-quality infrastructure, it could become the “driver of growth” in the country once again, but the decelerating growth of the capital hinders the whole economy. Improving the competitiveness of the capital at the international level, i.e. among global cities, is key as regards the country’s growth prospects. FDI-driven manufacturing regions Komárom-Esztergom, Fejér, Vas and recently also Bács-Kiskun): these units have become integrated into the European economy through the plants of multinational manufacturing corporations. Since 2011 economic growth in Hungary has been largely dependent on these regions. Their economic growth is “staggered”, and growth is boosted by individual investments only temporarily, decelerating again after that, which suggests that the subsidiaries of multinational corporations have become hardly integrated into the economy, and the initial push impact is not followed by others, i.e. local multiplier effects are minimal. This can be partly attributed to the fact that, on the one hand, the population of the regions is small (the labour market and the market for modern business services is limited) and, on the other hand, local companies are unable to join the FDI value chains (for example, by providing business services). In these regions, economic growth depends on multinational corporations. Their labour productivity has been improving, which points towards continued GDP growth, but this will be reflected in — 363 —

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local labour incomes to only a minor extent. Also, the population of these counties is 1.5–2 million, i.e. they can only influence the country’s economic growth to a modest degree (Lengyel–Szanyi 2011). Other regions: they have companies primarily producing and providing services for the domestic market, the improvement in the competitiveness of certain firms mainly drives domestic competitors out of the market, and economic growth is slow, which can principally be attributed to the improvement in employment. These regions form a heterogeneous group, and in counties with larger university cities (Debrecen, Miskolc, Pécs, Szeged) the skills of the labour force are close to the EU average, although a substantial portion of graduates work in the public sector, however, growth-driving industries may be established with connections to the universities. Within this group, small towns and rural regions do not have competitive economies: only a handful of their companies are competitive, and the skills of the labour force and the quality of corporate management are generally low.

7.4 Spatial pattern of certain factors determining human capital 7.4.1 Unemployment

The employment situation shows especially marked regional segmentation. In contrast to the high employment in the central and north-western regions of the country, the regions in the north-eastern part of Hungary and Southern Transdanubia still face enormous challenges with respect to employment. While unemployment increased in all counties but one between 2006 and 2010, the turnaround in employment after 2011 resulted in an improvement in almost all counties. Increasing employment did not significantly change the regional pattern, but caused a substantial realignment in the relative position of individual counties (Chart 7-18). — 364 —

7. Regional differences in economic growth in Hungary

Chart 7-18: Unemployment in Hungary (2008–2014)

Zala

Unemployment rate, 2014 3.0–4.3% 4.4–6.0% 6.1–7.6% 7.7–8.9% 9.0–11.3% 11.4–13.6%

Unemployment rate, 2008–2014 9.2% 2008 2009 2010 2011 2012 2013 2014

Source: HCSO STADAT

and in 2014 this county was followed by Vas and Komárom-Esztergom. The capital was ranked second in 2006, however, its relative position has weakened despite the steady decrease in unemployment (amounting to 3 percentage points overall) since 2011, as five counties had more favourable unemployment figures in 2014. During the period under review, the unemployment rate dropped the most, by 10 percentage points, in Nógrád, which has therefore moved close to the national average in three years, rising from the last place in 2011 (18.3 per cent). Vas County showed more moderate changes, as unemployment there fell by close to 7 percentage points between 2010 and 2014. The unemployment situation has changed the least in the south-eastern part of the country, especially in Bács-Kiskun, Békés and Hajdú-Bihar. The latter has become the second worst performing county in terms of unemployment after Szabolcs-Szatmár-Bereg, which was almost always ranked in last place in the period under review, despite the — 365 —

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improvement (amounting to 4.6 percentage points) as compared to the trough (in the period under review) in 2012. From the perspective of employment, Bács-Kiskun has been unable to take advantage of the exceptional growth in industrial production. Yet most of the counties where the unemployment rate has dropped most strongly are among the least developed ones, which has contributed to the dynamics of levelling-out and regional convergence. Youth unemployment (Chart 7-19) basically follows the territorial pattern of the overall unemployment rate. In the Northern Great Plain almost 30 per cent (28.9 per cent) of young people aged 15–24 do not have a job. Even in Western Transdanubia, which is in the most favourable position, youth unemployment is above 10 per cent. Youth unemployment has declined the most (by 9–10 percentage points) in Southern Transdanubia and Northern Hungary since 2011. Chart 7-19: Unemployment rate among people aged 15–24 (2008, 2011, 2014) Central Hungary 40 30

Southern Great Plain

Central Transdanubia

20 10 0 Northern Great Plain

Western Transdanubia

Southern Transdanubia

Northern Hungary 2008

2011

Source: EUROSTAT

— 366 —

2014

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7.4.2 Life expectancy

With regard to life expectancy, there are substantial regional differences behind the unfavourable Hungarian situation as compared to Europe. The east-west divide with respect to life expectancy can be considered traditional (Chart 7-21). With the exception of two counties (Csongrád and Hajdú-Bihar), the national average was only exceeded by the capital and the western counties, with the capital leading by far. The indicator shows close correlation with GDP per capita (Chart 7-20). Counties with the lowest GDP per capita also lag behind with regard to life expectancy. Komárom-Esztergom is a negative anomaly in this respect, as it ranks among the counties bringing up the rear in terms of life expectancy, despite its third highest GDP per capita. The position of Vas County is similarly unfavourable. The positive and negative anomalies can partly be explained by settlement structural features. Chart 7-20: Average life expectancy at birth and per capita GDP in the counties of Hungary (2014) 77.5 BUD

77.0 76.5

VESZ

Year

76.0

ZAL HB HEV BAR

75.5 75.0 74.5 74.0

TOL

SOM BK SZSZB BÉK NÓG

73.5 73.0 500

GYMS

CSON PEST FEJ VAS

JNSZ BAZ

2500

4500 Thousand HUF

Source: HCSO STADAT

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It is generally true that the lower the population of a settlement, the less favourable mortality and life expectancy are, while the most favourable life conditions are provided by cities with a population of between 50,000 and 100,000 (HCSO 2010). Taking into account the settlement structure of Vas County which has many small villages, and the relatively high level of urbanisation in Csongrád and Hajdú-Bihar, we can say that the idiosyncrasies in settlement structure may partly explain certain anomalies. With respect to the change in life expectancy, an almost uninterrupted rise was observed over the past ten years in the country overall (Chart 7-21). Life expectancy has increased by more than 4 years in the country since 2005. At the county level, however, there are significant differences in this respect as well. Life expectancy increased the most Chart 7-21: Average life expectancy at birth in Hungarian counties (2005, 2010, 2014) 78

Year

3.5 3.0

2.5

2.0

1.5

1.0

2014

2005

Source: HCSO STADAT

— 368 —

Vas

Heves

Pest

2010

Fejér

0.0

Zala

Veszprém

0.5 Budapest

7. Regional differences in economic growth in Hungary

in Szabolcs-Szatmár-Bereg, which is among the laggards, and has risen by almost three years in Borsod-Abaúj-Zemplén as well, although the figure for the latter remained the lowest in the country. Among the top performers, a considerable improvement was seen in the capital and in the counties Csongrád and Hajdú-Bihar. Life expectancy changed the average in the lowest-ranked counties of Békés, Nógrád and JászNagykun-Szolnok.

7.4.3 Population change

In Hungary, population decline has been observed since 1981. Since then the population of the country has decreased by more than 1 million, amounting to 9,877,000 in 2014 and 9,855,000 in 2015. Natural population growth varies across counties but is negative everywhere (Chart 7-22). The relatively highest values can be found in the counties Szabolcs-Szatmár-Bereg, Pest and Hajdú-Bihar. Budapest is even slower than in the country overall (–3.5 per thousand), and in the counties Borsod-Abaúj-Zemplén, Komárom-Esztergom and Veszprém the figure is slightly higher. In most of the country, population decline varies between –4.2 and –5.2 per thousand. The largest population decline can be observed in the counties Békés, Nógrád, Vas and Zala. Hungarian society has been ageing for decades. In 2014 the ageing index, which expresses the percentage of the old population (65 and over) relative to the child population (0–14 year-olds), was 121.5 per cent. The ageing index is one of the measures of the age structure of the population, and therefore it is basically determined by population change trends, and its value exhibits a pattern similar to natural population growth (Chart 7-22). Similar to Pest County, which benefits from the suburbanisation around Budapest and where the proportion of — 369 —

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old-age population does not exceed the share of the young yet, SzabolcsSzatmár-Bereg County has a youthful age structure. The counties Esztergom have better values than the national average, but in these counties the old already outnumber the young. In the other Hungarian counties the population is characterised by higher-than-average ageing, with the most unfavourable situation observed in Békés and Zala and Budapest. In the case of Budapest, ageing is exacerbated by the fact that families with children move out into the agglomeration. Chart 7-22: Natural population growth, ageing index, internal and international net migration in Hungary (2014)

Zala

Internal and external 4.4

Ageing index (percentage) 86.8–100.0 106.4–124.5 126.9–137.4 146.4–150.2

Natural increase/ decrease –7.5– –5.9 –5.8– –4.6 –4.5– –3.7 –3.6– –2.7 –2.6– –1.2

Source: HCSO STADAT

The negative, steadily downward trend in natural population growth (with the exception of minor interruptions) has always been offset by — 370 —

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cross-border migration in the past 24 years, albeit to varying degrees (Chart 7-23). The major recipients of immigration are the counties along the eastern and south-eastern border, with the exception of Békés, primarily Szabolcs-Szatmár-Bereg, as well as the capital, surplus. In the case of counties Pest and Békés, the balance shows a minor surplus, while emigration decreases the population of all the other counties, albeit to varying extents. Veszprém and Tolna were characterised by the highest outflows (Chart 7-22), but the emigration of skilled labour possibly affects more developed regions as well. Chart 7-23: Natural population growth, internal and international net migration and ageing index in Hungary (2001-2014) 0.0

Per thousand

Per cent

–0.5

140 120

–1.0 100

–1.5 –2.0

–2.5

–3.0

–3.5 20

–4.0

–4.5 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Actual increase/decrease (adjusted with international net migration) Natural increase/decrease Ageing index (right-hand scale) Source: HCSO STADAT, Regional Statistical Yearbooks

Up until the economic crisis, the main targets of internal migration were the regions that benefited from the developments of the political

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and Vas are still the primary targets of those changing their place of residence, but the counties Fejér and Komárom-Esztergom have had a negative internal migration rate since 2008, just like the other Hungarian counties. With respect to internal migration, Budapest is in a unique situation. Between the 1990s and 2006 its population declined on account of the suburbanisation processes, but this trend was reversed in 2007 as the dynamics of reurbanisation gained momentum, and today the capital is once again among the main targets of internal migration. As discussed in Chapter 7.3.3, demographic developments between 2009 and 2013 hampered growth in eight counties.

The basis for establishing a knowledge-based society is the human capital of population with higher education degree and the companies (and other institutions) where these people can utilise their knowledge. According to the data from the 2011 census, 13.9 per cent of the Hungarian population has a higher education degree. People with higher education degree are mostly concentrated in Budapest, where their proportion is more than double the national average. Other top performers in the country include counties Pest, number of them is about half of the figure for Budapest. In most of the country, the proportion of population with higher education degree fluctuates between 10 and 13.6 per cent, and it is only below 10 per cent in Szabolcs-Szatmár-Bereg and Nógrád. The concentration of companies engaged in professional, scientific and technical activities more or less corresponds to the population’s educational attainment. With the exception of Somogy County, Central Hungary and the western part of the country boast higher proportions, while in the east most of the counties that perform better than their environment are those with a substantial knowledge base (university or industrial centres) such as Csongrád, Hajdú-Bihar and Borsod-Abaúj-Zemplén (Chart 7-24). — 372 —

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Chart 7-24: Knowledge society in Hungary

Zala

Share of professional, scientific and technical businesses, 2014 (percentage) 12.3-13.1 13.2-14.8 14.9-16.6 16.7-19.8

Share of inhabitants with higher education degree, 2011 (percentage) 9.0-10.1 10.2-11.6 11.7-14.1 14.2-16.1 16.2-30.1

Source: Census, HCSO (2015b)

7.5. Conclusion â&#x20AC;&#x201C; Certain regional conditions for growth The increasing importance of spatial agglomeration advantages and the presence of regions that are moderately active economically draws attention to the fact that by taking into account geographically diverging development and understanding the regional dynamics of the economy, the reinforcement of the regional foundations of economic growth in Hungary holds growth reserves for the national economy. The territorial distribution of economic activity is not only the result of national economic processes, as macro-level economy performance is also substantially influenced by the socio-economic spatial structure, i.e. the settlement network, which may accelerate or, conversely, hamper economic growth. In conclusion of the present analysis, a few â&#x20AC;&#x201D; 373 â&#x20AC;&#x201D;

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phenomena resulting from the territorial structure and its shaping can be identified which may impose spatial limits on growth. The aspects presented briefly below only cover some of the elements of the role which spatial structure plays in economic growth that follow from the findings of the study, and do not include, for example, areas related to structure and operation such as the local or regional systems of public administration, regional governance, urban development, territorial planning, the systems of public services, which may also represent a considerable potential in regional terms from the perspective of economic growth. Strengthening urban-rural relations

Strengthening the links between urban centres with a substantial economic role and their surrounding regions is today more important than ever, in order to integrate rural regions into the economy, boost the spatial dynamics of economic growth and make the appropriate employment and necessary resources available in the regions outside the major economic centres. The transportation links enabling commuting, which influence the size of the local labour market, the cooperation among economic actors (supplier networks), the functional division of labour among settlements whereby smaller settlements are linked to the urban regions through their recreational, ecological and food producing role all serve this purpose. Taking into account the functionally developing urban regions in public regional governance and the implementation of local economic development programmes are important to achieve the above. The cooperation between urban and rural regions is a key aspect in EU policy documents (Territorial Agenda of the European Union 2011) and is one of the goals of the Hungarian National Development and Regional Development Plan (2014), the practical implementation of which also has economic significance. Alleviating the monocentric settlement structure of the country

In Hungary, metropolitan agglomeration advantages can only be observed in Budapest. This is because 2.6 million people live in the vicinity of the capital, while the labour markets of other regions â&#x20AC;&#x201D; 374 â&#x20AC;&#x201D;

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are small (the largest after Budapest are those of Debrecen with 243,000, Szeged with 208,000 and Miskolc with 205,000 people). The capital city region concentrates not only the institutions of social and political decision-making, but also the innovative human capital that influences development. Due to the disadvantages stemming from the peculiar Hungarian settlement network – such as the limited labour agglomeration of provincial urban regions that is below the critical mass – input substitution is expensive and difficult, launching modern business services is not financially viable and the proportion of employees with higher education degree working in the private sector is low. The monocentric spatial structure may be alleviated through the strengthening of rural regional centres and the economic and functional expansion of the Budapest metropolitan area. The inner circle of medium-sized cities around Budapest (Salgótarján, Kecskemét, Dunaújváros, Veszprém, Tatabánya) can be bound together to form an integrated economic region unifying agglomeration advantages and providing a larger supply of facilities and labour through transportation links, governance instruments and common economic programmes. As it has been pointed out in earlier studies (OFTK 2015; Matolcsy et al. 2007), the medium-sized cities around Budapest that can be reached within an hour may supplement the capital city region as circle of socalled „bearing cities”. The centres in the outer city circle may primarily strengthen their role through cross-border ties. Cross-border agglomeration

Due to the character of the Hungarian city network, the urbanisation clustering necessary for achieving the “critical mass” of agglomeration advantages has very limited opportunities outside the Budapest metropolitan area. The larger rural cities located near the border owing to historical reasons cannot be considered substantial agglomerations in international comparison, but in certain cases they may form a region of substantial economic weight together with large cities on the other side of the border. Such regions may be formed from the cooperation — 375 —

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between Miskolc and Košice, Debrecen and Oradea, Szeged, Arad and Timiș area of Bratislava and Vienna. This cross-border agglomeration can be stimulated by enhancing the cooperation between the cities and the economic actors concerned, encouraging clustering, improving the systems of accessibility as well as launching regional economic development programmes encompassing the economies of the Carpathian Basin. In addition, strengthening the Vienna–Budapest axis and complementing it with Bratislava may increase the global weight of the capital. The EU membership and funds from the European regional cooperation programmes that can be spent on cross-border programmes provide a theoretical opportunity for much more active cross-border integration. At the same time, the development of crossborder functional regions – agglomerations – has also emerged as a sort of common European regional priority (Zaucha–Salamin 2011; Salamin et al. 2011). Alleviating the radial, monocentric transportation network

The Hungarian transportation network is monocentric: the – otherwise necessary - construction of motorways reaching the border, i.e. the central transportation system, fostered the concentration of the economy. The motorways constructed have not produced the expected results yet, i.e. they have not boosted the economy of the regions they reached, but they have exerted a unique impact on spatial economies of scale. The construction of motorways reduced unit transport costs, and the markets of companies in the capital expanded; therefore, traded business activities are inevitably concentrated in and around the capital, as pursuing financial, logistical and business services activities utilising the economies of scale and covering the whole country is only financially viable there. In parallel, the business services of cities in rural areas lose market share, which may hamper growth not only in rural regions but also in the whole country. The unipolar transportation system inevitably concentrates mobile activities, which may have both advantages and disadvantages from the perspective of the country. The advantage is that clustering traded-type companies are strengthened — 376 —

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in the global competition and become successful internationally, thereby boosting employment and fostering economic growth. The disadvantage is that if the driving-out effect is strengthened, companies in rural areas engaging in non-traded activities (that only attract Hungarian consumers) go bankrupt, and unemployment rises in such regions. The GDP figures from the capital city regions may indicate that the concentration mainly amplified this driving-out effect rather than the internationally successful activities entailing growth, which was strengthened by, inter alia, the enhanced accessibility. The limited competitiveness of moderately active rural regions and local economic development

The consistently lagging regions of a rural character – mostly in the north-eastern, but increasingly also in the south-western part of the country – cannot enter the competition of the integrated European space. The economic policy aimed at international competitiveness cannot provide a solution to the problems of the typically peripheral and mostly rural regions that mainly have low-skilled labour, while managing the related social problems places a considerable economic burden on the country. The level of utilisation of the labour force and other resources of these regions is typically low. These regions may require a targeted economic policy beyond the current rural development and regional development, which, in line with the model of local economic development, stimulates production for both the domestic and the local (urban) markets in these regions, based on endogenous resources and taking into account the fact that these regions hold resources of strategic importance (food production, arable land, ecological resources). Regional aspects in economic and development policy

An economic policy with an appropriate regional “sensitivity” should not only shape the macroeconomic conditions, but also find differentiated solutions tailored to the needs of the regions on various development paths. The types of regions presented in the analysis require different economic policies. The economic growth of the — 377 —

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capital and its surrounding region is slow mainly because its companies are primarily present on the domestic market, owing, in part, to the developments in concentration. However, due to the decreasing or stagnant corporate and household demand in rural areas these companies cannot generate substantial growth. Few companies can take part in the international competition and expand, although the conditions for traded business services are in place. It should be noted that in the capital city region deindustrialisation developments can be observed, and manufacturing is on the back foot, since the number of employees in manufacturing is falling. In the FDI-driven regions, the dependence of the one-sided, one-legged economy poses a risk, and the main problem is that the “radiant effect” is weak, i.e. only few local companies can form ties with multinational corporations, and there are few local suppliers. Finally, in the other regions there are hardly any industries that reach the level and economies of scale necessary for global competition. In rural regions, the aforementioned local economic development requires an alternative economic policy. Economic development funds reached disadvantaged regions less, and in public developments, which dominated the economic framework, the previously forced tendering system generated unnecessary competition among local actors, thereby hampering regional coordination and synergies. The regional efficiency of development policy can be increased substantially if regional developments are coordinated and territory-based development programmes are implemented. According to international empirical results, in the globalising world the regional level plays a decisive role in economic growth. In Hungary, the role as well as the economic and development policy competence of the counties is unclear, and smaller local governments can only provide a limited economic stimulus due to their size and the size of their settlements. Larger cities have the best potential for local stimulation of the economy, but one of the problems of the fragmented Hungarian system of local governments is that there is no well-defined authority that presides over the governance and economic management at the level of regions and urban regions. — 378 —

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Krugman, P. (2003): Földrajz és kereskedelem (Geography and Trade), Tankönyvkiadó, Budapest. Hungarian Central Statistical Office (2010): Statisztikai Tükör (Statistical Mirror) 2010 Vol. IV, Issue 115. Hungarian Central Statistical Office (2015a): A gazdasági folyamatok regionális különbségei (The regional differences of economic developments), 2013. Hungarian Central Statistical Office (2015b): Megyék, régiók statisztikai zsebkönyve (Statistical pocket guide to counties and regions), 2014. Lengyel, I. (2010a): stratégiák (Regional economic development. Competitiveness, clusters and bottom-up strategies), Akadémiai Kiadó, Budapest. Lengyel I. (2010b): A regionális tudomány „térnyerése”: Reális esélyek avagy csalfa délibábok? (Regional studies “gaining ground”: Real chances or delusive mirages?) Tér és Társadalom, 3, pp. 11–40. Lengyel I. – Rechnitzer J. (2004): Regionális gazdaságtan (Regional economics), Dialóg Campus, Budapest–Pécs. Lengyel I. – Szakálné Kanó I. (2012): Competitiveness of Hungarian Urban Micro-regions: Localization Agglomeration Economies and Regional Competitiveness Function Regional Statistics, Vol. 52., special issue 2., pp. 27–44.

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Part I: International and national experiences in economic convergence Lengyel I. (2013): A gazdasági növekedés térbeli korlátai (The spatial limits of economic growth), 51. Itinerary Congress of Economists. Malecki, E. J. (2004): Jockeying for position: What it Means and Why it Matters to Regional Development Policy When Places Compete, Regional Studies, 9. pp. 1101–1120. Matolcsy Gy. – Csizmadia N. – Csordás L. (2007): A magyar gazdaság térszerkezeti változásai (The changes to the Hungarian economy’s spatial structure), Polgári Szemle, November, Volume 3, Issue 11. http://www.polgariszemle.hu/index.php?view=v_article&ID=232&page=0 McCann, P. – Van Oort, F. (2009): Theories of agglomeration and regional economic growth: a historical review, In: Capello, R. – Nijkamp, P. (eds) Handbook of regional growth and development theories, Edward Elgar, Cheltenham, pp. 19–32. Nemes Nagy J. (2009): Terek, helyek, régiók – A regionális tudomány alapjai (Spaces, Places, Regions – The Basics in Regional Studies), Akadémiai Kiadó, Budapest pp. 356. Péti M. (2014): Partnerségi Megállapodása 2014–20 (Another step in the renewal of regional and economic development: Hungary’s Partnership Agreement 2014–2020), Falu Város Régió 2014/2. Pike, A. – Rodrígues-Pose, A. – Tomaney, J. (2006): Local and regional development, Routledge, London – New York. Polenske, L. R. (2004): Competition, Collaboration and Cooperation: An Uneasy Triangle in Networks of Firms and Regions, Regional Studies, 9. Porter, M. E. (1990): The Competitive Advantage of Nations, The Free Press, New York. Porter, M. E (2008): Regional Competitiveness in a Global Economy. The Summit for American Prosperity, The Brookings Institution, Washington, 11 June Salamin G. – Kígyóssy G. – Borbély M. – Tafferner B. – Szabó B. – Tipold F. – Péti M. (2014): Az Országos Fejlesztési és Területfejlesztési Koncepció és a 2005-ös országos területfejlesztési koncepció Plan and from the implementation of the 2005 National Regional Development Plan). Falu Város Régió 2. Salamin G. (2013): Tervezési felkészülés a 2014–2020-as kohéziós politikai ciklusra (Planning preparation for the 2014–2020 cohesion policy cycle), 51. Presentation at the Itinerary Congress of Economists. http://www.mkt.hu/vandorgyules/2013/Salamin_Geza.pdf Territorial Perspectives – Towards priorities of the Territorial Agenda In: The Territorial State and Perspectives of the European Union 2011. update – Hungarian Presidency 2011. 1/2014. Parliamentary Decision I. 3. on the National Development 2030 – National Development and Regional Development Plan. http://www.complex.hu/kzldat/o14h0001.htm/o14h0001.htm UN, Department of Economic and Social Affairs (DESA) (2014) World Urbanization Prospects, the 2014 Revision, Final Report http://esa.un.org/unpd/wup/FinalReport/WUP2014-Report.pdf Vas Zs. – Lengyel I. – Szakálné Kanó I. (2015): feldolgozóipar a magyar városrégiókban (Regional clusters and agglomeration advantages: manufacturing in Hungarian urban regions). Tér és Társadalom, 3, pp. 49–72. Zaucha, J. – Salamin G. (2011): The revised Territorial Agenda of the European Union, ECOREGION PERSPECTIVES 2. pp. 16–18.

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Hungary’s position in terms of the determinants of growth potential – demographics and the labour market73

In the pre-crisis years, one of the most serious structural issues facing the Hungarian economy was low labour market activity and employment, which restrained the economy’s growth potential. As a result of the reforms introduced since the crisis, the activity rate has increased significantly, but it still remains low by international standards. Looking ahead, demographic processes and the educational attainment of the Hungarian labour force are central to economic growth. Human capital affects economic growth via two channels: the size of the available labour force and the education level of employees. Based on population forecasts, the size of the working-age population is expected to decline due to population ageing in the coming decades. The role of the labour force’s qualitative attributes may gain importance, as a better qualified labour force may contribute to economic growth through better productivity. In addition, a further increase in labour market participation of groups that are currently characterised by lower participation rates may also reduce the long-term growth impacts arising from demographic processes. The purpose of this chapter is to introduce the demographic processes and education level shaping growth potential, and to identify the groups exhibiting low labour market activity. Based on population projections, in the coming decades population ageing may continue in Hungary as well, in line with the global trends. As regards the labour market, the most important demographic change may be the significant 73

Source: Based on Chapter 2, Quantitative and qualitative conditions of the labour market, Growth Report, December 2015.

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drop in the working-age population. Demographic changes may exert the most significant labour market impact in the 2020s and the 2040s, as the number of working-age population may decrease to the largest extent in these decades compared to average of the preceding decades. Within several decades, the decline in the working-age population may represent an increasingly strong growth challenge. The qualitative features of the labour supply can best be captured by the education level of employees. Highly educated employees usually have more favourable labour market opportunities, their participation and employment rate is higher, and this group is also characterised by higher average wages and better health status compared to the group of less skilled employees. Since the millennium, the ratio of persons with a university or college degree has risen significantly in Hungary. The ratio essentially corresponds to the average value of the Visegrád Group, but lags behind the EU average and the average for more developed countries. However, there are significant differences between the regions of Hungary in terms of the education level. The ratio of persons with university or college degrees in technical or natural sciences is lower in Hungary than in the countries of Visegrád Group. In the coming decades, as a result of technological progress, labour demand for those with a degree in technical and natural sciences may further increase. In addition to the ratio of persons with a university or college degree, the number of those finishing vocational school in the secondary school system also shows a shortfall compared to other European countries. Based on the results of international surveys, the average test results of Hungarian students lagged behind the OECD average in the past period, implying that the quality of public education should be further improved. The quality of secondary education is characterised by a dichotomy in Hungary. Finally, in addition to the knowledge acquired in education, the health condition of the population is also the part of human capital. In the past decades, life expectancy has gradually increased in Hungary, but it is still lower than the value corresponding to the country’s level of economic development.

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8. Hungary’s position in terms of the determinants of growth potential

In the upcoming period, improving the health condition of the Hungarian population could contribute to strengthening growth potential, as increasing life expectancy could extend the number of years spent on the labour market. In past years, the participation rate has increased the most in Hungary among the Visegrád Group, but by international standards it has been low for a long time. The increase in labour supply was a general process in Hungary. The shortfall in the participation rate can be linked primarily to a few, partially overlapping, social groups: individuals with low qualifications, young people, people over the age of 50 and women of childbearing age. Hungary’s lag in terms of its activity rate can also be explained by differences in education level as well as demographic composition. While demographic determinants can only be influenced over the long term, the activity of these groups with lower labour market participation can be increased through various employment policy tools over the shorter term. The employment rate in Hungary has continuously been increasing since the first quarter of 2010. The number of employees exceeds the pre-crisis level since the first half of 2013. At the same time, labour demand still falls short of the pre-crisis level in terms of the hours worked per employee.

8.1 Demographic developments in Hungary Demographic developments impact the economy’s growth potential through the available labour force. A shrinking population and the gradual population ageing has been observed in Hungary since the 1980s, caused by the fall of birth rate and the increase of life expectancy. Population ageing is a global phenomenon, affecting both developed and less developed countries. In the coming decades, similarly to European trends, population ageing may continue in Hungary at a rate exceeding the European Union average. The ratio of working age population within the total population may shrink as a consequence of the changes in population structure, and the size of labour force may decrease at a constant labour force participation rate and labour supply. — 383 —

Part I: International and national experiences in economic convergence

This chapter presents the demographic trends expected in Hungary in an international comparison, as well as their labour market impacts.

8.1.1 Demographic developments and expected demographic trends 8.1.1.1 International outlook

Population ageing is essentially a global trend, but its extent and pace may differ in different regions. The proportion of the elderly (over the age of 65) may double by the year 2050 across the world (Table 8-1). According to the World Bank’s forecast, the proportion of the elderly within the population can be the highest in high-income countries: in these countries, one out of four people will be over the age of 65 by 2050. The speed of ageing, identifiable by the change in the proportion of the elderly (UN 2013a) may be the most significant in medium-income countries. In these countries, the ratio of people over the age of 65 may increase from 7 per cent in 2015 to over 15 per cent by 2050. The ratio of the elderly within the population may increase at a faster rate in less developed regions compared to more developed ones, mainly owing to the higher birth rates in earlier decades. In Hungary, the extent of ageing is expected to exceed the estimated average value of the European Union. Population ageing can result in the increase of rate of the elderly and the young generations and therefore – all things being equal - the rise of burdens of the economically active population. The old-age dependency ratio may rise to the largest extent in medium-income countries, driven by the increase in the ratio of population aged 65 or older, but the indicator may nevertheless fall significantly short of the value in high-income countries in 2050 (Table 8-1). Among global regions, the old-age dependency ratio may be the highest in the European Union in 2050, rising from 29 per cent in the 2015 to 51 per cent by 2050. It means that while there are 29 elderly people per 100 persons of working age, in 2050 100 working-age people will have to support nearly twice as many, i.e. 51, elderly people. The old-age dependency ratio may approach 60 per cent by 2050 in — 384 —

8. Hungary’s position in terms of the determinants of growth potential

Table 8-1: The expected extent of ageing in certain country groups of the world Country/Country group1

Share of population ages 65 and above 2015

2050

Change

Old-age dependency ratio5 2015

2050

Change

World

8.2

15.5

+88%

12.5

24.5

+96%

High income countries

16.3

25.3

+56%

24.5

43.2

+76%

Middle income countries

6.7

15.2

+128%

10.0

23.7

+137%

Low income countries

3.4

5.6

+63%

6.3

8.9

+42%

European Union2

18.9

28.9

+53%

28.8

51.4

+78%

European Union3

18.9

28.1

+49%

28.8

49.4

+72%

Average of V4 countries

16.3

29.0

+81%

23.7

50.9

+119%

Czech Republic

18.1

30.2

+67%

27.0

54.6

+102%

Poland

15.5

31.4

+102%

22.3

55.8

+150%

Slovakia

13.8

28.6

+106%

19.5

49.5

+154%

Hungary2

17.6

26.0

+47%

26.1

43.8

+68%

Hungary

17.9

27.5

+54%

26.4

47.3

+79%

Hungary4

18.0

31.2

+74%

26.6

56.0

+110%

database, which categorises countries based on gross GDP per capita for 2014. 2. World Bank (2015). 3. Eurostat (2013). 4. KSH NKI. 5. Old-age dependency ratio is the ratio of population ages 65 and older to the working-age population (ages 15-64). Source: Eurostat (2013), HCSO HDRI (2015), World Bank (2015)

several Western European countries (World Bank 2015). Ageing and the rise in the old-age dependency ratio is driven mostly by a substantial fall in the fertility rate compared to earlier decades, and only to a smaller extent by rising life expectancy (Bussolo et al. 2015). The fall in the fertility rate stems from the shrinking proportion of younger generations within the population, which also dampens the population’s growth rate. By 2050, the old-age dependency ratio in Hungary may increase from the present level of 26 per cent to 44-56 per cent based on currently available population projections. The old-age dependency ratio in Hungary may be 8 percentage points lower in 2050 compared to the European Union average based on the World Bank (2015) forecast, and — 385 —

Part I: International and national experiences in economic convergence

2 percentage points lower according to the Eurostat (2013) projection. The baseline scenario of the latest population projection of the HCSO HDRI (2015) shows – under different assumptions – that the old-age dependency ratio may reach 56 per cent in Hungary by 2050, exceeding the estimated average value of 49-51 per cent in the countries of the European Union. In the Visegrád countries, the ratio of the population over the age of 65 and the old-age dependency ratio are both lower than the average value in the countries of the European Union, but in the coming decades population ageing may accelerate in these countries as well, by 2050 the value of the two indicators in the Visegrád countries may equal to that of the European Union. Among the Visegrád countries, the degree of demographic changes may be the most subdued in Hungary according to the World Bank’s forecast. Based on the population projection of the HCSO HDRI (2015), the extent of ageing may be higher in Hungary, but on the whole it can equal the estimated value for Poland. Box 8-1: Dependency indicators

Demographic dependency ratios are most often used to investigate the impact of changes in age structure. The old-age dependency ratio shows the number of individuals aged 65 or over compared to the number of individuals of working-age (15-64 years) population (EC 2012). A rise in the indicator signals that supporting the elderly means an increasing burden for the working age population. The total dependency ratio reflects the number of elderly and children relative to the number of individuals of working age. Demographic dependency indicators with modified content also appear in the literature for investigating the growth and social impacts of ageing, which take into account the labour market participation of various age groups.

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8. Hungary’s position in terms of the determinants of growth potential

• The total economic dependency ratio is calculated as the ratio between the total inactive population and employed persons aged 15 to 64, revealing the number of dependents supported by each employed person. It differs from the total dependency ratio by comparing the number of dependents to the number of actually employed persons rather than to the working age population and is therefore more relevant in terms of per capita economic performance (EC 2012). The indicator can decrease despite unfavourable demographic developments, if the number of employed persons grows at a faster rate than the number of dependents. • The effective economic old-age dependency ratio is calculated as the ratio between the inactive elderly (65+) and the number of employed persons in the age group 15–64 (EC 2012). The dependency ratio can be decreased by raising the number of employed persons and the number of persons working in old age. • The real elderly dependency ratio compares the number of the elderly with a life expectancy of no more than 15 years to the working-age population (Spijker and MacInnes 2013). The indicator – similarly to the previous one – factors in that not every person of working age is employed (due to education or unemployment), and that an increasing number of elderly people will work longer as life expectancy rises. • The so-called cognition-adjusted dependency ratio shows the ratio of persons aged 15 and 49, and those above 50 with good cognitive capacities relative to persons over the age of 50 whose cognitive capacities fall short of the average. Skirbekk et al. (2012) find that the ranking created based on the indicator shows a different picture on the impact of ageing, with better results for Northern Europe and the US compared to China and India based on the cognition-adjusted dependency ratio, can be primarly in connection with the educational attainment.

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Part I: International and national experiences in economic convergence

8.1.1.2 Demographic developments in Hungary

In Hungary, the size of the population has been decreasing and the population has been gradually ageing since 1980, which is mainly caused by the declining birth rate compared to the previous decades. In 1981, Hungary’s population was 10.7 million, which had shrunk to 10.4 million by 1990 and declined by a further 360,000 individuals between 1990 and 2010 (Chart 8-1). Chart 8-1: Distribution of the Hungarian population by age groups (1960–2060) 12

Million person

Per cent

2060

2055

2050

2045

2040

2035

2030

2025

2020

2015

0 2010

0 2005

2000

1995

1990

1985

1980

1975

1970

1965

1960

Population ages 65 and older Population ages 15–64 Population ages 0–14 Share of population ages 65 and above within the population (right-hand scale) Note: Data between 1960 and 2010 come from the database of Eurostat, values between 2011 and 2060 show the results of the population projection of HCSO HDRI (2015). Source: Eurostat, HCSO HDRI (2015)

As a result of the gradual increase in life expectancy, the annual number of deaths decreased, but the number of births fell at an even faster pace in the past two decades. The number of annual births fell by approximately 30,000 per year from 127,000 in 1991, and then stagnated at around 95,000–100,000 between the turn of the millennium and the economic crisis, before falling further to 90,000 over the two — 388 —

8. Hungary’s position in terms of the determinants of growth potential

years after the crisis, between 2008 and 2010. The number of births is unable to offset the population decline attributable to mortality, and thus the natural population decline in Hungary has averaged 38,000 individuals per year in recent years (Chart 8-2). According to Eurostat data, the impact of this was partially offset by the positive balance of net migration, but even taking this into account the annual extent of population decline in Hungary is still significant. Chart 8-2: Decomposition of the change of the Hungarian population (1990–2014) 150,000

150,000

100,000

50,000

0 –50,000

–100,000

–150,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

–50,000

Net migration plus statistical adjustment Live births Deaths Total population change Natural change of population Source: Eurostat

Hungary’s total fertility rate is also low by European standards. The total fertility rate74 was still 1.87 in Hungary in 1990, but had dropped to 1.32 by the turn of the millennium. Since then, the rate has fluctuated between 1.23 and 1.35. The fertility rate has exhibited a rising tendency in recent years, and could have reached 1.41 by 2014 according to preliminary data. This may have been driven by a gradual decrease in 74

The total fertility rate is the “average number of children born alive that would be born to each woman during her lifetime if the prevailing age-specific fertility rates applied during her child-bearing years” (HCSO 2014).

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Part I: International and national experiences in economic convergence

the number of women of childbearing age (Kapitány and Spéder 2015). Despite the upward trend, the total fertility rate still falls far short of the 2.1 figure necessary for long-term reproduction, capable of ensuring the maintenance of the number of the population, and is one of the lowest figures in Europe (Chart 8-3). According to 2013 data, Hungary ranked 22nd among the 28 member states. The fertility rate varies significantly within the European Union: it was around 2 in Ireland and France and 1.3-1.4 in the Visegrád Group and Southern Europe in the past years. Taken together, the European fertility rate is the lowest among the world’s regions (UN 2013b). Chart 8-3: Total fertility rate in the countries of the European Union (2000–2013) 2.0

1.9

1.8

1.7

1.6

1.5

1.4

1.3

1.2

Ireland France Sweden Finland United Kingdom Denmark Belgium Netherlands Luxembourg EU28 Estonia Croatia Cyprus Malta Romania Bulgaria Austria Lithuania Latvia Slovenia Portugal Italy Germany Greece Czech Republic Spain Poland Hungary Slovakia

2.0

Average (2000–2013) Source: Eurostat

Life expectancy has increased slightly in Hungary since the millennium, but the level and rate of increase is still low in a European comparison. Life expectancy at the age of 60 averaged 24 years in 2013 in the European Union, while Hungary’s figure (20 years) — 390 —

8. Hungary’s position in terms of the determinants of growth potential

is one of the lowest in the EU. Since the millennium the life expectancy of women and men at the age of 60 increased equally in Hungary, thus the difference in the life expectancy of the genders did not decrease. Life expectancy exhibits large differences according to education. In Hungary, life expectancy for men with primary education at the age of 30 was 36 years in 2012, while life expectancy was 9 years longer on average for those with secondary education, and 12 years longer for those holding a university or college degree. Life expectancy is much longer for women with primary education, exceeding the figure for men by 11 years, and the differences by education among women amount to only half of the differences observed among men (Chart 8-4). The differences in life expectancy based on education are more pronounced in Central and Eastern European countries, while in Western European countries being more developed there are only smaller differences. Chart 8-4: Difference between the life expectancy of persons with tertiary education and secondary education at age 30 (2012) Men

Women

Years

Years Czech Republic Estonia Bulgaria Hungary Poland Slovenia Romania Slovakia Croatia Finland Denmark Norway Portugal Sweden Italy

Source: Eurostat

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Part I: International and national experiences in economic convergence

The population ageing characterises the change in age structure. Compared to previous decades and older generations, the recent lower fertility rate results in smaller cohorts of younger age and decreases the future number of women in childbearing age. At the same time, members of older generations are expected to live longer due to rising life expectancy. The population ageing can be captured by using several indicators. For instance, by the increase of the proportion of people over the age of 60 or 6575 within the total population, the rise in the dependency ratio and the increase in the population’s median age.76 In order to assess the changes in age structure, the total dependency ratio (the ratio of the elderly and children relative to the number of individuals of working age) and the young dependency ratio (individuals aged 0–14 relative to the number of individuals of working age) are often examined along with the old-age dependency ratio. In Hungary, the number of minors (ages 0–14) and the workingage population of ages 15–64 both decrease, while the number of individuals over the age of 65 accounts for an increasingly larger share (Chart 8-1). The ratio of individuals over the age of 65 within the total population increased from 13.5 per cent in 1980 to 17.5 per cent in 2014. The latter data is falling slightly short of the 18.5 per cent ratio pertaining to European countries. Similarly, the old-age dependency ratio also exhibits a more positive picture compared to the EU average: since 1980, the ratio increased from 20.9 per cent to 25.8 per cent in 2014, compared to 28.1 per cent on average in the EU in 2014. The median age of the Hungarian population rose from 34 years observed in 1980 to 41 years in 2014, which falls somewhat short of the 42 year average of the EU (Eurostat 2015).

Given that in most European countries, including Hungary, pensionable age is increasingly approaching 65, our analysis looks at the group of population over the age of 65. 76 Median age is the age that divides the population into two groups of equal size. 75

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8. Hungary’s position in terms of the determinants of growth potential

8.1.1.3 Expected developments in demographic processes

The future developments in the size and age composition of the population will be shaped by changes in the fertility rate, life expectancy and the balance of net migration. Several projections are available for the Hungarian population that offer different estimates on the expected developments based on diverse assumptions. According to the projections on future developments in Hungary’s population, the shrinking of the population may continue in the decades to come and ageing may accelerate. According to certain projections, the population may dwindle to between 6.7 and 9.2 million by 2060 (Table 8-2). The baseline scenario of the HCSO HDRI (2015) and Table 8-2: Expected headcounts of the Hungarian population until 2060 according to different population projections Source

Population forecast type

KSH NKI (2015)

Eurostat (2013)

ENSZ (2015)

World Bank (2015)

2020

2040

2060

2060–2010

Baseline scenario

9.5

8.6

7.9

–2.1

Low scenario

9.5

8.1

6.7

–3.3

High scenario

9.6

8.9

8.7

–1.3

Baseline scenario

9.8

9.5

9.2

–0.8

No migration scenario

9.7

8.8

7.9

–2.1

Higher life expectancy scenario

9.8

9.6

9.4

–0.6

Baseline scenario

9.7

8.8

7.9

–2.1

Low scenario

9.6

8.2

6.7

–3.3

High scenario

9.8

9.4

9.2

–0.8

Baseline scenario

9.7

9.1

–

Note: In case of KSH NKI (2015) the baseline scenario corresponds to the realistic future expected at the time of projection, while the low and high scenario appoint the lower and upper bound of the future population headcounts (Földházi 2015). The projection of Eurostat (2013) and UN (2015), introduces further alternative paths besides the scenarios presented above. The projection horizon of World Bank (2015) goes on until 2050. Source: Eurostat (2013), HCSO HDRI (2015), UN (2015), World Bank (2015)

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Part I: International and national experiences in economic convergence

the UN (2015) projections also forecast a population of 7.9 million in 2060, which corresponds to a population decline of 2 million individuals between 2010 and 2060. The baseline scenario in Eurostat’s 2013 population projection shows a higher population size of 9.2 million, primarily due to divergent assumptions on migration. In the following, assumptions of the HCSO HDRI (2015) and the Eurostat (2013) baseline scenarios are presented. Population forecasts assume a rise in the fertility rate (Table 8-3). Based on the HCSO HDRI’s (2015) hypothesis, the fertility rate will reach the roughly 1.6 European Union average and stabilise at this level until 2060. The Eurostat (2013) projection assumes a gradual convergence in the fertility rate, which may reach 1.74 by 2060. In the period ahead, the recent government measures may increase the willingness to have children. Future developments in the fertility rate may be strongly influenced, along with the willingness to have children, by the number of women of childbearing age. As we can expect a significant decrease in this group in the decades to come, the number of births is expected to gradually decline in spite of the rising fertility rate, resulting in a significant contraction of the population by 2060. The 90,000 births Table 8-3: Hypotheses of the Hungarian population projection Source KSH NKI (2015)

Indicator

2013 data

2030

2060

Fertility rate

1.34

1.60

Life expectancy at birth (years), men

72.0

76.7

84.8

Life expectancy at birth (years), women

78.7

82.4

88.7

Net migration Eurostat (2013)

-7 340

-5 960

7 500

Fertility rate

1.38

1.61

1.74

Life expectancy at birth (years), men

71.9

75.9

82.0

Life expectancy at birth (years), women

78.8

85.4

87.0

Net migration

8 100

20 900

14 000

Note: 1. Estimation for 2012. Source: Eurostat (2013), HCSO HDRI (2015)

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8. Hungary’s position in terms of the determinants of growth potential

in 2013 may dip to around 85,000 by 2060 – in conjunction with rising fertility – according to the Eurostat (2013) baseline scenario and to 63,000 according to the HCSO HDRI’s (2015) baseline scenario. By and large, the fertility rate defines the current population size on the one hand, and on the other hand, it presents a constraint on future population size through the number of women of childbearing age. In addition, certain forecasts also assume a gradual rise in life expectancy, but there are significant discrepancies in the case of migration hypotheses. Looking ahead, HCSO HDRI (2015) takes into consideration that according to certain estimation outcomes the balance of international migration has become negative in Hungary in recent years: the current number of migrants exiting the country exceeded the number of immigrants by 7,000 each year between 2010 and 2012 (Bleha et al. 2014). At the same time, migrant workers continue to maintain close ties to the Hungarian economy: the earned income of Hungarian residents working abroad within the balance of payments has remained steadily high over the past years, accounting for 3 per cent of GDP. The HCSO HDRI’s (2015) baseline scenario assumes that the number of immigrants will start rising slowly due to the Hungarian economy’s growing labour demand, parallel to which the rate of migration will slow and level out at a subdued level from the 2030s. The balance of net migration may therefore become positive from the 2030s and level out at an annual 7,500 individuals from the end of 2040s (Földházi 2015). By contrast, the Eurostat (2013) projection assumes a balance of net migration of 20,000–24,000 individuals per year between 2015 and 2045, falling to an annual 15,000 individuals after 2045. As a result of the above assumptions, ageing may accelerate in the decades to come according to the population projections, and the rate in Hungary may exceed the European Union average. The ratio of persons aged over 65 within the total population could rise to close to 30 per cent by 2060 in Hungary, up from 18 per cent in 2015 according to the Eurostat (2013) population projection, and to 33 per cent according to the HCSO HDRI’s (2015) baseline projection scenario. — 395 —

Part I: International and national experiences in economic convergence

In the European Union, the ratio of the population over the age of 65 may rise from 19 per cent in 2015 to 28.4 per cent in 2060, thus the increase in the proportion of older generations may be smaller in the EU compared to Hungary (Chart 8-5). Chart 8-5: Ratio of 65 years and older in the countries of the European Union in 2015 and in 2060 40

Per cent

40 35

Ireland Luxembourg Belgium Sweden Denmark France United Kingdom Lithuania Finland Cyprus Netherlands Czech Republic Latvia EU28 Malta Austria Romania Hungary* Croatia Slovenia Estonia Italy Spain Bulgaria Germany Poland Hungary** Greece Portugal Slovakia

2015

2060

Note: *Eurostat (2013), **HCSO HDRI (2015). Source: Eurostat (2013):

Hungary’s old-age dependency ratio may double compared to its current level by 2060, and as a consequence of ageing, the burden on persons of economically active age will increase in the decades to come. The ratio may rise to 52 per cent from 26 per cent in 2015 according to Eurostat (2013), or to 61 per cent according to the HCSO HDRI (2015) by 2060, surpassing the European average (of 50.2 per cent). While in 2015, there were 26 older individuals among every — 396 —

8. Hungary’s position in terms of the determinants of growth potential

100 persons of working age, by 2060 there will be more than twice as many, i.e. 52–61 older persons to be supported. The total dependency ratio may increase at a lower rate, as the decline in the number of children may offset the rise in the ratio of elderly. The total dependency ratio may rise to 85 per cent by 2060, which means that the number of individuals younger and older than working age will approach size of the working-age population, amounting up to 85 per cent of it. The young dependency ratio may rise only slightly, from 21 to 24 per cent between 2015 and 2060. Despite the shrinking proportion of children, the young dependency ratio may nevertheless rise, as the workingage population may shrink even faster than the number of children according to the HCSO HDRI’s (2015) population projection.

8.1.2 Labour market impacts of demographic changes

From the labour market perspective, the most significant demographic change may be the expected decline in the working age population. This is relevant because the labour available for production may shrink significantly in Hungary. The size of the working-age population, i.e. individuals aged 15–64 may fall from 6.6 million in 2015 to 4.3 million by 2060 in Hungary, representing a decrease of 2.3 million.77 In 2060, the potentially available labour supply will be one third smaller than the current volume. The ratio of persons of working age within the total population may also decline substantially, from 68 per cent in 2015 to 54 per cent by 2060. The impact may be less pronounced within the European Union as a whole, where the proportion of persons of working age may shrink by 11 per cent by 2060 compared to 2015, as opposed to the 35 per cent decline in Hungary. The ratio of individuals of working age within the total population in EU Member States may decrease at a slower rate, from 66 per cent in 2015 to 57 per cent by 2060. According to certain projections, the working-age population may fall to between 4.2 and 5.1 million by 2060 (Table 8-6). 77

CSO HDRI (2015), baseline scenario

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Part I: International and national experiences in economic convergence

Chart 8-6: Expected development of the headcounts of working age population between 2015 and 2060 in Hungary according to different population projections 7.0

Million people

7.0

4.0

Eurostat

World Bank

2060

4.5

2055

4.5

2050

5.0

2045

5.0

2040

5.5

2035

5.5

2030

6.0

2025

6.0

2020

6.5

2015

6.5

HCSO HDRI

Note: The graph shows the baseline scenarios of the population projections. The projection horizon of World Bank (2015) goes on until 2050. Source: Eurostat (2013), HCSO HDRI (2015), World Bank (2015), UN (2015)

Looking ahead, demographic processes present an increasingly significant labour supply challenge. The working-age population was still rising at a rate of 5 per cent in the 1970s compared to its average size in the 1960s, essentially followed by stagnation in the subsequent decades until the beginning of 2010s. According to the HCSO HDRI’s (2015) population projection baseline scenario, the size of the workingage population may shrink by 4.5 per cent in the 2010s compared to the average of the last decade. Demographic changes may exert the most significant labour market impact in the 2020s and the 2040s, with each of these periods undergoing an 11 per cent decline in the working-

— 398 —

8. Hungary’s position in terms of the determinants of growth potential

age population relative to the average of the preceding decades (Table 8-4). The Ratkó generations, far larger than the newer generations entering working-age, may contribute to this, as they will reach the age of 65 during these decades. The Eurostat (2013) projection presages similar trends, outlining a somewhat smaller, 25 per cent decline in the working-age population between 2010 and 2060, compared to the 38 per cent contraction projected by the HCSO HDRI’s (2015) baseline scenario. The ratio of working age individuals within the total population could shrink by a smaller extent than the size of the working-age population. This is because looking forward, the size of the population will also contract, but at a slower rate than the size of the labour force, mainly due to the growing population over the age of 65. The ratio of working age individuals / working age population within the total population was roughly stable between 1960 and 2010, ranging between 66 per cent and 69 per cent. The ratio may fall to 61 per cent by 2030 and 55 per cent by 2050, i.e. to approximately half the size of the total population by the end of the 2050s (Table 8-5).

Eurostat (2013)

HCSO HDRI (2015)

Table 8-4: Expected development of the headcount of the working age population (2010–2059) 2010– 2019

2020– 2029

2030– 2039

2040– 2049

2050– 2059

2010– 2060

Average headcount of working age population (million persons)

6.6

5.9

5.4

4.8

4.4

–2.6

Change in the headcount (%)

–4.5

–11.1

–8.0

–10.8

–8.0

–37.8

Average headcount of working age population (million persons)

6.7

6.3

6.0

5.6

5.3

–1.7

–3.5%

–6.2%

–3.7%

–7.1%

–5.4%

–25.1%

Change in the headcount (%)

Note: The group of working age population contains ages 15-64.. Source: Eurostat (2013), HCSO HDRI (2015)

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Part I: International and national experiences in economic convergence

Eurostat (2013)

HCSO HDRI (2015)

Table 8-5: Expected development of the share of working age population (2010–2059)

Share of working age population (%) Change (percentage point) Share of working age population (%) Change (percentage point)

2010– 2019

2020– 2029

2030– 2039

2040– 2049

2050– 2059

2010– 2060

–15

–1.6

–6.4

–3.0

–6.5

–4.1

–21.2

–12

–1.3

–4.9

–2.3

–5.5

–3.6

–18.2

Note: The group of working age population contains ages 15-64. Source: Eurostat (2013), HCSO HDRI (2015)

Changes in the size and age composition of the population may impact the key macroeconomic indicators through various channels, and thus have an effect on economic performance as well. Demographic change exerts an impact on both the demand and supply side: the supply side influences economic performance through the labour market, capital accumulation and productivity channels, while the demand side makes an impact through consumption and savings, and the fiscal channel (Hudák Kreiszné et al. 2015). The accelerating rate of decline in the working age population presages a slowdown in growth in the long run – ceteris paribus (unchanged labour force participation rate, technological progress and capital accumulation). Looking at the impact of labour market developments on growth based on the production function, assuming a Cobb–Douglas production function and the customary two-thirds labour ratio, it is evident that demographic processes made a positive growth contribution between 1980 and 1999, while a nearly 0.5-percentage point slowdown in growth can be identified after 2000 due to the falling number of persons of working age. The per capita slowdown in growth may be even higher (0.6-0.7 percentage points) due to the continuous rise in the participation rate. As the grandchildren of the Ratkó generation become economically inactive, the slowdown in growth in the 2040s could be — 400 —

8. Hungary’s position in terms of the determinants of growth potential

even larger than the European Union average (Chart 8-7). The impact of ageing on economic growth can also be defined using a number of different methods. Based on the estimation outcomes, per capita growth compared to the average of the 2000s may shrink by up to two percentage points in the 2050s, owing to demographic developments.78 Chart 8-7: Growth impact of the change in the working-age population compared to 2000–2009 (based on production function) 3

Per cent

–3

EU28 range

Hungary

2050– 2059

–2

2040– 2049

–2

2030– 2039

–1

2020– 2029

–1

2010– 2019

2000– 2009

1990– 1999

1980– 1989

1970– 1979

1960– 1969

EU28 average

Source: Kreiszné Hudák et al. (2015)

At the same time, the impacts of ageing on the labour market and growth may be shaped significantly by economic policy measures and the adjustment of economic agents. If rising life expectancy results in a higher number of years spent in good health, workers may remain active for longer compared to earlier generations. In the majority of European Union countries, including Hungary, parallel to a rise in life expectancy at the age of 55 since the turn of the millennium, the participation rate of workers aged between 55 and 64 has also increased. The participation rate of older age groups rose in Hungary from an 78

The detailed calculation results can be found in the Kreiszné Hudák et al. (2015) paper.

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Part I: International and national experiences in economic convergence

overall low level by European standards, by approximately 20 per cent between 2000 and 2013. The average retirement age in terms of old-age pension rose to 60 years in 2013 from 58 years in 2008 (ONYF 2013). Similarly, a rise in the effective retirement age among both men and women can also be observed in other Visegrád countries (Chart 8-8). Measures affecting the pension system and the market have also contributed to longer active career paths, along with adjustment impacts. Certain economies may respond to labour shortages stemming from ageing by progressively increasing their capital/labour ratio: corporations may invest in assets that boost labour productivity. Chart 8-8: Average effective retirement age in Visegrád countries (2000–2012) Years

64 63

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Czech Republic

Poland

Years

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Slovakia

Hungary

Note: The left-hand side panel shows the average retirement age of men, the right-hand side panel shows the average retirement age of women. The average effective retirement age shows the weighted average of retirement from labour market at different ages for 5-year periods. Source: OECD (2015a)

According to the economic dependency ratios that take into account labour market participation, the burden on the economically active population exceeds the degree expected based on demographic dependency ratios. The difference between the two ratios is explained in — 402 —

8. Hungary’s position in terms of the determinants of growth potential

large part by Hungary’s internationally low participation rate. On the one hand, economic support ratios factor in that members of older generations may work beyond the age of 65, and also the working age population that are present on the labour market. The old-age economic support ratio was 43 per cent in Hungary in 2015 (EC 2014), which substantially exceeds the old-age dependency ratio. On this basis, there were 43 inactive older individuals for each 100 employed persons of working age in 2015, and this ratio may rise to 74 per cent by 2060. An even greater discrepancy can be observed between the total dependency ratio and the total economic dependency ratio: the total dependency ratio was 48 per cent while the economic support ratio was 141 per cent in 2015, and may rise to 155 per cent by 2060 (EC 2014). The latter means that currently 100 employed persons support 141 inactive individuals and may have to support 155 inactive individuals in 2060 (Chart 8-9). However, the increase of economic dependency ratios can be significantly smaller than the extent shown by demographic dependency ratios. It implies that the economic burdens falling on active population may increase only slightly compared to the present level. Chart 8-9: Dependency ratios in Hungary 180

Per cent

Per cent Demographic dependency ratio

160

Modified dependency ratio

180 160

140

120

100

Old-age dependency ratio

Total dependency ratio

Effective Total economic economic old-age dependency dependency ratio ratio

2015 Source: EC (2014a)

— 403 —

2060

Part I: International and national experiences in economic convergence

The long-term unfavourable impacts of demographic processes may be mitigated in the long run by an increase in the level and quality of education. Due to the shrinking labour force in the upcoming decades, the role of the labour force’s education level may gain importance, as better qualified labour may contribute to economic growth through better productivity. The ratio of degree-holders falls short of the European Union average and the ratios prevailing in more advanced economies. Better qualified workers generally have better labour market opportunities, higher participation and employment rates, higher average incomes and higher life expectancy compared to their less qualified peers. The ratio of workers with secondary vocational qualifications is also lower in Hungary compared to other European Union countries. Improving the quality of education may help individuals find work suited to their qualifications. This chapter presents the benefits that can be derived from improving the level of education, provides an overview of the qualification of the Hungarian labour force, and presents the qualitative indicators of education and education expenditures.

Human capital is one of the fundamental determinants of longterm growth potential. There is a positive correlation between human capital79 and GDP per capita: first, countries with higher human capital stocks are able to achieve stronger economic growth, and second, more developed countries are able to allocate more resources to expanding human capital. Education – along with knowledge and experience gained in the context of work – may contribute significantly to increasing 79

The literature offers numerous definitions of human capital, for instance according to the OECD’s definition, “human capital is the knowledge, competencies and other economically relevant attributes embodied in the working-age population” (OECD 1998, p. 24). Other definitions pertain to the total population rather than the working age population, for instance the WEF (2015) defines human capital as the skills and capabilities that are used in a productive manner.

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8. Hungary’s position in terms of the determinants of growth potential

the volume of human capital. Education impacts economic growth through three channels: it improves labour force productivity and also enhances the economy’s innovative performance. Third, education facilitates the acquisition of knowledge necessary for understanding and applying new technologies (Hanushek and Wössmann 2007). The qualitative features of labour supply can be best expressed by the qualification level of workers. In the past period, in those countries where the ratio of highly qualified employees increased to a larger extent, per capita GDP growth was also higher (Chart 8-10). A highly qualified labour force is more productive and contributes to technological innovation, as it is more capable of developing and adopting new technologies. Highly educated employees usually have more favourable labour market opportunities, their participation and employment rate is higher; this group is also characterised by higher average wages and better health status compared to the group of less skilled employees. In terms of economic growth, the quality of the education system is even more important than the qualification level. The former is most frequently measured by the cognitive capacities of students, quantified based on their results in international surveys. The effect of students’ capabilities on per capita real economic growth is significantly positive based on developing and developed country data for 1960–1990, and the impact of the number of years spent in school on growth becomes insignificant if the quality of education is factored in (Hanushek and Wössmann 2010). As a result, besides increasing participation in education, further improving the quality of education is essential, and may also improve the capabilities of students entering the labour market. Education level strongly influences labour market activity. When examining the education level, three groups are differentiated: the lowskilled, who have no secondary school education, those with secondary school education and those with a higher education degree. Among the three groups, the participation rate of degree-holders is the highest in both in the EU countries and in Hungary. The activity rate of those — 405 —

Part I: International and national experiences in economic convergence

with a higher education degree in Hungary was 83 per cent in 2014, which, however, is one of the lowest values in the European Union compared to those with similar qualifications. The largest difference is between the participation rate of individuals with low education and those with secondary education: while the participation rate of the population with higher education exceeds the participation rate of the population with secondary education by 12 per cent on average, the participation rate of the latter exceeds the participation rate of those with low education by 22 per cent in the European Union (Chart 8-11). That is, the difference observed in Hungary is even higher than the average EU values: the labour force participation rate of those with secondary school qualification is almost twice as high than the rate of the low-skilled. Therefore, in Hungary a vast part of the labour market reserve consists of the low-skilled. Chart 8-10: Change in the share of tertiary educated persons within the working-age population and GDP growth between 1994 and 2007

Change in the share of tertiary educated between 1994 and 2007 (percentage points)

18 KOR

16 SGP

ESP

12 FRA

GBR

CHE 8

AUT

CRI

POL

BEL

ITA

DEU BRA

2 0

BGR

HUN

6 4

IRL

GRC

CHL

DNK PRT

CZE

LUX

CAN 0

Change in GDP per capita GDP between 1994 and 2007 (per capita, PPP) Source: World Bank

â&#x20AC;&#x201D; 406 â&#x20AC;&#x201D;

100

120

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-11: Activity rate of population ages 15–64 by educational attainment (2014, per cent) 100

Per cent

100 90

Lithuania Poland Czech Republic Slovakia Croatia Hungary Bulgaria Ireland Estonia Slovenia Latvia Belgium Luxembourg Finland Romania France Italy Cyprus Germany EU28 Austria Greece Malta Sweden Denmark United Kingdom Netherlands Portugal Spain

Low-skilled

Secondary education

Tertiary education

Source: Eurostat

Labour market opportunities are much better for those with a higher education degree compared to the groups of the low-skilled. In Hungary, in the 15–34 age group the employment rate – within 5 years after obtaining the highest school degree – of those with higher education degree is four times as high as that of the low-skilled. Similarly, the participation rate of individuals holding the highest level of education is the most highest within the total population of working age. In the EU countries more than 80 per cent of those holding a higher education degree are employed, as opposed to the average employment rates of 68 per cent and 43 per cent of those with secondary school education and the low-skilled, respectively.

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Part I: International and national experiences in economic convergence

Education can be regarded as a sort of insurance against unemployment: during the economic crisis, unemployment among more highly educated groups rose from a much lower level and to a far smaller degree compared to individuals with low qualification (Chart 8-12). In Hungary, the unemployment rate among those with low qualifications rose by 6 percentage points from 18 per cent until 2009, before decreasing to 19 per cent by 2014. The unemployment rate among the highly educated rose from 3 to 3.2 per cent between 2007 and 2014. In the EU, the unemployment rate among individuals without secondary education rose on average from 11 to 19 per cent by 2014, but only increased among degree-holders from 4 to 6 per cent. The more favourable labour market opportunities of those with a higher education degree in part may be attributable to the fact that they can also take on jobs that require lower skills than they obtained. However, this is inefficient for the economy as over-qualified employees cannot utilise their capabilities in full, while those with lower qualification are crowded out from the labour market. Employment that is not aligned with qualification results in lower aggregate labour productivity due to inefficient resource allocation, as it is more difficult for productive firms to find adequate workforce (McGowan and Andrews 2015). In OECD countries, one out of three employed persons were overqualified on average in 2010, meaning that their level of education exceeded the qualification required by their job. Underqualification is far less common, affecting one out of six workers. In Hungary, 40 per cent of the respondent workers considered themselves overqualified for their job, while the ratio of underqualified workers was only 12.5 per cent in 2010 (OECD 2015b). Employment not corresponding to the education level may be attributable to several factors. First, education does not properly reflect individual capabilities: the capabilities of workers having the same education level are different, and education also fails to reflect work experience. Second, the knowledge obtained may grow obsolete in parallel with the time spent outside the labour market. Third, specialisation may also substantially determine employment opportunities, irrespective of education level â&#x20AC;&#x201D; 408 â&#x20AC;&#x201D;

35 30 25 20 15 10 5 0

25 Spain Lithuania Greece Bulgaria Croatia Latvia Czech Republic Ireland Cyprus Sweden Poland EU28 Hungary Finland France Italy Belgium Slovenia Portugal Estonia Netherlands Germany Austria United Kingdom Denmark Luxembourg Malta Romania Spain Lithuania Greece Bulgaria Croatia Latvia Czech Republic Ireland Cyprus Sweden Poland EU28 Hungary Finland France Italy Belgium Slovenia Portugal Estonia Netherlands Germany Austria United Kingdom Denmark Luxembourg Malta Romania

40 35 30 25 20 15 10 5 0

20 20

15 15

Spain Lithuania Greece Bulgaria Croatia Latvia Czech Republic Ireland Cyprus Sweden Poland EU28 Hungary Finland France Italy Belgium Slovenia Portugal Estonia Netherlands Germany Austria United Kingdom Denmark Luxembourg Malta Romania

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-12: Unemployment rate by educational attainment Per cent

Per cent

Low-skilled

Per cent

2007

Note: Data refer to age groups 15–64.

Source: Eurostat

— 409 —

Per cent

Secondary education

Tertiary education

2014

Per cent

40 35 30 25 20 15 10 5 0

35 30 25 20 15 10 5 0

Part I: International and national experiences in economic convergence

(Quintini 2011). However, the phenomenon does not necessarily mean that there is an oversupply of highly qualified individuals on the labour market, as the wage advantage of individuals with tertiary education has not decreased in recent years. The wage of employees with higher qualification typically exceeds the average wage of lower skilled employees, which may be also attributable to the higher productivity and the scarcity of the higher education graduate labour force. The relative wage advantage of degreeholders is generally higher in Central and Eastern European countries compared to the rest of the European Union. In Hungary, individuals with high levels of education earn twice as much on average, while individuals with secondary education earn 1.5 times more on average compared to individuals with low education. There is a negative correlation between the wage advantage of degree-holders compared to individuals with secondary education and the ratio of tertiary graduates within the total population: in countries where fewer people hold degrees, tertiary graduates have a larger wage advantage (Chart 8-13). In addition, the wage advantage of higher education degree may be further increased if the wage level that can be achieved with secondary school qualification is relatively low, and it may be also impacted by the employment opportunities observable by education level. The increase in ratio of those holding a college or university degree can result in higher economic growth both on the supply and on the demand side. Individuals with higher education typically exhibit higher labour market participation, and are also able to contribute more to research and development compared to the groups with lower qualification. Tertiary educated workers usually earn higher wages and consume more, and this impact appears on the demand side of the economy. Highly educated employees also pay higher social security contributions, as well as labour and consumption taxes, and utilise social transfers to a lesser degree. The relative benefits of obtaining tertiary education may decrease in the long run as the labour supply of highly qualified individuals increases. At the same time, international experience â&#x20AC;&#x201D; 410 â&#x20AC;&#x201D;

8. Hungary’s position in terms of the determinants of growth potential

shows that even as the ratio of degree-holders increases within younger age groups, the employment rate of tertiary graduates has not decreased.80 Chart 8-13: Share of tertiary graduates in the population and the relative wage gap (2012)

Wage gap between workers with tertiary education and secondary education (per cent), 2012

280 CHI 260 240 220

HUN

200

TRK CZE

180

SVK PRT

160

SLV POL DEU

AUS GR

140

FRA

OECD CHE NL

ESP

ITA

120 100

LUX UK

FIN EST SWE

DEN BEL

USA

IRL

ISR

KOR AUT NOR

JPN

CAN

NZ 40

Share of tertiary graduates among population aged 25–64 (per cent), 2012 Source: OECD

8.2.2 Education level of the Hungarian labour force in an international comparison

In Hungary, 23 per cent of the population aged 25–64 has tertiary education, 60 per cent has secondary education and 17 per cent has low education, i.e. does not have secondary education. A gradual rise in the 80

OECD (2013).

— 411 —

Part I: International and national experiences in economic convergence

population’s level of education can be observed: the ratio of individuals with no qualification has continuously decreased since the turn of the millennium, and is lower than the European Union average (Chart 8-14). Since 2000, the ratio of individuals with secondary education has decreased slightly in Hungary, while this group represents the highest proportion on the labour market supply side in a breakdown by level of education. The ratio of tertiary graduates has increased from 14 per cent to 23 per cent since the turn of the millennium in Hungary within the 25–64 age group. In the European Union, the ratio of degree-holders rose from an initially higher level, from 20 per cent to 30 per cent. In Hungary, the ratio of college and university degree holders practically equals the average of the Visegrád countries, but it lags behind the EU average and the ratio observed in the more developed countries (Chart 8-15). Based on this, the qualification level of the labour force may be further improved in Hungary, which may also support the increase of competitiveness. Chart 8-14: Distribution of population ages 25–64 by educational attainment in Hungary and in the countries of the European Union 100

Per cent

Per cent 17

90 31

100 90 80

60 60

50 45

40 30

20 10 0

14 Hungary, 2000

EU 27 countries, 2000

Hungary, 2000

Low skilled Tertiary education

EU 27 countries, 2014

Secondary education

Source: Eurostat

— 412 —

10 0

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-15: Share of tertiary graduates among population ages 25–64 in the countries of the European Union Per cent

Per cent

Romania Italy Malta Slovakia Czech Republic Portugal Hungary Bulgaria Poland Germany Greece Slovenia Latvia France Netherlands Spain Denmark Belgium Sweden Estonia Cyprus United Kingdom Ireland Finland Luxembourg

50 45 40 35 30 25 20 15 10 5 0

2000

2014

50 45 40 35 30 25 20 15 10 5 0

EU28 – 2014

Source: Eurostat

The increase in the ratio of the higher education graduates within the population is attributable to the higher average education level of new employees entering the labour market. Within the age group of 25–34 years, the ratio of higher education graduates has doubled since the millennium, and in 2013 it amounted to 32 per cent, which is still low in an international comparison. In OECD countries, more than 40 per cent of the population aged 25–34 holds a university or college degree, and this ratio is as high as 60–70 per cent in Japan and Korea. The ratio of degreeholders within the population aged 25–34 exceeds the average figure for the population of working age, and it is almost twice as high as the ratio observed in the age group of 55-64 years (Chart 8-16). In an international comparison, the largest difference can be seen in the age group 35-44 years. In terms of qualification level there are also significant differences across various regions in Hungary. In the Central Hungary region, the ratio of higher education graduates within the population aged 25–64 is 35 per cent, which is twice as high as in the economically underdeveloped regions. — 413 —

Part I: International and national experiences in economic convergence

Chart 8-16: Share of tertiary graduates in certain age groups (2014) 45

Per cent

25–34 years old

35–44 years old

Hungary

45–54 years old EU28

55–64 years old

25–64 years old

OECD countries*

Note: * Data for year 2012. Source: Eurostat, OECD

Looking at the distribution of degree-holders by discipline in Hungary, within the population aged 20–29 there are less than 10 new graduates holding a degree in technical or scientific domains for every 1,000 individuals. This proportion has been gradually increasing, growing from 4 per cent in 2001 to 9 per cent in 2011. In parallel with this, among college and university students, the ratio of students studying at technical and natural science faculties increased from 20 to 25 per cent (HCSO 2012). However, the ratio of new graduates entering the labour market remains low compared to both the EU and the region (Chart 8-17). In some countries such as the Czech Republic and Romania, the past decade has seen a substantial rise in holders of technical degrees. Labour demand for workers holding a degree in technical and natural science domains may increase in the wake of technological development in the upcoming period, which may necessitate an additional increase in this ratio.

— 414 —

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-17: Tertiary graduates in science and technology per 1 000 inhabitants aged 20–29 years 25

Cyprus Hungary Netherlands Malta Bulgaria Belgium Estonia Latvia Greece Sweden Austria Germany Czech Republic Spain EU27 Portugal Slovenia Poland Denmark Slovakia Romania United Kingdom Ireland Finland France Lithuania

2001

2011

Source: Eurostat

On the supply side of the labour market, the number of employees with secondary school education is the highest. In Hungary, they account for 60 per cent of the population aged 25–64. Similarly to Hungary, the ratio of individuals with secondary education within the total population is also high in the Czech Republic, Slovakia, Poland and Germany (Chart 8-18). In terms of geographic inequalities, the proportion of individuals with secondary education is higher than the national average in the Transdanubian region, and lower in the capital and its agglomeration. The rise in the ratio of individuals with secondary education since the turn of the millennium has been driven in part by the decline in early school leaving. This ratio reflects the proportion of 18–24 year olds who do not have secondary education and are not participating in education or training. In Hungary, the ratio of individuals who fail to complete their secondary studies has fallen from 14 per cent in 2000 to 11.4 per cent within the population aged 18–24. Nevertheless, this figure remains elevated by regional standards, as it — 415 —

Part I: International and national experiences in economic convergence

is twice as high as the average value in the Visegrád countries. Early school leaving without obtaining secondary qualification makes finding a job on the labour market and social convergence more difficult. Chart 8-18: Share of population with upper secondary educational attainment level in population ages 25–64 (2014) 80

Per cent

80 70

Luxembourg Belgium Cyprus Ireland United Kingdom Greece Netherlands Italy Denmark France Finland Sweden EU27 Estonia Bulgaria Lithuania Romania Slovenia Latvia Hungary Germany Poland Slovakia Czech Republic

2000

2014

Source: Eurostat

The quality of the labour supply is also influenced by the language skills of the employees, in addition to their qualification level. The Hungarian Statistics reflect a significant lag in the domain of language learning and language skills. Approximately 80 per cent of students enrolled in secondary education learn English while this ratio approaches 100 per cent in most European Union countries. Similarly, the ratio of students learning German was also lower than the Central and Eastern European average. The number of foreign languages spoken is also low: over 60 per cent of the population does not speak any foreign language, and only a quarter speaks one foreign language (Chart 8-19).

— 416 —

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-19: Number of languages spoken (2011) 100

Per cent

100 90

Ireland Hungary Bulgaria Spain Belgium Greece Portugal France Italy Poland EU28 Czech Republic Austria Germany Cyprus Slovakia Estonia Netherlands Malta Finland Sweden Slovenia Denmark Latvia Lithuania Luxembourg

3 or more

Note: Self-reported data, as a percentage. Source: Eurostat

In addition to the ratio of holders of a higher education degree, there is also a significant lag in the number of participants in vocational training in secondary education compared to other EU countries. This can limit economic growth as enterprises state the lack of skilled labour as the limit to increasing production in different surveys. For instance, the ManpowerGroup’s Talent Shortage Survey (ManpowerGroup 2015) reveals that since early 2010, Hungarian corporations have expressed that that vocational positions are the most difficult to fill in Hungary, which is attributable to the lack of skilled workers with vocational training.

— 417 —

Part I: International and national experiences in economic convergence

In Hungary, the ratio of those participating in vocational training in the secondary education system is low by European standards (Chart 8-20). While a quarter of secondary school students took part in vocational training in Hungary in 2013, this figure is 50 per cent of students on average in the EU. In countries where vocational training works successfully, the school system places greater emphasis on the development of general skills. Vocational education institutions generally teach more general knowledge in these countries and are better at developing competencies than in Hungary. They provide a much more convertible knowledge, with which students can better adapt to the labour market demands of the changing world. For example, students in vocational training in Germany begin to take part in vocational training after 7,155 or 7,950 general lessons, while in Hungary only 5,742 lessons are used to teach general skills (EC 2014). Chart 8-20: Structure of secondary education in the European Union

General secondary education

Croatia

Czech Republic

Austria

Finland

Slovakia

Netherlands

Slovenia

Belgium

Romania

Italy

Bulgaria

Poland

Germany

Sweden

Portugal

United Kingdom

Denmark

France

Per cent

Greece

Spain

Hungary

Per cent

Ireland

100 90 80 70 60 50 40 30 20 10 0

Vocational secundary education

Source: Eurostat

â&#x20AC;&#x201D; 418 â&#x20AC;&#x201D;

100 90 80 70 60 50 40 30 20 10 0

8. Hungaryâ&#x20AC;&#x2122;s position in terms of the determinants of growth potential

8.2.3 Quality of education

An often-used metric of the quality and applicability of the knowledge acquired in the public education system is the average score achieved on PISA tests, which is based on measuring student performance. The test looks at the knowledge and capabilities of 15-year-old students in the areas of mathematics, reading and science, and evaluates primarily the knowledge obtained in elementary school, and in secondary school to a smaller extent. The role of secondary education is particularly important because it represents the highest level of education for most workers prior to entering the labour market, and also lays the groundwork for entering the higher education system. According to the results of the latest 2012 PISA81 survey, Hungarian students performed worse in all three areas compared to the OECD average, and the average score decreased in all three disciplines compared to the 2009 survey. The largest lag affects the field of mathematics, with the 2012 Hungarian score falling 17 points short of the OECD average and 13 points short of the 2009 survey (Chart 8-21). A significant duality can be identified in terms of the average score, which highlights the segmentation of secondary education. In Hungary, the ratio of best-performing students was 9 per cent, compared to 13 per cent in OECD countries. The ratio of students who performed the worst in mathematics was high by international standards, at 28 per cent in 2012. Hungary ranked as the sixth poorest performer among the OECD countries. Twenty-three per cent of the difference in student performance in Hungary is explained by the social and economic status of parents, which significantly exceeds the 15 per cent average for OECD countries (OECD 2014). This suggests that family background plays a stronger role in student performance compared to other OECD countries, and students from disadvantaged backgrounds have trouble achieving higher scores.82 The most recent PISA study was conducted in 2015, but the results of this test are still not available. 82 OECD (2014). 81

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Chart 8-21: Results of PISA test in mathematics 560

540

520

500

480

460

440

420

400

Mexico Chile Bulgaria Romania Turkey Greece Israel Croatia Hungary Sweden Lithuania United States Slovakia Spain Italy Portugal Norway Luxembourg Latvia Iceland OECD average United Kingdom France Czech Republic New Zealand Denmark Slovenia Ireland Australia Germany Belgium Poland Canada Finland Estonia Netherlands Switzerland Japan Korea

560

2009

2012

Source: OECD

With the exception of Poland, PISA test scores deteriorated in the Visegrád Group between 2003 and 2012. Within the region, Hungary’s test results were the poorest in mathematics in the past period. Meanwhile, Poland’s average test scores improved by nearly 30 points since 2003 from the same initial level (Chart 8-22). In international comparison a smaller lag can be observed in the other disciplines: Hungarian students performed 6 points below the OECD average in reading and 7 points below the OECD average in science (OECD 2012). The average results in problem-solving were particularly weak in Hungary in 2012. Hungarian test scores fall significantly short of the OECD average as well as of other Visegrád countries. The ratio of lowperforming students was 35 per cent in Hungary, far outstripping the 21 per cent OECD average. Based on the results, Hungarian students reveal a significant lag in terms of problem-solving skills not directly — 420 —

8. Hungary’s position in terms of the determinants of growth potential

Chart 8-22: PISA test results in Visegrád countries between 2003 and 2012, mathematics 530

530

520

510

500

490

480

470

460

460 450

450 Hungary

Slovakia 2003

Czech Republic

2006

2009

Poland 2012

Source: OECD

linked to the curriculum. These poor problem-solving skills may render finding subsequent employment opportunities more difficult.

8.2.4 Education expenditures in Hungary

Spending on education as a percentage of GDP and average per capita spending measures the investment in human capital. The volume of education expenditures is shaped by several factors: the number of school-age students, which is fundamentally defined by demographic trends in primary and secondary education, the number of enrolled students, wage level of teachers and the financing structure of education, for instance the ratio of budgetary and private funding. Diverging institutional structures make it difficult to compare budgetary spending on education in various countries, as the proportion of institutions — 421 —

Part I: International and national experiences in economic convergence

outside the general government system may differ significantly from country to country. The efficiency and the level of spending on education also shape the quality of education. Education expenditures and the performance of the educational system are linked by a positive correlation: in countries where a larger portion of gross national income is channelled into primary and secondary education, students performed better on average on PISA tests (Chart 8-23). At the same time, Hungary only scored 10 per cent lower on average despite spending far less compared to the OECD average, which may reflect the relative efficiency of public education expenditures. Chart 8-23: Average PISA test scores and per capita spending on primary and secondary education

Average PISA test scores, 2012

600

550

KOR

LTV HUN

500 TRK

450

RUS

SVK

EST POL CZE ISR

JPN

FIN CAN NL DEU BEL NZ AUS UK IRL DNK FRA SLV USA PRT OECD SWE ESP

CHE AUT LUX

NOR

ITA ICL

CHI MEX

400

IND

COL

BRA ARG

Per capita spending on primary and secondary education, 2011 (equivalent USD, PPP) Source: OECD

â&#x20AC;&#x201D; 422 â&#x20AC;&#x201D;

20 000

18 000

16 000

14 000

12 000

10 000

8 000

6 000

4 000

2 000

350

8. Hungary’s position in terms of the determinants of growth potential

In Hungary, budgetary expenditures on education as a percentage of GDP fall somewhat short of the OECD average, but exceed the average of successfully converging countries over the past decades. These expenditures reached 4.4 per cent of GDP in 2011, compared to 5.3 per cent on average in OECD countries (Chart 8-24). Chart 8-24: Public spending on education in 2011 (as a percentage of GDP and as a percentage of budget expenditures) 8

Per cent

24 21

Japan Slovakia Italy Australia Czech Republic Germany Hungary Spain United States Poland Korea Mexikó Portugal Canada Estonia Switzerland Slovenia OECD average Netherlands Austria France United Kingdom Israel Ireland Sweden New Zealand Finland Belgium Iceland Norway Denmark

GDP-proportionate public expenditurer (left-hand scale) Public spending on education as a per cent of total budget expenditures (right-hand scale) Source: OECD (2015c)

Hungary spent 9.5 per cent of budgetary expenditures on education in 2011, one of the lowest figures among OECD countries. Hungary’s spending as a percentage of GDP is consistent with the Visegrád Group average, but spending as a percentage of public expenditures is 1.5 percentage points lower than the Visegrád Group average due to the higher redistribution rate. Compared to the average figure observed in countries achieving successful economic convergence in earlier decades (such as Korea or Ireland), Hungary has been allocating a larger share — 423 —

Part I: International and national experiences in economic convergence

of GDP to education since 1998 (Chart 8-25). At the same time, in these countries the proportion of private spending (especially in Korea) exceeded the Hungarian figure. The current level of spending, which is lower compared to more developed countries, suggests that there is room for increasing education expenditures as a percentage of GDP in Hungary. Chart 8-25: Public expenditure on education in converging countries and spending on education in Hungary 7

Percentage of GDP

Education expenditures in the examined countries Average Hungary Note: Converging countries includes Ireland, Finland, Korea, Slovakia and Poland. In case of Austria, 1975 for Finland and Korea, in case of Slovakia, Poland and Hungary 1995. Spending on education refers to public expenditures. Source: World Bank, World Development Indicators

According to the available data, budget spending on education has shown a decreasing trend in recent years in Hungary: it shrank by one percentage point until 2012 from the 5.8 per cent in 2005, while â&#x20AC;&#x201D; 424 â&#x20AC;&#x201D;

8. Hungary’s position in terms of the determinants of growth potential

the average figure of the EU27 essentially stagnated (Chart 8-26). The fiscal adjustments due to the economic crisis resulted in spending cuts in education in several European countries, including Hungary. The adjustments affected primary and secondary education to the greatest extent in Hungary: expenditures in real terms decreased by more than 20 per cent between 2005 and 2011 (OECD 2014). Meanwhile, public spending on higher education increased by 12 per cent. Demographic developments may partly justify the reduction in public spending: the number of school-age population decreased from 2.3 million by 180 thousand (by 8 per cent) between 2005 and 2011.83 Chart 8-26: Development of public spending on education (2005–2012) 6.5

Percentage of GDP

6.5

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2005

2006

2007

Poland V4 countries

2008

2009

Hungary Czech Republic

2010

2011

2012

3.0

EU27 Slovakia

Source: Eurostat, COFOG database

Source: HCSO (2015). The population of school age includes individuals aged 3–22.

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Part I: International and national experiences in economic convergence

The volume of education spending shows significant differences by level of education. In OECD countries, primary and secondary education account for two-thirds of education outlays, while this ratio is much lower in Hungary, only 58 per cent. There is also a significant lag in terms of expenditure as a percentage of GDP on primary and secondary institutions: the Hungarian figure falls one percentage point short of the 3.6 per cent OECD average (Chart 8-27). The Hungarian budget spends 1.1 per cent of GDP on higher education, a smaller lag in international comparison than in public education. In total, the public funds available for the education system are low by international standards: Hungary’s public spending on primary, secondary and tertiary education is equal to the average spending on primary and secondary education in OECD countries. Chart 8-27: Total expenditure on education by level (2011) Percentage of GDP

Percentage of GDP

Turkey Slovakia Czech Republic Hungary Japan Chile Spain Italy Germany Poland Korea Estonia United States Mexico EU21 average Australia Switzerland OECD average Austria Slovenia France Portugal Netherlands Israel Sweden Finland Belgium United Kingdom Denmark Ireland Iceland New Zealand Norway

10 9 8 7 6 5 4 3 2 1 0

Primary and secondary education Tertiary education Pre-primary education Other OECD average – primary and secondary education

Note: The graph shows direct public expenditure on educational institutions plus public subsidies to households. Source: OECD (2014)

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8. Hungary’s position in terms of the determinants of growth potential

There are different per capita expenditures behind similar levels of public expenditures as a percentage of GDP (Chart 8-28). It is reasonable to look at per capita spending due to demographic trends, specifically the declining number of school-age population. In countries characterised by similar public sector spending as a percentage of GDP as Hungary, such as Germany and the Czech Republic, the expenditure per student is substantially higher, which may stem from higher private funding and higher GDP per capita. Chart 8-28: Spending on education per student by levels, 2011 (equivalent USD, PPP) 25,000

Equivalent USD, PPP

25,000 20,000

15,000

10,000

5,000

Turkey Mexico Chile Hungary Czech Republic Estonia Slovak Republic Portugal Poland Israel France Korea Spain Germany Netherlands New Zealand Finland Japan OECD average Italy Ireland Australia Slovenia Belgium Denmark United Kingdom Sweden Austria Norway Switzerland

20,000

Primary education

Secondary education

Tertiary education

Note: Public institutions only for Ireland, Poland, Hungary, Italy, Portugal and Switzerland. Source: OECD (2014)

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Part I: International and national experiences in economic convergence

Per capita spending in Hungary reached 57 per cent of the OECD average in 2011. If we analyse per capita spending by education level, the largest lag by international standards prevails in secondary education: Hungary spent 49 per cent of the OECD average per student in 2011. The international data reveal that the level of spending increases in line with the level of education, while Hungary essentially spent roughly the same amount per capita on primary and secondary education. Compared to Poland, featuring a similar level of economic development, Hungary’s per capita spending fell short by 20 per cent in 2011. Per capita spending in Hungary is one of the lowest among OECD countries, with only Mexico, Turkey and Chile spending even less.

8.3 Health status In addition to the knowledge obtained in education, the health status of the population is also part of the human capital stock and may contribute to economic growth through several channels.84 On the one hand, health status has a strong influence on labour market participation (the size of the labour force) and productivity, and thus improving the health status may result in higher per capita income. Healthy employees are less likely to be absent from work due to illness and in older age they are able to stay in the labour market longer. In the European countries absence due to illness accounts for 3-6 per cent of annual working time and its annual cost corresponds to 2.5 per cent of GDP.85 The working days worked sick result in lower productivity. On the other hand, a healthy society is able to accumulate higher physical capital. The higher life expectancy increases the years in retirement and a higher saving ratio to ensure consumption in old age, and thus results in higher capital accumulation.86 In addition, per capita physical capital may also rise because the increase in labour input of healthy employees Bloom et al., (2004). EC (2013). 86 Jack and Lewis (2009). 84 85

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8. Hungary’s position in terms of the determinants of growth potential

may add to the marginal product of capital.87 Thirdly, as a result of higher life expectancy, investment in education may also be larger, as the longer lifetime increases the return on investment.88 Health status may be captured the easiest by life expectancy. However, there is a bidirectional relation between health status and economic growth, as the richer countries may allocate a higher portion of their gross income to healthcare expenditure, they live under better conditions of life and their health awareness may be higher. Based on the Preston curve, per capita GDP is one of the determinants of health status: the higher the per capita income is, the higher the life expectancy will be (Chart 8-29). Based on the shape of the curve, a rise in GDP increases the life expectancy to a larger extent in low-income countries than in high-income countries. Chart 8-29: Preston curve on the data of OECD countries (2012) ICL

Life expectancy at birth, 2012

ESP KOR

ITA

JAP

FRA

FIN NL ISR UK AUT EL IRL DEU BEL SLV

AUS

SWE

CHE

LUX NOR

DEN

CHI

CZE POL

EST SVK

HUN TUR MEX

73 0

20,000

40,000

60,000

Per capita GDP, 2012 (US$)

Source: OECD

87 88

Weil (2007). Jayachandran and Lleras-Muney (2008).

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80,000

100,000

Part I: International and national experiences in economic convergence

Rising life expectancy has a significantly positive impact on economic growth. In terms of economic growth, the level of life expectancy89 and the rate of increase are both important. If we treat health as a component of human capital, i.e. a factor of production, we should assume a correlation between GDP growth and an improvement in health status, i.e. an increase in life expectancy.90 Based on another approach, health status increases GDP via technological innovation, and thus productivity growth moves closely together with health status, i.e. the life expectancy value.91 Aghion et al. (2010) explained the growth rate of per capita GDP using changes in life expectancy, the life expectancy at the start of the period and the initial per capita GDP with data on 96 countries between 1960 and 2000. Based on their results, the initial level and the increase rate in life expectancy both have a significant positive impact on the per capita GDP growth rate. According to the results of Bloom et al. (2004), an increase of 1 year in life expectancy increases GDP by 4 per cent in the long run. The health status of the Hungarian population is poor by international standards and lags behind the level that would be justified on the basis of Hungary’s economic development. In Poland, where per capita GDP almost equals to that of Hungary, life expectancy at birth is longer by about 2 years on average. Life expectancy at birth has gradually increased in Hungary in recent decades, but the Hungarian value is still one of the lowest in the European Union (Chart 8-30). In 2013, life expectancy at birth of women and men was 79 and 72 years, respectively, in Hungary. These values lag behind the average of the 28 EU member states, by 6 years in case of men and 4 years in case of

The life expectancy is the average number of years an individual is expected to live based on his/her age and gender, if the age-specific mortality rates observed in the given period remain in force during the remaining years of the given individual (Wilkie and Young, 2009). 90 Mankiw et al. (1992). 91 Aghion et al. (2010). 89

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8. Hungary’s position in terms of the determinants of growth potential

women (Chart 8-31). In terms of life expectancy only Latvia, Lithuania, Romania and Bulgaria lag behind Hungary in the EU. Chart 8-30: Life expectancy at birth in the countries of the European Union (2013) Men

Years

Women

Spain France Italy Cyprus Finland Portugal Malta Greece Luxembourg Sweden Austria Slovenia EU28 Netherlands Germany Belgium Ireland United Kingdom Denmark Estonia Czech Republic Poland Croatia Slovakia Lithuania Hungary Latvia Romania Bulgaria 60 60

Years

Source: Eurostat

In Hungary, a major part of the increase in life expectancy is attributable to the decrease in the mortality rate of generations younger than 65 years. In most EU countries, however, the increase in life expectancy is attributable to the fact that elderly people live longer.92 In Hungary, men’s life expectancy at birth increased from 65 years to 72 years between 1990 and 2013. Less than 1 year of the increase in life expectancy was attributable to the decrease in infant mortality, while 92

HCSO (2010).

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Part I: International and national experiences in economic convergence

an increment of 1.5 years is the result of the decrease in the mortality rate of the population older than 65 years.93 The decrease in pre-mature (below 65 years) deaths increased men’s life expectancy at birth by 5 years between 1990 and 2013 and a significant part of the improvement related to the age group of 40-64 years. Women’s life expectancy at birth increased by 5 years between 1990 and 2013, half of which was the result of lower mortality rate of the population over 65, but the life expectancy of young adults and of the middle-aged also improved. Chart 8-31: Development of life expectancy at birth in Hungary and in EU28 countries (2002–2013) 85

Years

Hungary – Men Hungary – Women

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

EU28 – Men EU28 – Women

Source: Eurostat

On average, the Hungarian population can expect fewer years in good health than the inhabitants of the EU countries, but this indicator still reflects a more favourable picture than life expectancy at birth (Chart 8-32). Healthy life expectancy shows the number of years that an average individual is expected to spend at a given age free from health-related disabilities.94 While Hungary ranks 24-25th among the 93 94

Bálint and Kovács (2015). HCSO (2015).

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8. Hungary’s position in terms of the determinants of growth potential

EU countries in terms of life expectancy at birth, in the healthy life expectancy ranking it takes the 20th position, preceding – amongst others – Denmark and Germany. Despite the fact that life expectancy at birth is 7 years longer in case of women than for men, there is only 1 year difference in the healthy life expectancy of women and men in Hungary. This is due to the fact that the number of years spent in a disabled health status requiring treatment, is lower in case of men than in the case of women. The average value for Hungary lags behind the average of the EU countries only by 1.5-2 years. The healthy life expectancy at the age of 65 in Hungary precedes only 5 EU countries (Romania, Lithuania, Estonia, Latvia and Slovakia). Chart 8-32: Healthy life years expected at birth in the countries of the European Union (2013) Malta Ireland Bulgaria Sweden Greece Cyprus United Kingdom France Czech Republic Spain Belgium Luxembourg Poland Portugal Lithuania EU28 Italy Croatia Austria Hungary Slovenia Denmark Romania Netherlands Estonia Germany Slovakia Latvia 0

Men, 2013

Women, 2013

Note: Sorted by the life expectancy of men. Source: Eurostat

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Part I: International and national experiences in economic convergence

The Hungarian figures suggest that the population’s health status is improving year after year. Between 2005 and 2013, women’s life expectancy at birth increased from 77 to 79 years, while healthy life expectancy at birth increased from 54 to 60 years. This suggests that in Hungary healthy life expectancy increased at a higher rate than life expectancy. During the same period, average healthy life expectancy slightly decreased in the EU countries, but it still exceeds the Hungarian value. In case of men the life expectancy at birth increased by 3.5 years between 2005 and 2013, while the healthy life expectancy increased by 7 years on average. Taken together, in recent years Hungary’s lag compared to the EU countries has significantly decreased in terms of healthy life expectancy. In Hungary, the most frequent causes of death are related to cardiovascular diseases and malignant tumours. In 2012, cardiovascular diseases were the most frequent causes of death of men, with the number of deaths per 100,000 twice as high as the average of the EU member states (Table 8-6.a and 8-6.b). The Hungarian ratio also exceeds the ratio observed in the other Visegrád countries. Malignant tumours represent the second most frequent cause of death within the total population of men, while among the inhabitants below 65 (premature death) this is the most frequent cause of death. Within the Hungarian population, the mortality rate of men substantially exceeds that of women. Women’s mortality rate also exceeds the average value of the EU countries and of the other Visegrád countries. The number of deaths due to cardiovascular diseases was twice as high as the EU average in 2012. In the case of women below 65 malignant tumours is the leading cause of death.

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8. Hungary’s position in terms of the determinants of growth potential

Table 8-6.a: Standardized death rates in Hungary and Visegrád countries, men (2012) Total population

Total

EU28 Czech Republic Poland Hungary Slovakia Under age 65

1281 1656 1767 1940 1862 Total

EU28 Czech Republic Poland Hungary Slovakia

297 359 506 561 467

Of which: diseases of the cardiovascular system 462 834 814 944 837 Of which: diseases of the cardiovascular system 73 107 151 172 133

Of which: malignant neoplasms 358 399 423 505 461 Of which: malignant neoplasms 97 108 127 190 134

Of which: diseases of the respiratory system 117 105 116 121 139 Of which: diseases of the respiratory system 12 16 17 24 21

Note: Deaths per 100 thousands inhabitants. Source: Eurostat

Table 8-6.b: Standardized death rates in Hungary and Visegrád countries, women (2012) Total population

Total

Of which: malignant neoplasms

849 1088

Of which: diseases of the cardiovascular system 340 610

204 232

Of which: diseases of the respiratory system 63 54

EU28 Czech Republic Poland Hungary

1031 1215

542 670

224 271

48 56

Slovakia Under age 65

1186 Total

621 Of which: diseases of the cardiovascular system

233 Of which: malignant neoplasms

60 Of which: diseases of the respiratory system

EU28 Czech Republic

146 162

25 35

69 72

6 7

Poland Hungary Slovakia

195 245 187

44 59 40

86 109 79

7 12 7

Note: Deaths per 100 thousands inhabitants. Source: Eurostat

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Part I: International and national experiences in economic convergence

The potential years of life lost in Hungary is high in an EU comparison. The potential years of life lost is one indicator of premature mortality, as it reflects the average years of life lost before the conventionally expected average lifetime (70 years, based on international practice).95 Based on Eurostat data in 2012 there was 5,464 years of life lost for 100,000 persons in Hungary, that is this many years were lost due to the fact that not everybody lived until the age of 70 (Chart 8-33). This is one of the highest values in Europe after the Baltic states. In Hungary, there is significant difference between genders: men lose almost twice as many years of life from the potential 70 years as women. Chart 8-33: Potential years of life lost (2012) 8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

Luxembourg

Sweden

Italy

Spain

Netherlands

Austria

Germany

Denmark

Greece

Portugal

Belgium

Finland

Czech Republic

Poland

Hungary

Estonia

Latvia

Lithuania

United Kingdom

8,000

Source: OECD (2015)

The Hungarian mortality rate, which is high in an international comparison, and the number of potential years of life lost, draws attention to the importance of preventive care and screening tests. By strengthening the role of preventive care, health expenses on chronic 95

At present the commonly accepted value is 70 years, that is the indicators show the number of years not lived by the deceased of the potential lifetime of 0-70 years (Health Strategic Research Institute (ESKI 2015).

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8. Hungary’s position in terms of the determinants of growth potential

illnesses may decrease over the long run and the number of healthy years of life may be increased. Health status can be improved not only directly via healthcare services, as health status is influenced by many other factors. Health status is influenced by the social and economic environment, the physical environment, the individual’s way of life and access to healthcare.96 As regards the social and economic environment, higher income level and social status is accompanied by better health status and the life expectancy of those with higher school qualifications typically exceeds the life expectancy of the low-skilled. The physical environment includes the quality of potable water and air quality, living and working conditions. The way of life factors are influenced by sports, proper nutrition, as well as the degree of alcohol consumption and smoking. In addition, the healthcare system plays an important role in the prevention and treatment of illnesses. Chart 8-34: Public and private spending on health care (2013) Percentage of GDP

Percentage of GDP

United States Netherlands Switzerland Sweden Germany France Denmark Japan Belgium Canada Austria New Zealand Greece Portugal Norway United Kingdom Italy Iceland Slovenia Finland Slovakia Chile Hungary Israel Czech Republic Korea Poland Mexico Estonia Turkey

18 16 14 12 10 8 6 4 2 0

Public sector

Private sector

Source: OECD

World Health Organisation (2015).

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OECD average

18 16 14 12 10 8 6 4 2 0

Part I: International and national experiences in economic convergence

Chart 8-35: Life expectancy at birth and spending on health care as a percentage of GDP in the OECD countries (2013) 84

ITA

Life expectancy at birth

83 82

KOR

ISR

ICL NOR NZ UK EL FIN SLV PT

81 80 79 78

EST

TRK

76 75 74

JAP

AUT BEL DK

CHE FRA SWE NL DEU

CHI CZE POL

SVK HUN

MEX 4

6 7 8 9 10 Spending on healthcare as a percentage of GDP

Source: OECD

The way of life factors may be determinant in the poor health status of the Hungarian population, as the ratio of alcohol consumption and smoking, as well the ratio of overweight persons, is high in Hungary compared to the EU average. According to the results of Lackó (2010), the poor health status of Hungarian men is attributable to the above, lifestyle related reasons, but the extra work at the expense of the leisure time (second job) also plays a role. In Hungary, healthcare expenditures are below the average in an international comparison. Healthcare expenditures are productive budgetary expenditures, as the expenditures spent on the health of the working-age population may increase healthy life expectancy and thereby also the number of years spent in work. The low level of healthcare expenditures may also contribute to the poor health status. In Hungary, 7.4 per cent of GDP was spent on healthcare in 2013 from private and public funds; this value lags behind the average value of 9 per cent of the OECD countries. In Hungary, the ratio of private funds slightly exceeds the international average, while the level of public — 438 —

8. Hungary’s position in terms of the determinants of growth potential

expenditures is lower than the OECD average. There is a positive relationship between the GDP-proportionate healthcare expenditures and life expectancy at birth (Chart 2-61). By improving the efficiency of the healthcare expenses and increasing the expenditures, the Hungarian population’s health status may be further improved.

8.4 Participation rate in Hungary in an international comparison The participation rate in Hungary (for the age group of 15–64 years) increased significantly after the crisis. In 2008, 61.2 per cent of the working-age population participated in the labour market actively, but this ratio had already risen to 67 per cent in 2014 (Chart 8-36). The sharp increase in public work programmes, the tightening of the allowance system and certain employment incentive schemes (Job Protection Chart Chart 8-36: Participation rate in EU countries 90

Per cent

90 80

Italy Romania Croatia Malta Hungary Greece Belgium Poland Bulgaria Ireland Slovakia Luxembourg Slovenia France EU28 Portugal Czech Republic Lithuania Spain Cyprus Latvia Estonia Austria Finland United Kingdom Germany Denmark Netherlands Sweden

2014 Note: From 15 to 64 years. Source: Eurostat

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2008

Part I: International and national experiences in economic convergence

Action Plan, First Job Guarantee) may all have facilitated the increase in the labour force participation rate. However, despite the improvement, the Hungarian participation rate still lags considerably behind the EU countries. In addition to the difference arising from the composition of the population, the current lag in the participation rate in Hungary is attributable to differing participation rates in certain social groups. While demographic factors can be influenced only over the long run, groups with lower participation rates can be encouraged by various employment policy instruments over the shorter term as well. Hence it is important to identify those main groups where the participation rate lags behind the EU average. Examining the participation rate by education level, it can be stated that the lower educated belong to the group of the most disadvantaged EUwide; they appear in the labour market at a lower rate from the outset as their employment opportunities are worse and they are linked more loosely to the labour market. In Hungary, despite the growth in recent years, the participation rate of the lower educated in 2014 still lagged significantly behind the EU average, while the lag in Hungary is much smaller at other education levels. (Chart 8-37). Examining the participation rate by age groups, it can be stated that the participation rate of both the young generation (aged 15–24 years) and those over 50 significantly lagged behind the EU average in 2014. There is no lag in the age group of 25–49 years (Chart 8-38).

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8. Hungary’s position in terms of the determinants of growth potential

Chart 8-37: Participation rate by highest level of education in EU countries (2014) Per cent

Per cent

Lithuania Poland Czech Republic Slovakia Croatia Hungary Bulgaria Ireland Estonia Latvia Slovenia Belgium Luxembourg Finland Romania France Italy Cyprus Germany EU28 Austria Greece Malta Sweden Denmark United Kingdom Netherlands Portugal Spain

100 90 80 70 60 50 40 30 20 10 0

Low

Middle

100 90 80 70 60 50 40 30 20 10 0

High

Note: From 15 to 64 years. Source: Eurostat

Chart 8-38: Participation rate by age groups in EU countries (2014) Per cent

Per cent

Luxembourg Italy Bulgaria Greece Hungary Romania Belgium Slovakia Czech Republic Croatia Slovenia Poland Lithuania Portugal Spain France Ireland Estonia Cyprus Latvia EU28 Germany Finland Malta Sweden United Kingdom Austria Denmark Netherlands

100 90 80 70 60 50 40 30 20 10 0

15–24 years old

25–49 years old

Note: From 15 to 64 years Source: Eurostat

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50–64 years old

100 90 80 70 60 50 40 30 20 10 0

Part I: International and national experiences in economic convergence

Looking at the labour market participation of women, we find that in Hungary the participation rate of women of child-bearing age (young and middle-aged) is significantly lower compared to the EU countries (Chart 8-39), although this rate also improved considerably in recent years. Chart 8-39: Participation rate of women aged 15-49 in EU countries (2014) 80

Per cent

80 70

Italy Romania Malta Ireland Hungary Slovakia Bulgaria Greece Poland Czech Republic Belgium Croatia Luxembourg EU28 Estonia France Latvia Lithuania United Kingdom Spain Germany Finland Cyprus Portugal Slovenia Denmark Austria Netherlands Sweden

Women aged 15 to 49 years Note: From 15 to 64 years. Source: Eurostat

Taken together, it can be stated that Hungary’s participation rate lag is linked primarily to the following groups: the lower educated, the young, persons over 50 and women of child-bearing age. The participation rate in Hungary shows a shortfall also in comparison with the Visegrád countries, albeit in the case of the latter four countries it is Hungary where the most dynamically improving trend has been seen since the crisis (Chart 8-40).

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8. Hungary’s position in terms of the determinants of growth potential

Chart 8-40: Comparison of participation rate in Visegrád countries 74

Per cent

Hungary Poland

Czech Republic Slovakia

2014

60 2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

EU28

Note: From 15 to 64 years. Source: Eurostat

For the purpose of presenting the reasons for the shortfall, we examined the difference in the participation rate of groups with special attributes – the young (aged 15–24 years), women of child-bearing age (aged 15–49 years), those in pre-retirement age (aged 50–64 years) and the lower educated (based on the Eurostat ISCED classification) – in the Visegrád countries compared to the average of the EU28 (Chart 8-41).

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Part I: International and national experiences in economic convergence

Chart 8-41: Comparison of participation rate in Visegrád countries 80

Per cent

Lower educated (15–64) 2014

Elderly (50–64)

Youth (15–24)

2008

Slovakia

Poland

Hungary

Czech Rep.

Slovakia

Poland

Hungary

10 Czech Rep.

Slovakia

Poland

Hungary

Czech Rep.

Slovakia

Poland

Hungary

Czech Rep.

Women of child-bearing age (15–49)

EU28 average (2014)

Source: Eurostat

Examining the reasons for being absent from the labour market, the role of those participating in education (typically the younger generation) and of pensioners is striking, which also supports the assumption that these are the most typical inactive groups (Chart 8-42). Comparing the EU28 average with the Hungarian figures, we find that according to the reasons for inactivity the largest difference appears among pensioners; in Hungary the absence due to this reason is higher by almost 6 per cent. To quantify the contribution of the aforementioned groups, we used the decomposition method described in the study of Kátay and Nobilis (2009).97 The essence of the method is that we divide our lag measured in the participation rate into two effects (composition of the population 97

For the decomposition we eliminated the non-respondents, thus the main numbers may differ from the aggregate value published by Eurostat.

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Chart 8-42: Proportion of inactive people in 15 to 64 years population by reasons for not seeking employment (2014) 40

Per cent

Hungary

Other reasons

Think no work is available

Retired

In education or training

Looking after children or incapacitated adults

Other family or personal responsabilities

Own illness or disability

Awaiting recall to work (on lay-off)

EU28

Note: From 15 to 64 years. Source: Eurostat

and the difference in the participation rate of the individual groups). In calculating the structural difference of the population, we weighted the participation rate of the appropriate groups of the individual countries (of Hungary) with the EU28 population ratios, and then took the difference from the given group’s actual participation rate. Chart 8-43 shows the groups that made a major contribution to the difference between the Hungarian participation rate and the EU28 average. In Hungary, the largest contribution is made by the lag of the elderly, but the participation rate lag of this group is similarly high in Poland as well. The contribution of the lower educated and the women of child-bearing age to the lag is significant in all of the Visegrád countries.

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Chart 8-43: Contributions by groups resulting from differences in participation rates (2014) 2

Percentage point

–1

–2

–3

–4

–5

–6

PL Lower educated Youth Total difference

–6

Elderly (above 50 years) Women of child-bearing age

Source: Eurostat

In the individual groups, Hungary’s lag in the participation rate may be also attributable to the composition effect, in addition to the difference in the willingness to participate in the labour market. Examining the population ratio of the groups in the Visegrád countries, we find that in Hungary the ratio of persons with primary school education within the population is significantly higher compared to the other Visegrád countries, while there is no relevant difference in the other groups (Chart 8-44). Based on this, a relevant composition effect may only appear at those with primary school education.

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Chart 8-44: Proportion of different groups in the Hungarian population (2014) 40

Per cent

Lower educated Hungary Slovakia

Elderly

Youth Czech Republic EU28

Women of child-bearing age

Poland

Source: Eurostat

In the following, we examine more thoroughly the factors that may underlie the low participation rate in the four identified groups.

8.4.1 Factors underlying the low participation rate of the lower educated

The participation rate of the lower educated is also low by international standards and this may be attributable to several reasons. On the one hand, the majority of the lower educated do not meet the requirements of the enterprises with vacancies based on their skills (skill mismatch). The filling of most vacancies (even in low-grade jobs) requires higher level, complex skills, while the lower educated often lack even the basic competences (reading, writing, counting skills, basic — 447 —

Part I: International and national experiences in economic convergence

computer skills, communication skills) (see the results of the PISA test) and often their attitude to work and to the rules of conduct at work is also not appropriate. In addition, there is also a geographical mismatch between vacancies and labour supply. This labour market difficulty may also impact the lower educated the most, as they are the ones who face a number of difficulties in the area of obtaining information related to work and also in terms of mobility. In Hungary, the proportion of minimum wage level to wage average (Kaitz index), which may affect the employment of the lower educated the most, is in the mid-range in an international comparison, although it belongs to the higher ones among the Visegrád countries (Chart 8-45). Chart 8-45: Kaitz index in international comparison (2014) 60

Per cent

Source: Eurostat

— 448 —

Slovenia

Luxembourg

Malta

Lithuania

Poland

Portugal

Latvia

Ireland

Hungary

United Kingdom

Bulgaria

Croatia

Spain

Estonia

Slovakia

Czech Republic

8. Hungaryâ&#x20AC;&#x2122;s position in terms of the determinants of growth potential

The low level of the minimum wage may hamper labour supply, as the surplus income that can be obtained by employment is not sufficiently high compared to the size of social transfers. However, examining this from the labour demand side, a minimum wage that is set too high may also hamper the employment of the lower educated, as it raises the cost of employment. After the crisis, the number of discouraged unemployed increased in Hungary as well (inactive persons who would like to work, but after a shorter or longer period of failed attempts give up looking for a job and leave the labour market, because they think that they cannot find a job anyway under the present labour market conditions). Most of them come from among the lower educated, as they are the ones who most often experience competition where they compete with better educated employees for jobs. Thus, this effect also contributes to their low participation rate

8.4.2 Factors underlying the low activity of the youth

The respondents that specify participation in education as the reason for inactivity typically come from the group of the youngest working-age population; 88.6 per cent of the age group of 1524 years specify studying as the obstacle to entering the labour market (Chart 8-46). The inactive labour market status due to studying alone does not suggest negative processes; the real problem is the ratio of working-age young people who do not study, but do not work either. Presumably this group is one of the most sensitive to changes in educational and employment policy changes, and therefore it is worth focusing on these groups when elaborating measures, because their lag in terms of activity can be reduced in the short run.

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Chart 8-46: Proportion of inactive people in 15 to 25 years population by the main reason for not seeking employment (2014) 100

Per cent

100

Hungary

Other reasons

Think no work is available

Retired

In education or training

Looking after children or incapacitated adults

Other family or personal responsabilities

Own illness or disability

Awaiting recall to work (on lay-off)

EU28

Source: Eurostat

The NEET ratio (Not in Education, Employment or Training) to capture the above-mentioned group, was developed at the recommendation of international organisations; this is the ratio of young people in the age group of 1524, who do not participate in education or employment (Chart 8-47). Based on the OECD data in the age group of 2024 years – the most typical group of those participating in higher education – Hungary is at the bottom of the ranking, well above the average of the OECD countries. The weakest performing countries are those from the Mediterranean region, being well behind the other countries. By contrast, in the younger, secondary school-age group, in Hungary the ratio of those 1519 year-old young people who do not participate in any education or employment activity is better compared to the OECD average.

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Chart 8-47: NEET-ratio in OECD countries (2013) 40

Per cent

40 35

Luxembourg Iceland Netherlands Switzerland Germany Austria Norway Sweden Denmark Slovenia Canada Australia Czech Republic Finland New-Zealand Estonia Lithuania Israel OECD average Belgium USA United Kingdom France Poland Slovakia Ireland Portugal Mexico Hungary Spain Greece Italy Turkey

15–19

20–24

Source: Eurostat

As regards the young, there has been a rising trend in the participation rate since 2011 in Hungary, while there is stagnation both in the European average and in the other Visegrád countries. Examining the development of the participation rate of the youngest age group, it is apparent that whilst the ratio stabilised at the level of 2011 in the other Visegrád countries, in Hungary it shows a rising trend (Chart 8-48). This may be attributable, in addition to the demographic reasons, to the lowering of the compulsory school attendance age.

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Chart 8-48: Developement of participation rate of young people 50

Per cent

Hungary Czech Republic

EU28 Slovakia

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

Poland

Note: From 15 to 24 years. Source: Eurostat

8.4.3. Factors underlying the low participation rate of persons over 50

In Hungary, the age group of over 50 years makes the highest contribution to the lag in the participation rate. One reason for this is that in the pre-crisis years the effective retirement age was low due to the liberal regulation of early retirement. As a result of the measures taken after the crisis, the effective retirement age started to rise, which will generate a gradual increase in the activity rate of this group. In addition to the pensionable age, the low activity ratio of the older age-group may also be attributable to the fact that in Hungary the population’s health-related quality of life attributes considerably deteriorate over the age of 50 (Kopp–Skrabski 2009).

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However, the development of the age group’s participation rate in terms of time is similar to that of the European countries. Since 2008, there is a rising trend in the labour market participation rate of the elderly both in the Visegrád countries and in the EU28 (Chart 8-49). The increasing participation rate may primarily be attributable to the increase in the pensionable age. Chart 8-49: Developement of participation rate of people over 50 years 70

Per cent

Hungary Czech Republic

EU28 Slovakia

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

Poland

Note: From 50 to 64 years. Source: Eurostat

8.4.4 Factors underlying the low participation rate of women of childbearing age

The participation rate of women of child-bearing age may be substantially influenced by the differences in the social benefits related to having children and in the social norms. In the case of women those of child-bearing age represent the most typical group — 453 —

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of inactivity, albeit the over-50 age group also makes a significant contribution to the divergence from the European average (Chart 8-50). Children are traditionally taken care of by women, who are the ones to stay at home with the infant, which may be regarded as a kind of unpaid work. However, in Hungary women stay at home with their children for several years on average, which may be attributable to a number of factors. On the one hand, the public nursery school capacity does not satisfy the demands adequately, and it is also not fully aligned with the requirements of working women (e.g. short opening hours). Private childcare services are not affordable for many or significantly increase the marginal cost of employment, which may also hamper the activity of women with children. Chart: 8-50: Contribution to the total deviation of participation rate of Hungarian women to EU28 (2014) 3.0

Percentage point

3.0

2.5

2.5 Women from 50 to 64 years 1.30

2.0

1.5

Women from 25 to 49 years 0.45

1.0

0.5

1.5

Women from 15 to 24 years 1.08

0.5

0.0

0t0 Source: Eurostat

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Moreover, in Hungary atypical forms of employment are less common, and the lack of part-time employment is also the reason for the low participation rate of women with small children. Although part-time employment increased significantly in Hungary after the crisis – with both cyclical and long-term factors contributing to this (for more details, see Bodnár 2014) – the spread of part-time employment came to a halt in recent years. Accordingly, the ratio of part-time employed is still exceptionally low by European standards (Chart 8-51). Chart 8-51: Ratio of part-time workers in EU countries (2014) 50

Per cent

50 40

Bulgaria Slovakia Croatia Czech Republic Hungary Latvia Poland Estonia Lithuania Romania Greece Slovenia Portugal Cyprus Finland Malta Spain Italy Luxembourg France EU28 Ireland Belgium Denmark Sweden United Kingdom Germany Austria Netherlands

Note: From 15 to 64 years. Source: Eurostat

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8.4.5 Developments in employment

During the recent period, the expansion of labour supply was coupled with an improvement in employment. While 56.4 per cent of the working age population was employed in 2008, this figure was 61.8 per cent in 2014. However, Hungary still lags far behind other EU countries in terms of the employment rate, as also with respect to the participation rate (Chart 8-52). Chart 8-52: Employment rate in EU countries 90

Per cent

90 80

Greece Croatia Italy Spain Bulgaria Romania Slovakia Ireland Poland Hungary Belgium Cyprus Malta Portugal France Slovenia EU28 Lithuania Latvia Luxembourg Finland Czech Republic Estonia Austria United Kingdom Denmark Netherlands Germany Sweden

2014

2008

Note: From 15 to 64 years. Source: Eurostat

As regards different social groups, the employment rate of the low skilled, the young and those over 50 lagged further behind the EU average in 2014, compared to women of child-bearing age (i.e. young and middle-aged women).

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After the crisis, as demand dropped, the labour demand of companies fell substantially, and as a result, the number of people employed in the national economy nosedived. The level of employment in the national economy bottomed out in 2010 Q1, and after that, in parallel with the economic recovery and the introduction of structural measures targeting the labour market, the number of people in employment started to rise. The number of people working in the national economy reached the pre-crisis level in the first half of 2013, growing dynamically after that. Chart 8-53: Changes in employment structure

400

Thousand persons cumulative change (2007Q4 = 0)

400

300

200

100

100 0

0 –100

–100

–200

–300 2008

–300 2009

2010

Total economy

2011

2012

2013

Domestic private sector

2014

2015 Public sector

Source: HCSO

The public work programmes played a central role in the expansion of employment in the national economy, facilitating employment for those who had very low chances of finding work on the open labour market. In the years following the crisis, the proportion of those working abroad within the employed rose, which can be attributed to both cyclical and — 457 —

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structural factors. After the downturn, the number of people employed in the domestic private sector reached the pre-crisis level in early 2014 (Chart 8-53). The actual amount of work utilised in the private sector can be seen more clearly from the total number of hours worked rather than from the number of people in employment. After the crisis, fulltime equivalent employment in the Hungarian private sector expanded at a slower pace than employment. Meanwhile, labour demand still falls short of the pre-crisis level in terms of the hours worked per employee (Chart 8-54). Chart 8-54: Evolution of employment in the private sector 3,200

Thousand persons

3,200

2,600

2,500

Total private sector

2015

2,700

2014

2,700

2013

2,800

2012

2,800

2011

2,900

2010

2,900

2009

3,000

2008

3,000

2007

3,100

2006

3,100

FTE domestic private sector*

Note: * Full-time equivalent without workers employed abroad.. Source: HCSO

In recent years, the tax regime has been subject to significant changes aimed at the reduction of taxes on labour. With the introduction of the flat-rate personal income tax and family taxation as well as the targeted measures complementing the system, the tax burden on employment was reduced considerably after 2010, which was also â&#x20AC;&#x201D; 458 â&#x20AC;&#x201D;

8. Hungary’s position in terms of the determinants of growth potential

apparent in the improvement of Hungary’s relative position. At the same time, despite the effects of the Job Protection Action Plan, the total tax burden on labour (tax wedge) remains higher in Hungary than the international average (Chart 8-55). The high tax wedge raises the labour costs of domestic companies, which may dampen labour demand, as over the longer term firms can replace simpler jobs with capital. Once the allowances provided to families (family tax allowance, family allowance) are also taken into account, Hungary ranks average in international comparison with respect to the tax burden. The allowances provided to families stimulate labour supply. Chart 8-55: Tax wedge of single workers earning 67 per cent of average wage childless/with two children, international comparison (2014) 60

Per cent

Income tax Employee contribution 2 children

Employer contribution Family tax benefit

2015. Source: OECD

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Greece

France

Belgium

Sweden

Germany

Spain

Poland

Austria

Finland

Estonia

Italy

Slovak Republic

Hungary*

Portugal

Czech Republic

Slovenia

Netherlands

Denmark

–40

Luxembourg

–40

United Kingdom

–20

Ireland

–20

Family benefits Childless

Part I: International and national experiences in economic convergence

8.5. Conclusion Demographic processes may become increasingly acute challenges in Hungary in the coming decades. Due to the population ageing, the labour force that can be involved in production may shrink in Hungary: by 2060, the potentially available labour supply will be one-third smaller than the current size. Demographic changes may exert the most significant labour market impact in the 2020s and the 2040s, with each of these periods undergoing an 11 per cent contraction in the workingage population relative to the average of the preceding decades. In view of the fact that ageing is primarily a consequence of the low birth rate of earlier decades, supportive family policies and the incentivisation of birth rates may mitigate the adverse economic and labour market impacts. Despite the rising trend observed in recent years, Hungary exhibits one of the lowest total fertility rates. In addition, the adjustment of economic agents and economic policy measures may also mitigate the economic impacts of demographic developments. With the gradual rise of years spent in good health, individuals may remain longer on the labour market. In addition, further improvements in the level of education and the quality of education may bolster the Hungarian economyâ&#x20AC;&#x2122;s growth potential. Increasing the proportion of highly qualified labour may improve labour force productivity, which in turn contributes to economic growth. Better qualified workers generally have better labour market opportunities, higher activity and employment rates, higher average incomes and higher life expectancy compared to their less qualified peers. The number of degree-holders has significantly increased since the turn of the millennium in Hungary, but still falls short of the European Union average. The ratio of tertiary education graduates might be increased through a structure better adapted to labour market needs. Within the secondary educational system, the ratio of vocational training participants (vocational secondary schools or vocational schools in Hungary) is also lower by European standards,

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and there is less emphasis on teaching general skills in the Hungarian school system by international standards. PISA test scores revealed that there is room for improving the standard of public education in Hungary, which may improve students’ employment opportunities and thus the economy’s convergence opportunities. Further improvements in the participation rate may mitigate the impacts of demographic developments. The low participation rate is linked to a few partially overlapping social groups: individuals with low qualifications, young people, people over the age of 50 and women of childbearing age. While demographic determinants can only be influenced in the long run, the activity of these groups exhibiting the lower labour market participation can be incentivised through various employment policy tools in the shorter run.

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References Bálint L. – Kovács K. (2015): Halandóság. portré 2015. Bleha B. – Földházi E. – Sprocha B. – Vano B. (2014): Population projections for Hungary and Slovakia at national, regional and local levels. Population projections developed within the project “SEEMIG Managing Migration and Its Effects – Transnational Actions Towards Evidence Based Strategies” http:// www.seemig.eu/downloads/outputs/SEEMIGPopulationProjectionsHUSK.pdf Bloom, D. E. – Canning, D. – Sevilla, J. (2004): The Effect of Health on Economic Growth: A Production Function Approach. World Development Vol. 32, No. 1, pp. 1–13. Bodnár K. (2014): Part-time employment during the recession. MNB Bulletin, March 2014, Magyar Nemzeti Bank. Bussolo, M. – Koettl-Brodmann, J. – Sinnott, E. (2015): Golden ageing: prospects for healthy, active, and prosperous ageing in Europe and Central Asia. Europe and Central Asia Studies. Washington, D.C.: World Bank Group. http://documents.worldbank.org/curated/en/2015/06/24707415/golden-aging-prospects-healthy-activeprosperous-aging-europe-central-asia Egészségügyi Stratégiai Kutatóintézet (2015): Egészségtudományi Fogalomtár, Potenciálisan elvesztett életévek száma. http://fogalomtar.eski.hu/index.php/Potenci%C3%A1lisan_elvesztett_%C3%A9let%C3%A9vek European Commission (2012): The 2012 Ageing Report. Economic and Budgetary Projections for the 27 EU Member States (2010–2060). European Commission (2013): Investing in Health. Commission Staff Working Document Social Investment Package February 2013. European Commission (2014a): The 2015 Ageing Report, Underlying Assumptions and Projection Methodologies. European Economy 2014/8. European Commission (2014b): Recommended Annual Instruction Time in Full-time Compulsory Education in Europe 2013/14, Eurydice – Facts and Figures. http://eacea.ec.europa.eu/education/eurydice/documents/facts_and_figures/Instruction_Time_2013_14.pdf Eurostat (2013): EUROPOP2013. http://epp.eurostat.ec.europa.eu/portal/page/portal/population/data/database Eurostat (2015): Population and Social Conditions, Demography and Migration, Population, Population: Structure Indicators. http://ec.europa.eu/eurostat/data/database

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8. Hungary’s position in terms of the determinants of growth potential Földházi E. (2015): Demográfiai portré 2015. Hanushek, E. A. – Wössmann, L. (2007): The Role of Education Quality in Economic Growth. World Bank Policy Research Working Paper 4122. Hanushek, E. A. – Wössmann, L. (2010): Education and Economic Growth. In: Penelope Peterson, Eva Baker, Barry McGaw, (eds), International Encyclopedia of Education, Volume 2, pp. 245–252. Oxford: Elsevier. Jack, W. – Lewis, M. (2009): Health Investments and Economic Growth: Macroeconomic Evidence and Microeconomic Foundations. In Spence: Health and Growth: Commission on Growth and Development. The World Bank. Jayachandran, S. – Lleras-Muney, A. (2008): Life Expectancy and Human Capital Investments: Evidence from Maternal Mortality Declines. NBER Working Paper No. 13947. Kapitány B. – Spéder Zs. (2015): Gyermekvállalás, Demográfiai portré 2015. Kátay G. – Nobilis B. (2009): Working Papers 2009/5.

MNB

Kopp M. – Skrabski Á. (2009): Pongrácz T. (eds): Szociális és Munkaügyi Minisztérium, 2009, pp. 117–136.

In: Nagy, I. – Budapest: TÁRKI –

HCSO Hungarian Central Statistical Office (2010): Társadalmi Helyzetkép, 2010. HCSO Hungarian Central Statistical Office (2012): Magyarország, 2011. HCSO Hungarian Central Statistical Office (2014): Teljes termékenységi arányszám (1990–2012). https://www.ksh.hu/docs/hun/eurostat_tablak/tabl/tsdde220.html HCSO Hungarian Central Statistical Office (2015): Az oktatásra ható népesedési folyamatok (2004– 2015). http://www.ksh.hu/thm/2/indi2_2_1.html Hungarian Demographic Research Institute of the Hungarian Central Statistical Office (2015): Kreiszné Hudák E. – Varga P. – Várpalotai V. (2015): A demográfiai változások makrogazdasági Financial and Economic Review, June 2015, Volume 14, Issue 2. Lackó M. (2010): makroelemzés magyar és osztrák adatok alapján, 1960–2004. ManpowerGroup (2015): Hiányszakma Felmérés. http://hianyszakmafelmeres.hu/

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Part I: International and national experiences in economic convergence McGowan, A. – Andrews, D. (2015): Labour Market Mismatch and Labour Productivity: Evidence from PIAAC Data. OECD Economics Department Working Papers, No. 1209, OECD Publishing, Paris. http://dx.doi.org/10.1787/5js1pzx1r2kb-en OECD (1998): Education at a Glance: OECD Indicators, OECD Publishing. OECD (2013): How can countries best produce a highly-qualified young labour force? Education Indicators in Focus. http://www.oecd.org/edu/skills-beyond-school/EDIF%202013--N16%20(eng).pdf OECD (2014): Education at a Glance: OECD Indicators, OECD Publishing. OECD (2015a): Ageing and Employment Policies - Statistics on average effective age of retirement. http://www.oecd.org/els/emp/ageingandemploymentpolicies-statisticsonaverageeffectiveageofretirement. htm OECD (2015b): Self-reported skills mismatch in selected OECD countries, 2010. http://skills.oecd.org/useskills/documents/32bself-reportedskillsmismatchinselectedoecdcountries2010.html OECD (2015c): Public spending on education (indicator). https://data.oecd.org/eduresource/public-spending-on-education.htm Statisztikai Évkönyv 2013. Skirbekk, V. – Loichinger, E. – Weber, D. (2012): Variation in cognitive functioning as a refined approach to comparing ageing across countries. Proceedings of the National Academy of Sciences of the United States of America. Vol. 109, No. 1, pp. 770–774. http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3271876/ Spijker, J. – MacInnes, J. (2013): Population ageing: the timebomb that isn’t? http://www.bmj.com/content/347/bmj.f6598 Quintini, G. (2011): Right for the Job: Over-Qualified or Under-Skilled? OECD Social, Employment and Migration Working Papers, No. 120, OECD Publishing. http://dx.doi.org/10.1787/5kg59fcz3tkd-en United Nations (2013a): World Population Ageing 2013. Department of Economic and Social Affairs, Population Division United Nations (2013b): World Fertility Patterns 2013. Department of Economic and Social Affairs, Population Division. http://www.un.org/en/development/desa/population/publications/pdf/fertility/world-fertilitypatterns-2013.pdf United Nations, Department of Economic and Social Affairs, Population Division (2015): World Population Prospects: The 2015 Revision. World Bank (2015): Population Estimates and Projections, 1960–2050. http://data.worldbank.org/data-catalog/population-projection-tables

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8. Hungary’s position in terms of the determinants of growth potential Weil, D. N. (2007): Accounting for the Effect of Health on Economic Growth. The Quarterly Journal of Economics, August 2007, Vol.122(3), pp. 1265–1306. Wilkie, J. – Young, A. (2009): Why health matters for economic performance. Department of the Treasury, Australia. http://archive.treasury.gov.au/documents/1496/PDF/05_Why_health_matters.pdf World Economic Forum (2015): The Human Capital Report 2015.

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Hungary’s position in terms of the determinants of growth potential – investments Balázs Spéder

The evolution of investments, i.e. changes in capital stock and new capital formation, is a crucial factor in determining economic growth. Hungarian investment processes started to diverge from the regional trend during the second half of the 2000s and the rate of investment was only around 23-24 percent of GDP. During the crisis, the rate fell on average by 2.5-3 percentage points in all countries in the region, but dipped to much lower levels of 18-19 per cent in Hungary. A modest turnaround occurred in Hungarian investment activity around 2012 and 2013, but the investment rate remains low even by regional standards. The level of corporate investments as a percentage of GDP in Hungary has remained stable at around 12.5-13.5 per cent, but still falls 1 percentage point short of the pre-crisis level. The low level of corporate investments may stem from various factors, including the sustained decline in domestic demand in the wake of the crisis, unfavourable lending developments and slow deleveraging. Household investments have exhibited a declining trend since the onset of the crisis, slipping to 2.7 percent of GDP by 2014 compared to the 4.5 percent level of the regional counterparts. The persistently low levels of household investment activity contribute significantly to the low investment ratio by regional standards. The decline in household investments in Hungary is driven by two processes. First, a significant portion of household investments in Hungary was financed using loans, in particular using FX loans during the pre-crisis period. Deleveraging these loans is an extremely slow process. Secondly, household investment activity mainly takes the form of

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9. Hungary’s position in terms of the determinants of growth potential – investments

residential property investment. The current upswing in the housing market, the continued deleveraging of households, and increasing real incomes may foster a positive shift in direct investments (house purchases) or in indirect investments (house renovations). The unsuccessful fiscal adjustment attempts already restrained government investment in Hungary before the crisis. During the 2008 financial crisis, Hungary was unable to offset the decline in the corporate sector through higher government spending due to the very high levels of government debt and government deficit accumulated earlier. Following the crisis, the upswing in public investment was mainly fuelled by the strong absorption of EU funds. In Hungary, almost 60 percent of the available EU funding has been drawn down for direct state investments and infrastructure development.98

9.1. Introduction Developments in investments, i.e. changes in the capital stock, are pivotal in terms of economic growth. The renewal and expansion of the capital stock determines how capacities develop, and thereby also how the volume of economic output changes. Therefore investments provide the basis for medium and long-term economic growth on the supply side of the economy. In Central and Eastern European countries, investments amount to 20–25 per cent of the expenditure side of GDP. Although the figure was 25 per cent in the early 2000s, the Hungarian investment rate declined after the 2006 fiscal consolidation in all sectors even before the crisis, that is Hungarian developments increasingly diverged from regional trends. While before the crisis the investment rate in CEE countries was much higher – with the exception of Poland – in some cases as high 98

The statements and calculations in this chapter are based on the results of the 2015 Growth Report by the Magyar Nemzeti Bank.

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as 30 per cent of GDP, Hungarian investments amounted to merely 23-24 per cent of GDP. During the crisis, the investment rate fell considerably, on average by 2.5-3 percentage points, in all countries within the region. However, in Hungary it dropped by more, to 18-19 per cent (Chart 9-1).99 In 2012–2013 a turnaround occurred in Hungarian investment activity, which was low even by regional standards, and the total rate started to rise. This was significantly supported by the increase in government investments from 3.4 to 5.5 per cent between 2011 and 2015, which was mainly attributable to the intensifying utilisation of European Union funds. Chart 9-1: Developments in the total investment rates in regional comparison 35

Percentage of GDP

Regional average of investment rates

15 13

2000Q1 Q3 2001Q1 Q3 2002Q1 Q3 2003Q1 Q3 2004Q1 Q3 2005Q1 Q3 2006Q1 Q3 2007Q1 Q3 2008Q1 Q3 2009Q1 Q3 2010Q1 Q3 2011Q1 Q3 2012Q1 Q3 2013Q1 Q3 2014Q1 Q3 2015Q1

Hungary

Regional average (V3)

Source: Eurostat

According to Martonosi (2006), the 2006 consolidation in itself reduced the investment rate by 1 percentage point.

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9. Hungary’s position in terms of the determinants of growth potential – investments

Following the turnaround in recent years, the Hungarian investment rate has been close to the regional average of 21 per cent. The slightly lower-than-average rate is due to the current investment activity of households, which remains below the regional average. Household investments in Hungary have exhibited a declining trend since 2008, falling to 2.7 per cent of GDP by 2014. Corporate investments amount to 12–13 per cent relative to GDP, which is moderate in regional terms, but not exceptionally low. In contrast to the trend in household investments, corporate investments showed a stable trend (Chart 9-2). Chart 9-2: Developments and decomposition of the investment rate relative to GDP in the region 35

Percentage of GDP

35 30

2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014

Czech Republic Businesses

Hungary Government

Poland Households

Slovakia Total investment rate

Note: For Poland and Slovakia only aggregate data is available in 2014. Source: Eurostat

The volume of dwellings and other construction related investments had already declined 3-4 years prior to the crisis, while in the same period growth was observed in all the other countries of the region. After the crisis, construction investments dropped the most: by 2012 — 469 —

Part I: International and national experiences in economic convergence

they fell below 60 per cent of the 2005 level. Although construction investments have shown a downward trend in all countries of the region since 2011, Hungary still reaches barely half of the regional average. The exceptionally large drop in construction investments can be attributed to the pre-crisis heavily indebted general government, and the postponement of home construction by household sector. Among the Visegrád countries, Hungary has the lowest volume of real estate investments. However, other construction related investments may also play a role in the decline, such as the drop in real estate construction for commercial purposes and in infrastructural investments by the state (Chart 9-3). Chart 9-3: Material-technical decomposition of the investment rate in the region

Hungary

Czech Republic

Note: 2005 = 100 per cent Source: MNB calculations based on Eurostat data

— 470 —

Poland

Slovakia

2013

2012

2011

2010

2009

2008

2007

2013

2012

100

2011

100

2010

120

2009

120

2008

140

2007

140

2006

160

2005

160

2006

180

Machinery and other equipment Per cent

2005

180

Dwellings and other buildings Per cent

9. Hungary’s position in terms of the determinants of growth potential – investments

In the case of machinery investments, a homogeneous growth pattern can be observed in the region. In contrast to construction investments, Hungarian machinery investments relative to GDP remained comparatively stable, and corresponded to the regional average. Similarly to several other countries the growth trend was disrupted by the crisis, but a steady recovery has been observed since 2010. The accumulation of emerging countries’ capital stock is more rapid than in developed countries due to the higher returns of capital. Corporate investments stabilising at low levels and the decreasing trend in construction investments have a negative impact not only on the short-term development of GDP, but also on long-term growth. In the following, we seek to find answers to the following questions. Which factors determine the investment activity of the individual economic sectors? Why has Hungarian investment activity stabilised at a persistently low level after the crisis?

9.2. Corporate investments The development of corporate investments is regarded to be an exceptionally important factor for long-term economic growth, as the corporate capital stock exerts sustained, long-term effects on growth potential. The level of corporate investments relative to GDP in Hungary has remained stable at around 12.5-13.5 per cent since the crisis, but still falls somewhat short of the pre-crisis level. By contrast, the Czech rate has steadily been the best among regional countries at a level above 17 per cent, while the Polish figure stays at its historically lowest levels at approximately 10 per cent. The development of corporate investments in Slovakia is more volatile than in other CEE countries, and aside from a surge in 2013, it has fluctuated at around 13–14 per cent.

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Part I: International and national experiences in economic convergence

The low level of corporate investments in Hungary may stem from various factors, including the sustained decline in domestic demand in the aftermath of the crisis, unfavourable lending developments, slow deleveraging, the differences between companies producing for domestic consumption and for exports, the positive investment activity of foreign-owned companies settling in Hungary and producing for export, as well as the different corporate performance and behaviour between SMEs and large enterprises.

9.3. Financing situation After the crisis, corporate lending in Hungary fell well short of the level observed in other countries of the region. Since 2010 the developments in corporate credit have diverged from the experiences of regional peers. Lending resumed in the CEE countries in the second half of 2010, and by 2013 it exceeded the pre-crisis level in all countries. While surveys showed loosening lending conditions, the volume of corporate credit moves on a downward trend in Hungary (Chart 9-4). The reason behind the developments in corporate lending is deleveraging, which is still substantial in the country. Compared to the pre-crisis period, the lending capacity of the financial system weakened, which may have a sustained dampening effect on investment activity, especially in the corporate sector but in the household sector as well. Aggregate developments in corporate lending are characterised by a dual trend according to company size. Overall, lending in the SME sector expanded in the recent period, exceeding the previous yearâ&#x20AC;&#x2122;s level by 1.9 per cent last year. The lending programmes of the central bank, the FGS and the FGS+ interrupted the downward trend, without which lending in the SME sector would still be in negative territory as compared to 2009. Nevertheless, market-based lending is still anaemic,

â&#x20AC;&#x201D; 472 â&#x20AC;&#x201D;

9. Hungary’s position in terms of the determinants of growth potential – investments

which also hinders the comprehensive expansion of credit, thereby elevating the risk of a creditless recovery. The volume of outstanding loans of large enterprises was reduced considerably, which, however, may have been caused by a few larger, individual transactions, for example the replacement of domestic bank funding with direct parent company funding. Although this entails a reduction of credit, it does not pose a direct growth risk to Hungary. Chart 9-4: Outstanding corporate loans since the crisis 140

Per cent

140

100

Poland

Czech Republic

Hungary

2015

100

2014

110

2013

110

2012

120

2011

120

2010

130

2009

130

Slovakia

Note: October 2008 = 100 per cent Source: Statistics of the individual countries’ national central banks

The trends in corporate lending are characterised by limitations both from the demand and supply sides. Overall, external demand conditions are still fragile, while banks’ willingness to take risks continues to be characterised by cautiousness. The postponement of investment activity results in a downside risk in loan demand and thus

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Part I: International and national experiences in economic convergence

in lending as well. Stringent lending conditions loosen only slowly, as in the first two quarters of 2015, 30 and 17 per cent of banks eased their corporate lending conditions, but credit standards may still be deemed tight on the whole. This, however, cannot be considered a wideranging easing or opening up towards riskier companies, as the sizeable non-performing portfolio may continue to considerably reduce banks’ willingness to take risks. Domestic financing constraints affect large, foreign-owned enterprises less, while they exert a marked impact on the activity of small and medium-sized domestic enterprises. While large enterprises find alternative sources of funding easier, in the case of SMEs the role of non-bank financing – such as stock market, bond market and venture capital market funding – is extremely small. Still, looking ahead, the easing of credit standards and the central bank’s supportive lending programmes may ease financing constraints. As precautionary motives diminish, debt reduction will be much less problematic.

9.4. Corporate duality In the second half of the 2000s, the unfavourable demand conditions stemming from the attempts at fiscal consolidation led to the reduction of corporate investments even before the crisis. In the context of worsening profitability prospects, companies did not reduce their capital stock, which resulted in a drop in capacity utilisation, and eventually the postponement of new investments. The unfavourable situation was exacerbated by the strong negative shock of the global financial crisis, which caused a sustained slump in domestic demand. In addition, the future developments of demand and the prospects of the general macroeconomic and business environment became increasingly uncertain.

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9. Hungary’s position in terms of the determinants of growth potential – investments

In Hungary, the fall in aggregate demand after the crisis had a strong impact both on companies producing and providing services for the domestic market, and on exporting firms as well. The protracted deleveraging after the downturn, however, curbed mostly the investments of sectors producing for the domestic market, making their investment activity exceptionally low in the region. The investments of the sectors producing mostly for domestic demand dropped by one half between 2008 and 2013. In 2014, for the first time in 6 years, the investment rate started to rise again. The drop in the investment activity in the case of companies producing and providing services for the domestic market was considerably influenced and strengthened by the frequent changes in the domestic regulatory environment, which may have reduced predictability and entrepreneurship activity (Chart 9-5). In contrast to companies producing for the domestic market, exporting firms’ improving investment activity since the crisis can be, in large part, attributed to the fact that the imports from emerging markets gained momentum, and to the start of production of the new regional manufacturing capacities. In the case of these sectors, the main future risk is posed by the global slowdown: since the crisis, world trade has been far less sensitive to the pace of economic growth than in previous years. The exceptional growth of the quasi-fiscal sector’s investments that started in 2012 is predominantly linked to the pattern of European Union fund utilisation. Yet Hungarian growth was not unique. In Poland, for example, investments linked to the 2012 European Football Championship caused a temporary spike in the years after the crisis. In the case of the Czech Republic and Slovakia, however, the quasi-fiscal sector only played a minor role in investments.

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Part I: International and national experiences in economic convergence

Chart 9-5: Developments in corporate investments in the region by sectors 260

2005 = 100

260

Czech Republic

Hungary

Non-exporters

Poland Exporters

2013

2011

2009

2007

2005

2013

2011

2009

60 2007

2005

100

2013

120

100

2011

140

120

2009

140

2007

160

2005

180

160

2013

180

2011

200

2009

220

200

2007

240

220

2005

240

Slovakia Quasifiscal

According to the data on individual companies in the private sector, the distribution of investment activity by company size shows a similar duality as international trade activity. Investments in the private sector rose considerably in 2013. The decomposition, however, clearly shows that the increase in SMEs’ investments was similar to the growth contribution of large enterprises, although the former is mainly to be explained with its low base. Large enterprises’ investments reached the pre-crisis levels in 2013, while SMEs’ activity was considerably below that (Chart 9-6). The firm-level data also underline the duality of the sector’s investment habits. Additional new investments are more frequent among exporting companies than among those not engaged in exports, and the same is true for the difference between large enterprises and SMEs. The investment rate relative to the capital stock was the highest in manufacturing and among exporting companies. The comparison based — 476 —

9. Hungary’s position in terms of the determinants of growth potential – investments

on company size shows that in 2013 SMEs’ investment rate was able to grow at a rate comparable to large enterprises, which may have demonstrated the investment-stimulating effect of the Funding for Growth Scheme (Endrész et al. 2015). Chart 9-6: Decomposition of domestic real investment growth in the private sector (contribution in percentage points) 40

Percentage point

–10

–20

–30

–40

–50

2006

2007 SMEs

2008

2009

2010

Big enterprises

2011

Classifiable

2012

2013

–50

Total

Source: MNB calculations based on National Tax and Customs Administration data

9.5. Competitiveness Finally, the moderate level of corporate investments may also reflect the perception of the domestic economy’s general business climate. According to international competitiveness reports (e.g. World Economic Forum, and World Bank), Hungary’s relative situation has worsened since the crisis. Although macroeconomic indicators have improved, this was offset by the deterioration of other competitiveness factors. — 477 —

Part I: International and national experiences in economic convergence

The index of the World Economic Forum (WEF) measures individual countries’ competitiveness and its 12 pillars (based partly on actual data and partly on surveys), taking into account micro and macroeconomic aspects with respect to the level of development of each economy. The WEF ranked Hungary 63rd in competitiveness this year, while last year the country was 60th out of 144 economies. Hungary’s competitiveness can be considered average globally, while in a European Union context the country is only 24th among the 28 Member States. With respect to the Visegrád countries, the Czech Republic (31st) and Poland (41st) are ranked higher, while Slovakia (67th) is ranked lower than Hungary. In terms of the level of development of infrastructure and labour market efficiency, Hungary was already ranked higher than the average of the other Visegrád countries last year, and this was true in this year’s survey as well. According to indicators measuring goods market efficiency and innovation, Hungary’s performance corresponds to the regional average. Hungary lags behind the regional average with respect to the tax burden, the debt-to-GDP ratio, healthcare and primary education, financial and capital market development, institutional background and business sophistication (Chart 9-7). The annual Doing Business Report published by the World Bank provides a comprehensive picture of countries’ business climate and institutional conditions. In the past year, Hungary slid down two places compared to its ranking two years ago, and is now 42nd. With respect to the Visegrád countries, Poland (25th), Slovakia (29th) and the Czech Republic (36th) are all ranked ahead of Hungary. It should be noted that Hungary is a world leader in the weight of international trade (1st), and is ranked relatively high in access to credit (19th), the enforcement of contracts (23rd), registering property (29th) and starting a new business (55th). However, compared to its regional peers, Hungary lags far

— 478 —

9. Hungary’s position in terms of the determinants of growth potential – investments

behind in bankruptcy proceedings (65th), the protection of minority investors (81st), the issuance of construction permits (88th), the rate of taxation (95th) and access to electricity (117th). Hungary’s performance compared to the highest ranked country improved slightly, but both Poland and Slovakia showed greater progress (Chart 9-7). Chart 9-7: Competitiveness of the Hungarian economy according to certain international rankings Ranking of Doing Business

Ranking of the World Economic Forum

Czech Republic

2015

2014

2013

2012

2011

2010

2009

2008

2007

Hungary

Note: *Predicted values based on own estimates. Source: World Economic Forum, World Bank

— 479 —

Poland

Slovakia

2016*

2015*

2014

2013

Ranking

2012

2011

2010

In percentage of the value of the frontier country

Part I: International and national experiences in economic convergence

9.6. Household investments Household investments in Hungary have exhibited a declining trend since 2009, dipping to 2.7 per cent of GDP by 2014. In contrast, household investments amount to 4.5 per cent in all of Hungary’s regional peers. Therefore Hungarian households’ investment activity is considerably lower than the regional average. In Hungary, the investment rate relative to GDP dropped from 5 to 2.5 per cent in the 4–5 years after the crisis, so it declined by 40–50 basis points in 5 years, while in the same period it was steadily above 4.5 per cent both in the Czech Republic, Poland and Slovakia. The decline in household investments in Hungary is driven by two different factors. First, in the pre-crisis period a significant portion of domestic household investments were realised from loans, particularly foreign currency loans, the resolution of which is an extremely slow process. After the crisis, the postponement of investments became one of the most important adjustment channels for households (Martonosi 2013). The excessive indebtedness of households is still a substantial factor, albeit to a decreasing extent. In parallel with the progress of deleveraging, the ratio of household investments remained the same, which can be attributed to the decline in the investment preferences of households that were affected by the crisis and became more cautious (Chart 9-8). Second, household investment activity is mainly linked to housing market investments. The long-term negative trend on the Hungarian housing market was halted in 2014, and a slow recovery started, but agents in the sector were increasingly characterised by a wait-and-see strategy, mainly because of the ever more stringent regulations, the growing administrative burden and expectations in connection with the VAT reduction of homes. Consequently, the number of new homes constructed and the construction permits issued diverged. The shortterm potential of the market may be substantial, which may be realised as early as 2016, after the recently announced government measures are implemented. — 480 —

9. Hungary’s position in terms of the determinants of growth potential – investments

Over the course of the coming years, the dampening effect of debt reduction on household investments may gradually decline, and therefore households’ investment activity may approximate the regional average. This may be supported by a moderate increase in households’ housing investments. A significant recovery is expected after the debt reduction of households is finished, which is also supported by the economic policy measures. Medium-term expectations on Hungary’s housing market may be shaped by the fact that the ageing population hinders the recovery of the housing market. Over the long term, the continued debt reduction of households and increasing real incomes may foster a steadily positive shift in direct investments (purchases) and indirect investments (renovations) in housing. Chart 9-8: Developments in households’ outstanding loans relative to disposable income 90

In percentage of total real disposable income

Czech Republic

Hungary

Poland

Source: Eurostat, central banks of the individual countries

— 481 —

Slovakia

2014

10 2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Part I: International and national experiences in economic convergence

9.7. Public investments Due to their lower import content, developments in public investments exert a significant short-term impact on the economy. In addition, the state can also have a long-term influence over the potential growth of the economy through certain investments (e.g. infrastructure, basic research) and their externalities. Fiscal consolidation was already attempted in Hungary even before the crisis, which restrained government investments. During the course of the 2008 financial crisis, Hungary was unable to offset the decline in the corporate sector through higher government spending due to the excessive government debt and budget deficit accumulated earlier. As a part of the fiscal retrenchment, public investments also diminished. In the period that followed the crisis, the upswing in public investments was mainly fuelled by the increasingly intense utilisation of EU funds. Public investments relative to GDP increased from 3.4 to 5.2 per cent between 2011 and 2014. There were significant differences between the regional countries with respect to the timing of EU fund use. In the Czech Republic and Slovakia, the utilisation of EU subsidies peaked in the middle of the 2007–2013 funding cycle. By contrast, the withdrawal of transfers gradually increased in Poland, while it was optimised to peak at the end of the cycle in Hungary. The proportion of public investments only showed an upward trend in Hungary. In the Czech Republic, it has been on the decline since the crisis (2009). In Poland, prior to the European Football Championship it increased to 6 per cent by 2011, but it has decreased since then. Finally, in Slovakia it has been steadily around 3 per cent of GDP. The base effect stemming from the fading of the previous programming period may lead to an exceptionally large decline in public investments in Hungary, in contrast to most of the regional countries (Chart 9-9).

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9. Hungary’s position in terms of the determinants of growth potential – investments

The decomposition of the European Union subsidies shows that the withdrawal of EU funds in connection with the corporate sector is poor in Hungary, and Hungary has utilised 60 per cent of the available EU funding for direct state participation and infrastructure development. Chart 9-9: Distribution of the utilisation of EU funds in Hungary by sectors and purposes 8

Percentage of GDP

–1

Direct transfers Government, operational Government, investment-related

2016*

2015*

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

Private, operational Private, investment-related Total

Note: Actual data until 2014, projection for 2015–2016. Source: MNB calculation

9.8. Conclusion Investments provide the basis for medium and long-term growth from the supply side of the economy. Although in Central and Eastern European countries investments amount to 20–25 per cent of the expenditure side of GDP, the Hungarian investment rate declined in all sectors in the second half of the 2000s – after the 2006 consolidation — 483 —

Part I: International and national experiences in economic convergence

– i.e. even before the crisis. In 2012–2013, a significant turnaround was observed in investment activity, and therefore the current total investment rate is close to the regional average. In examining the structure of the investment rate, it must be noted that corporate investments, which exert the greatest impact on the longer-term productivity potential of the economy, showed a stable trend even after the crisis. Since the launch of the Funding for Growth Scheme in 2013 domestic small and medium-sized enterprises also expanded their capacities. Demand conditions restrict the developments in corporate investments less and less, but a pick-up in activity requires further improvement in the financing situation and lending conditions. The domestic investment rate has been lower than the regional average in recent years, which was due to households’ substantially subdued investment activity as compared to the regional average. Households’ activity was considerably influenced by the need for debt reduction. The long-term negative trend on the domestic housing market was interrupted in 2014, and a slow recovery started, which is also supported by the recently announced government measures. Over the course of the coming years, the dampening effect of debt reduction on household investments will gradually fade, and thus households’ investment activity may approximate the regional average. In recent years, the upswing in public investments was mainly fuelled by the growing utilisation of EU funds. The decomposition of the European Union subsidies shows that in the recent period the drawdown of EU funds in connection with the corporate sector was moderate in Hungary. In order to achieve a sustained increase in the investment rate and to accomplish successful convergence, the proportion of subsidies granted to the private sector should be raised, and funds should be allocated to sectors that facilitate productivity growth.

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9. Hungary’s position in terms of the determinants of growth potential – investments

References Benczúr P. – Rátfai A. (2010): Economic fluctuations in Central and Eastern Europe: the facts. Applied Economics, 42(25), pp. 3279–3292. Gál P. (2007): growth?) MNB Bulletin, June 2007, pp. 12–21. Magyar Nemzeti Bank (2014): Inflation Report, June. Martonosi Á. (2013): of domestic investments), MNB Bulletin, January 2013, pp. 40–48. Munkácsi Zs. (2009): Kik exportálnak Magyarországon? Vállalati méret és külföldi tulajdon szerinti exportkoncentráció és a külföldi tulajdon hatása az exportorientációra (Who exports in Hungary? Export concentration by company size and foreign ownership, and the impact of foreign ownership on export concentration), MNB Bulletin, June, pp. 22–33. Endrész M. – Harasztosi P. – Lieli P. R. (2015): The Impact of the Magyar Nemzeti Bank’s Funding for Growth Scheme on Firm Level Investment, MNB Working Papers 2.

— 485 —

Hungary’s position in terms of the determinants of growth potential – productivity Péter Harasztosi – Péter Varga

The growth rate of productivity has been declining in the developed economies since the second half of the 2000s. In Hungary and the Central and Eastern European region, the process already started before the crisis, worsened as a result of the recession and grew slowly in the subsequent years. Of the processes determining Hungarian productivity, positive developments started to take shape in the area of employment. In the last three years, the number of people in employment has continuously increased in annual terms. Another measure of employment, the average number of hours worked per week, has decreased since EU accession in most countries of the CEE region, and thus in Hungary as well. Although since 2013 the negative trend appears to be faltering in this indicator as well, it is changing much more slowly than the number of people in employment. With improving employment statistics, per capita productivity returned to the pre-crisis level in 2011-2012 after the decline in 2009 and has been increasing ever since. The return to the pre-crisis level was still one of the slowest in a regional comparison. Productivity per working hour has been stagnating since 2009 and did not surpass its pre-crisis level before 2014. The increase in labour productivity measured in working hours is the slowest in Hungary among the Visegrád countries: the labour productivity of the other countries has been above the pre-crisis levels since 2012.

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10. Hungary’s position in terms of the determinants of growth potential – productivity

Similarly to labour productivity, total factor productivity was also impacted negatively by the crisis and this only started to grow again in the last two years. Examining manufacturing companies, it can be established that the role of individual productivity increase (TFP) is the most significant; companies achieved relatively smaller growth with the more efficient utilisation of the resources within the company, such as investment or hiring. The reallocation between the companies made a major contribution to the aggregate productivity increase after 2009. The reallocation took place primarily among the manufacturing industries rather than within specific industries. Productivity is a long-term determinant of economic growth. Productivity expresses the efficiency that helps the production factors generate output. This chapter examines the productivity of the Hungarian economy and Hungarian companies, comparing them with the processes in the Visegrád countries (Czech Republic, Poland, Romania and Slovakia). We examine the changes in the factors that determine productivity, the development of employment, value added and investments in the context of the countries and the key macroeconomic sectors. We also touch upon the issue how the resource allocation between the industries and the companies impacts growth in productivity. Moreover, we briefly discuss how productivity can be measured and what kinds of problems arise in relation with estimation.

10.1 Development of productivity and the components thereof since the crisis 10.1.1 Development of GDP

The growth of the Hungarian economy has lagged behind growth in the other Visegrád countries since 2005 (Chart 10-1). When comparing the sum of Hungary’s gross domestic product with the GDP growth of the neighbouring countries, it is clear that the Hungarian gross domestic product was relatively high before the crisis, but economic growth

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Part I: International and national experiences in economic convergence

was slower in the 2000s compared to the region, and only by 2014 did growth recover to the pre-crisis level of 2008, while it still lagged behind regional leaders by more than twenty percent. The recovery rate is similar to that of the Romanian economy; however, it lags behind the growth of the Czech, Slovakian or Polish economies, where the precrisis level was reached by 2010, at the latest. The deceleration of Hungarian GDP growth compared to the Visegrád countries can be seen in several sectors. The largest difference is in the construction industry, where the Visegrád countries recorded 75-percentage point higher GDP growth on average since 2004. A smaller, but still substantial lag can also be identified in manufacturing, as well as in retail and wholesale trade, which make a major contribution to overall GDP growth. There is also a significant shortfall in the growth of financial services (Chart 10-2). Chart 10-1: Real GDP growth compared to neighbouring countries 160

per cent

160

Hungary Poland

Slovakia Czech Republic

Note: 2004 = 100 per cent Source: Eurostat

— 488 —

Romania

2014

2013

2012

2011

2010

2009

100

2008

100

2007

120

2006

120

2005

140

2004

140

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-2: Sectoral GDP growth compared to the average for the Visegrád countries since 2004 20

Percentage point

20 0

Finance and insur. Manufacturing Info. and comm.

Trade, transp., hotels Real estate activities

2013

–100 2012

–100 2011

–80

2010

–80

2009

–60

2008

–60

2007

–40

2006

–40

2005

–20

2004

–20

Industry Construction

Source: Eurostat

In relation to the comparison of GDP with the neighbouring countries, it should be noted that there were significant differences (both in the output level and economic structure) during the economic transition period, which is also identifiable in the dynamics of convergence. The countries that implemented the reforms later (e.g. Romania) realised part of the productivity growth arising from the structural transformation of the economy in the second half of the 2000s, while these processes in Hungary were particularly important in the second half of the 1990s. Hence, in the following we attempt to identify the structural reasons for the deceleration of the Hungarian economy, relying on the HCSO’s detailed output side GDP statistics, broken down by sectors, as well as corporate balance sheet reports; these documents are available only up to 2013. The advantage of using corporate data is that they help identify the shocks that hit the individual companies or industries, which often have a tangible impact on the macroeconomic developments as well (Gabaix 2011).

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Part I: International and national experiences in economic convergence

The deceleration of manufacturing is attributable to almost all industries. Chart 10-3 shows the contribution of the individual industries to the total GDP growth of the manufacturing sector. It is worth mentioning that – albeit the weighting of manufacturing in the national economy has hardly changed since 2000 – the structure thereof has changed considerably. By 2013 the automotive industry and the production of machinery had become the two key sectors of manufacturing at the expense of the textile, clothing and food industries. An important consequence of the structural transformation within manufacturing is the change in Hungary’s exports structure. (See more details on this topic in the Box). Chart 10-3: Contribution to intra sector GDP growth of manufacturing industries in percentage points 15

Percentage point

Other manufacturing Vehicles and motors Electric and machinery equipment Computers, electronics, optics

2013

–17

2012

–17

2011

–13 2010

–9

–13 2009

–5

–9

2008

–5

2007

–1

2006

–1

2005

2004

2003

2002

Coke and oil Food industry [C] Manufacturing

Note: Food industry (10–12); Coke and oil (19); Computers, electronics, optics (26); Electric and machinery equipment (27–28); Vehicles and motors (29); Other Manufacturing (13–18, 20–25, 30–33). Sources: HCSO, MNB

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10. Hungary’s position in terms of the determinants of growth potential – productivity

Two sectors are key factors in the deceleration of the manufacturing sector after the crisis. On the one hand, since 2009 the contribution of the crude oil sector has been continuously and considerably negative. Here, factors playing an important role mainly included the high concentration of the sector, the price shocks impacting the individual companies and the global economic process, as well as the reallocation within the value chains connecting to the sector, for example outsourcing and reform of the trading activity. Another important industry that contribute to the slower growth was the electronics industry. Despite the positive contribution in 2011, the sector’s growth contribution has significantly decreased compared to past years. In this sector, the shutdown of Nokia’s plant in Komárom and the relapse impacting several important actors (e.g. Samsung, Bosch, NI Hungary) play an important role. In the electronics and machinery sector, key companies were transformed, hence these two sectors are analysed here together. Although between 2009 and 2011 they made a major positive contribution to growth, in 2012 and 2013 their growth contribution was moderate. The automotive industry has played an outstanding role in manufacturing growth since 2011. Growth was seen both at vehicle manufacturers and companies manufacturing automotive parts. In addition to Audi’s major growth contribution and the launch of manufacturing at Mercedes, by 2013 both Opel and Suzuki had also significantly expanded their production.100 Based on the balance sheet data related to 2014 the performance of the key companies improved further. Audi, Mercedes and Opel increased their business profit by

100

Opel Szentgotthárd Magyarország opened the Flex motor factory in 2012 and commenced series production in February 2012 (Source: Opel.hu). The Suzuki plant in Esztergom started the series production of the SX4 models in 2013. Source: Suzuki.hu.

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Part I: International and national experiences in economic convergence

4.6, 1.4 and 25.2 per cent, respectively. It was only Magyar Suzuki that closed its financial year with a result that fell short of 2013.101 Based on the growth decomposition, the slow growth in market services is primarily attributable to processes in the wholesale and retail sector. There is no such industry in the that is curbing GDP growth continuously and to a great degree; instead deceleration is affecting almost all sectors. On the other hand, due to the modest demand persisting since the crisis the income generation contribution of both the wholesale and retail trade, as well as of transportation, is smaller than between 2002 and 2007. More particularly, the decrease in GDP Chart 10-4: Contribution to intra sector GDP growth of market services sectors in percentage points 16

Percentage point

–12

Const. Retail Publ.

Mot. Trade Transp. Realest.

Wholes. Hotel. Telec.

2013

–8 2012

–8 2011

–4

2010

–4

2009

2008

2007

2006

2005

2004

2003

2002

Others. Market services

Note: Const. = Construction; Mot. Trade = Motor vehicle trade; Wholes. = Wholesale; Ret. = Retail; Transp. = Transport, post and storage; Hotel. = Hotels and Restaurants; Publ. = Publishing; Telec. = Telecommunication; Realest. = Real estate service; Others. = Other market services. Source: HCSO, MNB

101

Source: http://e-beszamolo.im.gov.hu/

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10. Hungary’s position in terms of the determinants of growth potential – productivity

in 2009 is primarily attributable to the downturn in wholesale trading determined by individual corporate shocks (Chart 10-4). The dynamics may have reflected the global or domestic intra-group optimisation of the sector’s largest companies102 better than the processes of the sector’s actual earnings potential.

10.1.2 Employment trends

As a result of the crisis, Hungarian employment fell by roughly 5 per cent compared to 2004, but in the last three years it has posted a continuous growth on an annual basis. With the exception of Romania and Hungary, employment returned to nearly pre-crisis levels in all economies. In contrast to employment, the average number of hours worked per week has decreased since EU accession in most of the countries, and thus in Hungary as well. The frequency of part-time employment increased in Hungary as a result of the crisis, which may partially be due to the changes in the labour market institutional system (the new Labour Code). Thus, the volume of hours worked increased at a slower rate than employment and reached the pre-crisis level (Charts 10-5.a and 10-5.b). The slower growth of Hungarian employment compared to the Visegrád countries can be observed in several sectors. Charts 10-6.a and 10-6.b summarise the sectoral processes. Similarly to GDP, in a regional comparison, the largest deceleration in growth can be observed in construction, although the lag compared to the region has gradually decreased in recent years. On the other hand, employment growth is slower in retail and wholesale trade, manufacturing and in financial services compared to the other countries of the region. The only sector that posted employment growth measured in working hours that is more dynamic than in the rest of region is real estate transactions.

102

Amongst others MVM Földgáz Trade Zrt, Fibria Trading International Kft, Glencore Grain. Source: Hvg.hu/top500

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Part I: International and national experiences in economic convergence

Chart 10-5.a: Number of employed and hours worked since 2004 120

per cent

120

Hungary Poland

Slovakia Czech Republic

2014

2013

2012

2011

100

2010

100

2009

105

2008

105

2007

110

2006

110

2005

115

2004

115

Romania

Note: 2004 = 100 per cent. Source: Eurostat

Chart 10-5.b: Number of employed and hours worked since 2004, by hours worked 120

per cent

120

Hungary Poland

Slovakia Czech Republic

Note: 2004 = 100 per cent. Source: Eurostat

â&#x20AC;&#x201D; 494 â&#x20AC;&#x201D;

Romania

2014

90 2013

2012

2011

100

2010

100

2009

105

2008

105

2007

110

2006

110

2005

115

2004

115

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-6.a: Sectoral employment growth compared to the average of the Visegrád countries since 2004 20

Percentage point

Finance and insur. Construction Real estate activ.

2013

2012

2011

2010

2009

2008

2007

–40

2006

–40

2005

–20

2004

–20

Manufacturing Trade, transp., hotels

Industry Info. and comm.

Source: Eurostat

Chart 10-6.b: Sectoral employment growth compared to the average of the Visegrád countries since 2004, by hours worked 90

Percentage point

Finance and insur. Construction Real estate activ.

Industry Info. and comm.

Source: Eurostat

— 495 —

2013

2012

2011

2010

2009

2008

2007

–60

2006

–60

2005

–30

2004

–30

Manufacturing Trade, transp., hotels

Part I: International and national experiences in economic convergence

Box 10-1: Indicators used to measure productivity

Productivity can be captured by a variety of indicators depending on the respect in which the production process is examined. The most commonly used measure is labour productivity, which measures output per working hour or employee. Its advantage is that the quantitative measurement of labour as a factor of production is evident, while output per working hour does not capture the contribution of other factors to output, the efficiency of the allocation of production factors, the technological components or the labour intensity (Mark 1986). Several problems of measuring productivity are known, some of which are highlighted here. Firstly, it is important to measure the individual factors in an accurate and comparable manner. A good example of this is the comparison of the capital value of machine pools from investments waves implemented in different years among the enterprises (OECD, 2009). Secondly, as the production factors reflect either an annual average (e.g. headcount) or a year-end status (capital stock), the efficiency increase of the enterprise (under fixed factors) and the investment implemented as a result of the productivity shock cannot be separated from each other. A solution for the problem is offered by, amongst others, Olley and Pakes (1996), Levinsohn and Petrin (2003), and recently also by Wooldridge (2009). The total productivity factor (TFP) may also be used for the more comprehensive measurement of productivity, which may remedy the aforementioned shortcomings.103 Thus, the efficiency and degree of capital absorption compared to labour may be taken into account. The total factor productivity approaches assume the existence of an identical production function within a narrow industry. That is, it assumes, for example, that the small and large enterprises use very similar or identical production technology, which is not necessarily true. This same

103

TFP – Total Factor Productivity or MFP – Multi Factor Productivity

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10. Hungary’s position in terms of the determinants of growth potential – productivity

argument may be also valid in the context of the domestic and foreignowned enterprises. It is worth mentioning that during the calculation of the change in labour productivity and in TFP the real value added is compared in time within the company. The comparison becomes the more difficult, the higher the number and the more specialised products and services a company sells, as it is more difficult to separate the price change from the value change. For example, in this context it is easier to compare two cement plants (Syverson 2004) than two IT service companies.

10.1.3 Labour productivity trends

Per capita productivity returned to the pre-crisis level in 2011–2012 after the decline in 2009, and it has been increasing ever since. Hungary was one of the slowest to return to the pre-crisis level. Productivity per working hour has been stagnating since 2009 and did not reach its pre-crisis level before 2014. The increase in labour productivity is the slowest in Hungary among the Visegrád countries, while the labour productivity of the other countries has been above the pre-crisis levels since 2012 (Charts 10-7.a and 10-7.b). At the sector level, the development of the Hungarian labour productivity can be also compared to the average performance of the region (Charts 10-8.a and 10-8.b). Productivity per capita shows the largest lag compared to the regional growth in financial services, construction and manufacturing. This lag can also be identified in productivity per working hour. The smallest deceleration in productivity can be observed in the information, communication, trade and transportation sectors. Per capita and per working hour productivity differ considerably in the real estate sector, which is primarily attributable to the higher number of working hours due to the real estate market recovery after the crisis.

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Part I: International and national experiences in economic convergence

Chart 10-7.a: Real labour productivity, per employee

Hungary Slovakia

Poland Romania

2014

2013

2012

2011

2010

per cent

2009

per cent

2008

125 120 115 110 105 100 95 90

Czech Republic

Note: 2008 = 100 per cent. Source: Eurostat

Chart 10-7.b: Real labour productivity, per hours worked

Hungary Slovakia

Poland Romania

Note: 2008 = 100 per cent. Source: Eurostat

â&#x20AC;&#x201D; 498 â&#x20AC;&#x201D;

Czech Republic

2014

2013

2012

2011

2010

per cent

2009

per cent

2008

125 120 115 110 105 100 95 90

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-8.a: Sectoral productivity growth compared to the average of the Visegrád countries since 2004 20

Percentage point

20 0

Construction Industry Manufacturing Trade, transport, hotels

2013

2012

2011

2010

2009

–60

2008

–60

2007

–40

2006

–40

2005

–20

2004

–20

Finance and insurance Info. and communication Real estate activities

Sources: Eurostat, MNB calculation

Chart 10-8.b: Sectoral productivity growth compared to the average of the Visegrád countries since 2004, by hours worked 20

Percentage point

20 0

Construction Industry Manufacturing Trade, transport, hotels

Finance and insurance Info. and communication Real estate activities

Sources: Eurostat, MNB calculation

— 499 —

2013

2012

2011

–80

2010

–80

2009

–60

2008

–60

2007

–40

2006

–40

2005

–20

2004

–20

Part I: International and national experiences in economic convergence

The Polish economy was not shaken by crisis in terms of labour productivity; in Romania (as later becomes clear from the sectoral and micro-level decomposition) productivity has considerably increased due to the info-communication (ICT) sector and to the expansion of ICTintensive sectors. In the case of Hungary and the Czech Republic, the expansion of productivity continuously falls short of the EU average, but the deceleration is not so strong as in the case of the Romanian economy. In the period between 2010 and 2014, average productivity growth significantly decreased in the region, and more particularly Hungary posted a negative average. Additionally, in the early 2010s, a further decline was observed in productivity, although with an outstanding increase in labour, compared to the regional countries (Chart 10-9). The value added decreased along a similar trend in the countries of the region, with the exception of Poland and Romania: in the former, a quick rebound in productivity was observed, whilst in the latter employment already decreased in the period 2001–2007 and this process continued after the crisis as well. In the case of the Czech Republic and Slovakia, there was no employment growth, while in Hungary and Poland the employment growth rate was positive. In the case of manufacturing, there was a moderate decrease in productivity growth as the regional average, and the negative contribution of employment significantly reduced the sector’s value added. Hungarian manufacturing productivity continued to increase in the period of 2010–2014. The picture is distinctive at the level of the individual countries as in the case of the aggregate decomposition. The productivity decline is somewhat smaller; in the case of Romania the trend reversal suggests structural reform in the sector, as production must have become less labour-intensive (Chart 10-10).

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10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-9: Decomposition of value added growth in the national economy: regional comparison

Employment Productivity

10 8 6 4 2 0 –2 –4

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

Per cent

2010–2014

2008–2009

Per cent

2001–2007

10 8 6 4 2 0 –2 –4

Value added Average productivity growth

Sources: Eurostat, MNB calculations

Chart 10-10: Decomposition of value added growth in manufacturing: regional comparison

CZ Employment Productivity

Value added Average productivity growth

Source: Eurostat, MNB calculations

— 501 —

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

Per cent

2010–2014

2008–2009

Per cent

2001–2007

15 10 5 0 –5 –10 –15

Part I: International and national experiences in economic convergence

Chart 10-11: Decomposition of value added growth in market services: regional comparison

CZ Employment Productivity

15 10 5 0 –5 –10 –15

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

2010–2014

2008–2009

2001–2007

Per cent

2010–2014

2008–2009

Per cent

2001–2007

15 10 5 0 –5 –10 –15

Value added Average productivity growth

Source: Eurostat, MNB calculations

In Hungary, productivity growth in market services posted a stronger decline than in the manufacturing sector in 2008–2009, but remained positive. With the exception of the Czech Republic, Hungary and Romania, the sector remained positive even after the crisis in the context of total valueadded growth. On the other hand, the growth rate in the market services sector decreased significantly (except in Poland). It is apparent that in most of the economies productivity growth has declined drastically compared to the pre-crisis period (Chart 10-11).

10.1.4 Total factor productivity

Total factor productivity (TFP) shows how many times the output of a company exceeds or falls short of the other company’s output in the same sector with the use of the same volume of capital and labour. Similarly to labour productivity, TFP was also impacted negatively by the crisis and the growth thereof only restarted in the last two years.

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10. Hungary’s position in terms of the determinants of growth potential – productivity

When assessing the production process, total factor productivity also considers the capital in addition to labour. In the 2000s, there was a considerable convergence to the fifteen most advance member states of the European Union, based on the aggregate TFP growth rates of the regional economies. Romania was clearly the vanguard of the region: by 2008 its productivity was one and a half times higher than in 2000. Apart from the Romanian economy, Slovakia also performed well, albeit for most of the period the Visegrád countries achieved a similar development. In the case of Hungary, the Czech Republic and Poland, productivity growth was already characterised by deceleration and stagnation in the pre-crisis years. Productivity in Poland increased considerably in the post-crisis period; and from the regional countries, Slovakia’s productivity also exceed the EU15. After the crisis the fastest growth in productivity was seen in the Romanian and Slovakian economies (Chart 10-12.a and 10-12.b). Chart 10-12.a: Aggregate TFP in the region per cent

per cent

100

Hungary Poland

Czech Republic Slovakia

Note: 2000 = 100 per cent. Source: EC AMECO database, MNB calculations

— 503 —

Romania EU15

2008

100 2007

110

2006

110

2005

120

2004

130

120

2003

130

2002

140

2001

150

140

2000

150

Part I: International and national experiences in economic convergence

Chart 10-12.b: Aggregate TFP in the region 115

per cent

115

Hungary Poland

Czech Republic Slovakia

2016

2015

90 2014

90 2013

2012

100

2011

105

100

2010

105

2009

110

2008

110

Romania EU15

Note: 2008 = 100 per cent. Source: EC AMECO database, MNB calculations

In the following, we examine the development of TFP in the context of companies, focusing on the manufacturing sector. With the help of corporate financial statements the GDP growth of manufacturing can be broken down to individual total factor productivity change and value added growth linked to the change of capital and labour force. The detailed description of the methodology is included in the study of Kátay and Wolf (2008).104 The efficiency of the conversion of production factors (capital and labour) into a product and the productive development thereof has a strong influence on the economic growth.105 In the period 2002–2007, GDP growth in the manufacturing sector was determined in each year primarily by the increase in total factor productivity at the individual level (Chart 10-13).This is well illustrated by the decomposition of the growth of the gross product produced by the manufacturing sector. For the decomposition we use the production function-based estimation procedure of Levinsohn and Petrin (2003). The analysis ignores the tobacco and oil industries, as due to the change in the accounting rules introduced in 2001 the corporate value added must not be recognised directly. 105 The problems of measuring corporate productivity and the empirical literature related to the topic is summarised best by Syverson (2008). 104

— 504 —

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-13: GDP and aggregate TFP growth in manufacturing 20

Per cent

2013

2012

2011

2010

2009

2008

2007

–30

2006

–30

2005

–20 2004

–20 2003

–10

2002

–10

Estimated growth of aggregate TFP, manufacturing GDP growth, manufacturing Note: Manufacturing net of the tobacco and oil industries. Sources: NTCA, HCSO, MNB

Apart from individual productivity growth, the growth via hiring is also significant. Although the growth via investment is essentially positive in almost every year, its impact is less than that of labour (Chart 10-14).106 Chart 10-14: Decomposition of manufacturing growth 25

Per cent

Labour contribution TFP growth

2013

–35

2012

–35

2011

–25 2010

–25 2009

–15

2008

–15

2007

–5

2006

–5

2005

2004

2003

2002

Capital contribution GDP growth (HCSO)

Sources: NTCA, HCSO, MNB

106

It is important to note that here the investment is calculated from the corporate level tangible asset change, which may differ from the whole-economy fixed investment, due to, for example, the secondary market of machinery and real estate.

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Part I: International and national experiences in economic convergence

On average for the period 2008–2013, GDP growth is primarily determined by the capital and – to almost the same degree – by the increase in labour force. The fixed investments in the automotive industry and metal processing implemented after 2010 play a key role in the positive impact of the capital and employment growth.107 The GDP of manufacturing increased on average by 0.5 percentage point in the period of 2008-2013 both by capital and employment growth.

10.2 Causes of the deceleration The slowdown in economic growth had already started in most countries before the crisis. Hungary was no exception in this regard. However, recovery from the crisis was also slower than in the case of the previous recessions. This chapter deals with the potential causes of the deceleration and the slow recovery.

10.2.1 Investments

One cause of the slowdown in productivity and growth may be that the growth rate of investments also declined and – in contrast to the recoveries from the previous recessions – remained at a low level. However, it should be noted that the decline in investments is also attributable to demand side and balance sheet adjustment reasons (Martonosi 2013). In Hungary, after many years of declining and the 2006 austerity measures, capital intensity is at the pre-crisis level. In the countries of the region – except in Poland – the volume of investments significantly decreased after the crisis (Chart 10-15a.). There are different reasons behind the falling investment rates. On the one hand, investment rate of the private sector is lower, even in a regional comparison, on the other hand, the balance sheet adjustment which took place in the household and corporate sector, and additionally 107

The productivity decline of the metal processing industry is attributable to the decrease in output levels, which impacts most companies of the sector.

— 506 —

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-15.a: Regional decomposition of GDP proportionate investment rates 35

Percentage of GDP

35 30

0 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2003–2005 2006–2008 2009 2010 2011 2012 2013 2014 2000–2002 2006–2008 2009 2010 2011 2012 2013 2014

Czech Rep.

Hungary Corporations Government

Poland

Slovakia

Households Total investment rate

Source: Eurostat, MNB calculations

Chart 10-15.b: Results of SME loan applications (2014) 100

Per cent

100

Hungary

Slovakia

EU28

Conditions not accepted by applicant Declined Source: European Commission (SAFE survey)

— 507 —

Poland

Czech Republic

Partially approved Total amount aproved

Part I: International and national experiences in economic convergence

the macroeconomic uncertainties and debt reduction by the corporate sector, restrained the pace of economic recovery. Furthermore, supply side credit burdens hampered SME sector investment (Chart 10-15b.). In 2013, a turnaround occurred in the regionally rather low investment activity, thanks to government investments between 2011 and 2015 accounting for up to two per cent of GDP growth, which is largely explained by intensified use of EU funding. The uncertainties in the global real economy and the higher country risks that followed the crisis may have also played a major role in the decline in investments. Many economists believe that foreign direct investments (FDI) play an important role in productivity and economic growth (Rivera-Batiz 1991). The uncertain economic environment may significantly lower the inflow of new foreign direct investments into the economy, and in certain cases it may even lead to disinvestment, which was observed throughout the region in the post-crisis years.

10.2.2. Human capital

As this report explains in Chapter 1, human capital expansion is one of the most important pillars of long-term growth. In addition to the deceleration of direct investments, growth in human capital also started to stagnate both in the developed OECD countries and in the CEE region. For example, in Great Britain the stagnation may have been caused by the declining level of education; as a result of the underskilled labour supply the companiesâ&#x20AC;&#x2122; strategy is shifted toward the less knowledge- and technology-intensive activities, which jeopardises the economic growth and the improvement of the living standards in the long run (Sisson 2014). Based on the data of the Penn World Table 8.1 and the study of Barro, Lee from 2012 the mean years of schooling of the population over the age of 15 significantly increased in the 1990s (in the case of Hungary by more than 18 per cent).

â&#x20AC;&#x201D; 508 â&#x20AC;&#x201D;

10. Hungary’s position in terms of the determinants of growth potential – productivity

10.2.3. Innovation processes

Innovation is an important growth driver and is also essential to lay the foundation for future growth. The typical measure of innovation activity is resources used for research and development (R&D); however, the concentration of R&D activity between firms is also an important factor, besides the total amount spent. We approach the analysis of Hungary’s innovation processes from two aspects and compare them to the countries in the region. Firstly, we examine the frequency of innovation activity. Secondly, we compare Hungary’s GDP-proportionate R&D spending with the figures of the region to get a view of the degree of investment in innovation. To answer the first question, the questionnaire-based database of EBRD–BEEPS108 can be used, which focuses on companies in the Central and Eastern European countries. The fifth wave of the survey (2011–2014) already contains questions related to innovations, which ask about product, process, organisational and marketing innovations. The BEEPS survey primarily focuses on the representative sampling of the manufacturing sector’s management activity. In the Visegrád region, they survey on average 380 companies per country. We try to obtain an overview of Hungarian companies’ innovation position by comparing the answers of the Hungarian sample with the answers provided by the companies from neighbouring countries. Of the four questions examining the activity of the last three years, the first one related to product innovation, i.e. introduction of new technology or use of new material (Chart 10-16.a). In Hungary, a barely more than one-fifth of respondents introduced a new product. Compared to the rest of the Eastern European countries, this is one of the lowest rates, particularly compared to the responses of Czech and Romanian companies.

108

Business Environment and Enterprise Performance Survey (BEEPS).

— 509 —

Part I: International and national experiences in economic convergence

Chart 10-16.a: Innovations in the years 2011-2014 – share of respondents (product innovation) 60

Per cent

0 SL

Sources: BEEPS database, MNB calculations

The second question asks about the use of a new production system and/or new sales channel (Chart 10-16.b). In Hungary merely a little below one-fifth of the respondents introduced a new production system, more than 70 per cent of which is product innovator. Chart 10-16.b: Innovations in the years 2011–2014 – share of respondents (prod./sales innovation) 40

Per cent

0 SL

Sources: BEEPS database, MNB calculations

— 510 —

10. Hungary’s position in terms of the determinants of growth potential – productivity

The third question relates to organisational innovation and the development of a new organisational-management structure, or reorganisation (Chart 10-16.c). This impacted 13 per cent of the Hungarian respondents, albeit eight per cent of them are product innovators, and reorganisation is usually not typical for product innovators. Compared to the other Eastern European countries the ratio of Hungarian innovators belongs to the lowest ones in this innovationrelated question as well. In the fourth question, related to marketing innovation, the Hungarian companies also show a similarly low activity. Merely 19 per cent of them introduced new marketing strategy (Chart 10-16.d). Chart 10-16.c: Innovations in the years 2011–2014 – share of respondents (organisational innovation) 45

Per cent

0 SL

Sources: BEEPS database, MNB calculations

— 511 —

Part I: International and national experiences in economic convergence

Chart 10-16.d: Innovations in the years 2011-2014 – share of respondents (marketing innovation) 50 45 40 35 30 25 20 15 10 5 0

Per cent

50 45 40 35 30 25 20 15 10 5 0

Sources: BEEPS database, MNB calculations

The innovation activity rate, which is low in a regional comparison, does not mean that the R&D expenditure is low as a per cent of GDP (Chart 10-17). Chart 10-17: R&D expenses to GDP, by sector 2.5

Per cent

2.5

2.0

1.5

1.0

0.5

0.0

EU15

Czech Republic Corporations Government Higher education

Hungary

Poland

Slovakia

Non-profit organisations Total

Source: Eurostat

— 512 —

0.0

10. Hungary’s position in terms of the determinants of growth potential – productivity

Hungary already spent almost 0.5 per cent of GDP on R&D before the crisis, and this ratio has been continuously increasing since 2008. In a regional comparison, this ratio is the second best after the Czech economy. It may follow from the innovation activity rate and the relation of the GDP-proportionate R&D spending that the Hungarian innovation is performed by a relatively few companies of high value. Thus, the R&D activity in Hungary is highly concentrated.

10.2.4 Reallocation processes

During reallocation, the distribution of production factors and market share among the companies changes. Its potential degree depends considerably on the distribution of productivity between the companies: the productivity growth achievable within the sector and by the resource reallocation among them is inherent in the heterogeneity of productivity. Both labour productivity and TFP show a significant variance even in a narrowly defined industry. In the case of Hungarian manufacturing companies, employing at least 5 persons, there is a seven-fold output difference on average between the companies in the lowest and highest productivity decile, calculating with the same volume of output. A similarly persistent heterogeneity, albeit of different degree, exists in the industries of other countries.109 For example, in the USA this difference is two-fold on average.110 Based on the labour productivity of the least and most productive companies and the difference between them, it is apparent that in Hungary the heterogeneity in terms of productivity decreases between the companies over time (Charts 10-18.a and 10-18.b). The process has two underlying impacts: the least productive companies achieve relatively higher productivity growth, and there is an average productivity growth due to the elimination of the worst companies. 109 110

Lopez–Garcia (2015). Syverson (2011).

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Part I: International and national experiences in economic convergence

Based on the positive impact, the reallocation appears to be stronger in manufacturing than among the market service companies (Chart 10-18.a). On the other hand, the formerly strong reallocation appears to decelerate after 2007 in both sectors. Chart 10-18.a: Difference in labour productivity of the highest and lowest

10.0

HUF – logscale

3.0 2.7

9.0

2.4

8.0

2.1

2013

2011

2009

2007

2005

2003

2001

1.5 1999

6.0 1997

1.8 1995

7.0

Lowest 10% Highest 10% Difference between highest and lowest decile (right-hand scale) Sources: NTCA, MNB calculations

Chart 10-18.b: Difference in labour productivity of the highest and lowest

10.0

HUF – logscale

3.0 2.7

9.0

2.4

8.0

2.1

Lowest 10% Highest 10% Difference between highest and lowest decile (right-hand scale) Sources: NTCA, MNB calculations

— 514 —

2013

2011

2009

2007

2005

2003

2001

1.5 1999

6.0 1997

1.8 1995

7.0

10. Hungary’s position in terms of the determinants of growth potential – productivity

Box 10-2: Examination methods of reallocation processes

In the absence of an international database, the regional reallocation processes can be examined by sector and enterprise size categories, focusing on the static allocative efficiency. We examine the static allocative efficiency relying on the methodology of Olley and Pakes (1996).111 The method examines the correlation between productivity and market share or employment compared to a random – usually even – distribution. For example to what degree it is true that the more productive sectors have higher market share. This can be best expressed by a correlation. The correlation does not necessarily express a distance from a desirable status, since the even distribution – compared to which the strength of the correlation is measured – is not necessarily good, as identical market share is assumed among the sectors. Hence, we focus primarily on the change in the correlation. The correlation increasing towards the positive values expresses that the more productive companies and sectors can obtain an increasing market share.

Static allocative efficiency is calculated in two ways: The first approach (Chart 10-19) permits the examination of the distribution among the sectors: the correlation between the weight of the sector in value added and the sector’s labour productivity is examined. In Hungary the index of the static reallocation increases, which means that the more efficient sectors make an increasing contribution to GDP. Although the result is in line with the results calculated from the enterprise data: we found positive reallocation impacts in both cases in 2010–2011. It should be noted that here we examine the entire market sphere and manufacturing is treated as one sector. In a regional comparison it is clear that a similar process takes place in Romania and Poland as well.

111

The Olley Pakes decomposition is used, amongst other, in the recently issued thematic publication of the European Commission (2013) examining business dynamics.

— 515 —

Part I: International and national experiences in economic convergence

Chart 10-19: Static reallocation across sectors of the economy 0.00

Correlation

0.00

–0.20

–0.25

Hungary Slovakia

Poland Romania

2014

–0.20 2013

–0.15

2012

–0.15

2011

–0.10

2010

–0.10

2009

–0.05

2008

–0.05

Czech Republic

Sources: Eurostat, MNB

Another approach to static allocative efficiency is the analysis of reallocation within the sector. The intra-sectoral reallocation by enterprise size is one of the most dynamic growth stimulating processes. This is also highlighted by a recently published OECD (2014)112 study, according to which the most dynamic growth is generated by the small, but mostly start-up companies, aged between 0 and 2 years. In the following, we examine the correlation within the sector between the productivity of various enterprise size categories and the weight of the size category’s value added in the sector. The enterprise size categories differentiate micro, small, medium and large enterprises.113 According to Eurostat data, almost 70 per cent of all employees in Hungary are employed by micro, small and medium-size companies. This ratio is similar in other Central and Eastern European countries as well (Chart 10-20.a).114 Of the examined countries, only Romania shows a structural difference in the ratio of the number of employees employed by micro and small companies relative to each other. Criscuolo et al. (2014). Here we use the employee number categories of 0 –9, 10 – 49, 50 – 249 and over 250 persons definition. 114 Without agrar sector and public services. 112 113

— 516 —

10. Hungary’s position in terms of the determinants of growth potential – productivity

100

Per cent

100

20 0

0 Czech Republic

Hungary 0–9

Poland 10–49

Romania 50–249

Slovakia

250+

Note: All sections Source: Eurostat

100

Per cent

100

20 0

0 Czech Republic

Hungary 0–9

Poland 10–49

Romania 50–249

Slovakia

250+

Note: All sections Source: Eurostat

Based on the percentage ratio of GDP produced by the corporate sector, the Hungarian structure – similarly to employment – does not differ significantly from the same statistics of the regional countries — 517 —

Part I: International and national experiences in economic convergence

(Chart 10-20.b). The structural distribution – i.e. a little more than half of GDP is produced by large enterprises – resembles the Czech and Polish economies the most. Of the examined countries, only Slovakia shows a structural difference as the GDP produced by large enterprises there is only about 35 per cent and the micro companies have the highest weight in production. Based on the employment and GDP distribution pattern, it is not obvious that the structural distribution would justify Hungary’s lower growth compared to the countries of the region. Apart from the similar value added and employment distribution there are also differences between the countries in the degree of the productivity of the companies of different size compared to each other. It is clear from the chart that the productivity of the micro and small companies considerably lags behind that of the large enterprises in all countries (Chart 10-21). Chart 10-21: Average labour productivity of enterprises compared to large enterprises, 2010–2014 average 90 80 70 60 50 40 30 20 10 0

Per cent

Czech Republic

Per cent

Hungary

Poland

Micro-

Romania

Small-

Note: Large companies = 100 per cent. Source: Eurostat

— 518 —

Slovakia Medium-sized

Germany

90 80 70 60 50 40 30 20 10 0

10. Hungary’s position in terms of the determinants of growth potential – productivity

The productivity of micro enterprises in Hungary on average for 2010–2014 is roughly one-quarter of that of Hungarian large enterprises, which is the second largest relative difference after Poland among the countries of the region. The productivity of Hungarian small and medium-sized enterprises is 55–70 per cent of that of the large enterprises, which is a difference that may be compared with the regional average. Analysis of the processes of the static allocative efficiency within the sector is possible by examining four sectors of the countries in the region based on the correlation between the productivity of the sector’s enterprise size categories and its weight in value added. The static efficiency allocation in the Hungarian manufacturing sector shows a high value, which is not reduced by the crisis either. In a regional comparison: the high efficiency is also typical for the other countries under review; the impact of the crisis in this sector does not affect the allocative efficiency or impacts it only to a small degree. The reallocation within manufacturing can be examined in more detail based on the Hungarian enterprise data, focusing on the total factor productivity. The manufacturing sector’s aggregate TFP growth can be divided into two parts: the weighted amount of individual efficiency growth and the reallocation following from the change in the individual enterprises’ participation in production and in their weight. Chart 10-22 compares the efficiency-increasing reallocation within the sector (by the 2-digit TEAOR code within the manufacturing sector) – when the employees and the capital flow from less productive to productive enterprises – with the reallocation among the sectors.

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Chart 10-22: Decomposition of manufacturing productivity reallocation 10

Per cent

Within sector

Between sectors

2013

2012

2011

2010

2009

–10

2008

–10

2007

–5

2006

–5

2005

2004

2003

2002

Reallocation

Sources: NTCA, HCSO, MNB calculations

In the period ending with the crisis, the intra-sector reallocation plays a more important role. More particularly, the food industry (especially in 2001–2003) and the manufacturing of electronic equipment (2003–2005) made an outstanding contribution. In terms of degree, the reallocation between the sectors has a relatively less important role in the period of 2002–2007. In the post-crisis period (2008–2013), within the reallocation the movement among the industries becomes more significant on average, particularly in the first half of the period. The reallocation is primarily attributable to the transformation in the electronics and machinery industries,115 while the automotive and food industries (in 2008–2009) are also characterised by productivity attributable to positive reallocation. In the intra-sector reallocation, 2013 shows a negative value; this is primarily due to the transformation of the food industry. 115

On important transformation in 2009 was that GE Zrt. was transformed into a limited liability company.

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10. Hungary’s position in terms of the determinants of growth potential – productivity

Box 10-3: Transformation of export structure

The economic crisis and the recovery processes, as well as the reallocation among the enterprises and the sectors, also have an effect on the export structure. The link between economic growth and export concentration is important in several respects. On the one hand, concentrated exports raises the risk that economic processes related to a single sector or depending on a single buyers’ market may strengthen and the eventual negative shocks may impact the entire economy. On the other hand, the increase in export diversification may indicate that an increasing number of companies or an increasing number of multiproduct companies are able to enter the global market, which may suggest an increase in productivity.116 Goods exports In a regional comparison, the concentration of Hungarian goods exports is among the highest. This is reflected in Chart 10-23.a, which shows the concentration of the export value by products,117 expressed by the Herfindahl index. Apart from the slightly increasing export concentration of Slovakia, the concentration ratio of the other countries in the region has been relatively stable since 2005. By contrast, the concentration of the Hungarian goods exports has decreased significantly since 2010. This decrease is attributable to two opposite underlying processes (Chart 10-24). The share of machinery and electronic equipment in export value decreased significantly after 2010. More particularly, it is primarily the contraction of the export ratio for two technical articles that are the key factors: the ratio of telephones and their accessories (HS8517) and the monitors and projectors (HS8528). In parallel with this, the ratio of the value of automotive exports has significantly increased in exports, which is in line with the higher

116 117

For more details, see Cadot et al. (2013). For the calculation of the concentration, we used the 2-digit Harmonised System nomenclature.

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automotive industry investment and productivity that commenced after 2009. However, it should be noted that after the ousting of the electronic products over time the chemical and plastic industry products are gaining increasing importance. Hungarian services exports are the least concentrated in the region, with no material change in its degree since 2005. Chart 10-23.a: Concentration of exports in goods 0.20

Herfindahl-index

0.20

Hungary Slovakia

Poland Romania

2014

2013

2012

0.00

2011

0.00

2010

0.05

2009

0.05

2008

0.10

2007

0.10

2006

0.15

2005

0.15

Czech Republic

Chart 10-23.b: Concentration of exports in services 0.40

Herfindahl-index

0.40

Hungary Slovakia

Poland Romania

groups. Sources: NTCA, HCSO, MNB calculations, Comext, UNCTAD

â&#x20AC;&#x201D; 522 â&#x20AC;&#x201D;

2014

2013

2012

0.00

2011

0.00

2010

0.10

2009

0.10

2008

0.20

2007

0.20

2006

0.30

2005

0.30

Czech Republic

10. Hungary’s position in terms of the determinants of growth potential – productivity

Chart 10-24: Share of most important product groups in the value of exports (2007–2014) Per cent

Per cent

60 45 30

Prepared food Chemicals Plastics and rubber

2014

2013

2012

2011

2010

2009

2008

2007

18 16 14 12 10 8 6 4 2 0

Machinery (right-hand scale) Vehicles Optical, medical instruments

Sources: Comext database, HS 2007, roman num. categories

Services exports Services exports accounts for an increasing part of global external trade. In Hungary these exports account for almost one-fifth of total exports, similar to the neighbouring countries. This ratio (10 per cent) is the lowest in the Visegrád countries, while it is the highest in Romania (22 per cent) on the average of the period of 2006–2014. Contrary to goods exports, the value of services exports did not decline to the same degree as goods exports as a result of the crisis. While the latter decreased by roughly 21 per cent from 2008 to 2009, services exports fell only by 5 per cent. However, there are significant differences compared to the EU27 average services exports structure. The services export linked to manufactured goods represents on average a much smaller weight in the EU27 countries, while in these countries the emphasis is rather on the export of financial and other business services.

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Part I: International and national experiences in economic convergence

Chart 10-25: Distribution of the value of exported services over service categories, 2010–2014 average 0

Hungary

30 Percentage point

Goods related services Transport Travel Construction Insurance and pension Financial services Intellectual property rights Telecommunications Other business services Cultural and recreat. services Government services V4 average

EU 27

Note: V4 = Czech Republic, Slovakia, Poland, Romania Source: UNCTAD

Foreign trade companies stand out among the rest of the enterprises in several respects. They are larger, more capital intensive, demonstrate higher productivity and pay considerably higher wages than the nonforeign trade companies. Export sales are much more concentrated than domestic sales, i.e. the gross exported value is controlled by a few companies. For examples, see the studies of Mayer and Ottaviano (2008) or Békés (2011). Services exporters stand out even from the exporters. They are the best and largest companies. Table 10-1 shows how many times the exporter enterprises are bigger and more productive compared to the non-exporters. While the goods-only and the services-only exporters employ almost four and seven times, respectively, as many employees as non-exporters, the companies that export both goods and services employ thirty times as many persons. There is a similar ranking also in labour productivity and TFP.

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10. Hungary’s position in terms of the determinants of growth potential – productivity

How many times bigger is Employment

Labor Productivity

TFP

3.7

1.9

1.7

Service exporter

4.4

3.6

Product & Service exporter

29.1

4.8

Product exporter

Source: Rariga J. (2015)

Services exports is a considerably concentrated activity. In the two sectors that provide the highest number of exporters – that is in manufacturing and trade – merely 13 per cent of the exporter companies sell services abroad. The share in exports of the largest services exporters (for example the 10 or 20 largest companies) is twice as high as that of goods exporters. The descriptive statistics show that although services exports play an important and increasing role in Hungary’s global competitiveness, only the largest and best Hungarian enterprises participate in this activity. The productivity requirements for a service provider to become an exporter and be competitive in the international markets are even more stringent than in the case of goods.

10.3 Conclusions It can be concluded that the economies of Hungary and other countries of the region are characterised by duality regarding productivity and that the productivity difference between small and large firms is relatively greater than in the developed members of the European Union. In the wake of the economic crisis, the reallocation processes slowed down, and the convergence of the productivity difference

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Part I: International and national experiences in economic convergence

between the least and the most productive companies has been sluggish. This phenomenon is explained by a combination of factors. On the one hand, the productivity expansion linked to the economic transformation phase following the fall of communism ended by the mid 2000s in the Hungarian economy. On the other hand, certain elements of the business environment may impede the efficient reallocation of resources in the process. Although new business start-ups in Hungary are relatively simple, the regulatory environment makes it difficult to start the operation, in addition the relatively slow liquidation practice the prevailing “zombie companies” hamper the process of productivity expansion and the cleaning of the firm portfolio. The previously shown financing constraints further inhibit the growth of businesses, as well as reducing the rate of aggregate fixed investments to GDP.

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10. Hungary’s position in terms of the determinants of growth potential – productivity

References Bétry, E. – Chich, M. – Ennouchy, P. – Faure, M.E. –Gaudy, L. (2015): The United Kingdom’s productivity puzzle, Trésor economics, No. 146. Békés G. – Muraközy B. – Harasztosi P. (2011): Firms and products in international trade: Evidence from Hungary, Economic Systems, Elsevier, vol. 35(1), pp. 4–24. Cadot, O. – Carrère, C. – Strauss-Kahn, V. (2013): Trade Diversification, Income, And Growth: What Do We Know? Journal of Economic Surveys, Wiley Blackwell, vol. 27(4), pp. 790–812, 09. Criscuolo, C. – N. Gal, P. – Menon, C. (2014): The Dynamics of Employment Growth New Evidence from 18 Countries, OECD Science, Technology and Industry Policy Papers No. 14. European Comission (EC) (2013): Product Market Review 2013: Financing the real economy, European economy 8/2013. Gabaix, X. (2011): The Granular Origins of Aggregate Fluctuations, Econometrica, Econometric Society, vol. 79(3), pp. 733–772, 05. Kátay G. – Wolf Z. (2008): Driving Factors of Growth in Hungary – a Decomposition Exercise, MNB Working Papers 2008/6, Magyar Nemzeti Bank. Levinsohn, J. – Petrin, A. (2003): Estimating Production Functions Using Inputs to Control for Unobservables, Review of Economic Studies, Wiley Blackwell, vol. 70(2), pp. 317–341, 04. Lopez-Garcia, P. – COMPNET team (2014): Micro-based evidence of EU competitiveness: the CompNet database Working Paper Series 1634, European Central Bank. Mayer, T. – Ottaviano, G. (2008): The Happy Few: The Internationalisation of European Firms, Intereconomics: Review of European Economic Policy, Springer, vol. 43(3), pp. 135–148. Mark, A. J. (1986): Problems encountered in measuring single- and multifactor productivity, Monthly Labor Review, December, 1986. Martonosi Á. (2013):

, MNB-Szemle, january 2013.

OECD (2009): Measuring Capital, OECD Manual, second edition. OECD (2015): The Future of Productivity, OECD books. ECO/CPE/WP1(2015)6 http://www.oecd.org/eco/growth/OECD-2015-The-future-of-productivity-book.pdf Olley, G. S. – Pakes, A. (1996): The Dynamics of Productivity in the Telecommunications Equipment Industry, Econometrica, Econometric Society, vol. 64(6), pp. 1263–1297. Pessoa, J. – van Reenen, J. (2014): The great British jobs and productivity mystery, Voxeu, June Rariga J. (2015): Szolgáltatásexport Magyarországon, MNB-kézirat Rivera-Batiz, F. – Rivera-Batiz, L. (1991): The Effects of Direct Foreign Investment in the Presence of Increasing Returns Due to Specialization, Journal of Development Economics, November 1991, 34(1-2), pp. 287–307.

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Part I: International and national experiences in economic convergence Sisson, K. (2014): The UK Productivity Puzzle – is employment relations the missing piece? Acas Policy Discussion papers, September 2014. Syverson, C. (2004): Market Structure and Productivity: A Concrete Example, Journal of Political Economy, University of Chicago Press, vol. 112(6), pp. 1181–1222., December. Syverson, C. (2011): What Determines Productivity? Journal of Economic Literature, American Economic Association, vol. 49(2), pp. 326–365, June. Uppenberg, K. (2011): Economic growth in the US and the EU a sectoral decomposition, EIB Papers, Vol. 16, No1, 2011 pp. 18–52. Wooldridge, J. M. (2009): On estimating firm-level production functions using proxy variables to control for unobservables, Economics Letters, Elsevier, vol. 104(3), pp. 112–114.

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Present situation and outlook for the banking system in Hungary Máté Bálint – Gábor Horváth

Based on its resilience to shocks and liquidity position, the Hungarian banking sector is in a sound condition. However the legacy of overheated lending leading up to the crisis, intensive deleveraging and substantial stocks of nonperforming loans in the realm of mortgage and commercial property lending continue to dampen lending and profitability prospects. Lending conditions, which remain tight, and the poor cost efficiency by international standards contribute to this to a large degree. The excessive rise in corporate lending characterised two sectors based on growth dynamics: the construction industry and the property sector. Project loans are an obstacle to a turnaround in market lending primarily due to the stock of non-performing loans, exacerbating procyclicality even after the crisis as a result, while deleveraging by banks affected each industry. The Hungarian corporate sector is currently under-funded, partly due to the small securities market for Hungarian corporate debt. In view of credit supply constraints, the risk of subdued credit demand due to loan applications rejected earlier still persists, coupled with the risk of a creditless recovery. The pre-crisis period of household lending in Hungary was characterised by the accumulation of risks, mainly unhedged exchange rate risk, which was the most relevant issue in terms of stability. Conversion removed this risk factor from household balance sheets, while the settlement significantly improved the quality of the portfolio; nevertheless, the stock of non-performing mortgage loans is still over HUF 1,000 billion. Early 2015 saw the introduction of significant regulatory changes geared towards establishing fair and prudent household lending and mitigating the related macroprudential risks. The — 529 —

Part I: International and national experiences in economic convergence

household loan portfolio has been undergoing erosion since 2010, but the negative trend reversed in 2013: by eliminating the impact of settlement, the rate of erosion exhibits a slow improvement, and the earlier overheated lending is not expected to return over the short term, given the prudent conduct of banks and customers. Cleaning the high volumes of non-performing loans is facilitated by MARK Zrt. in the corporate segment and by the NAMA and the institution of personal bankruptcy in the case of mortgage loans. Cleaner balance sheets and bank levy cuts both help the banking system to focus on lending activity and the generation of fair profits as sound, self-funding banks, with robust capital stocks and sufficient liquidity. Working in conjunction with transparent and responsible financial institutions, the central bank is committed to financial deepening in Hungary through the stimulation of prudent lending.

11.1 Introduction to the analysis of the banking system

The financial intermediary system links economic agents seeking stable and affordable funding and private and institutional savers and investors, to enable them to find investment opportunities aligned with their needs and risk tolerance. Needs are matched in the context of intermediation through maturity, interest or currency transformation, and by sharing and distributing (diversifying) risks. In the context of this process, the banking system plays a pivotal role, because as an institution specialising in risk assessment and management, it is able to mitigate credit, liquidity and market risks on the basis of a highly developed creditworthiness assessment and monitoring methodologies. Optimally, banks also accelerate the flow of capital between savers and borrowers, fostering access to funding for investments. By virtue of their access to international money markets, they can also facilitate the funding of domestic economic agents through financial intermediation between countries. Thanks to â&#x20AC;&#x201D; 530 â&#x20AC;&#x201D;

11. Present situation and outlook for the banking system in Hungary

their loss-absorbing capacity based on their capital reserves, institutions can mitigate the real economic impact of temporary shocks, while their access to central bank instruments can alleviate liquidity shocks during times of market turmoil. Compared to purely market-based financing, these offer cheaper and smoother financial intermediation among borrowers and savers. At the same time, from a macroeconomic perspective, through their lending activity, banks can also create money, thereby enabling the amount of money to be adjusted to economic agent needs according to the endogenous money theory (McLeay et al. 2014).

in an international comparison Per cent

Per cent

United States South Africa Peru Mexico Chile Colombia Philippines Malaysia Indonesia Korea, Rep. Australia Thailand Canada Sweden India Brazil Japan Norway Denmark Singapore Iceland Spain Netherlands Switzerland Poland Portugal Belgium Turkey China France Argentina Finland Czech Republic United Kingdom Ireland Italy Austria Greece Germany Hungary Slovenia Malta Slovak Republic Luxembourg

100 90 80 70 60 50 40 30 20 10 0

Countries outside Europe

100 90 80 70 60 50 40 30 20 10 0

European countries

Note: Based on 2011 data; European countries are indicated in red.

Bank funding is the traditionally predominant form of funding in the European financial sector. In Europe, it accounts for over 70 per cent of total funding within the entire economy (Noyer 2015). This is significantly higher compared to the practice on the American continent. Among the countries under review, the proportion of market financing is the highest in the USA (Chart 11-1), fostered by the creation of a unified capital market through decades of effort. There is also great diversity in terms of the weight of market financing across Europe. Bank â&#x20AC;&#x201D; 531 â&#x20AC;&#x201D;

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funding plays a stronger role in financing the economy in Hungary compared to the European average, and its small, underdeveloped capital market is extremely concentrated; therefore, aside from a few larger actors, capital market financing is not an alternative for corporations. Developing capital markets could be beneficial in terms of the diversification of alternative access to corporate funding and to make investment opportunities more attractive (Csáky 2015), but it has its limits in the context of the transformation of corporate liability structure. During a crisis of confidence or a real economic shock, the absence of restructuring opportunities, more procyclical and turbulent operation, weaker investor risk assessment methods, greater information asymmetry, and the limitations of the opportunity for forward-looking preventive regulation are all additional risks confirming that bank financing would remain predominant even if a European-scale capital markets union were established. On the basis of the above, risks perceived by banks, risk-taking capacity and risk appetite associated with bank lending and the cost of intermediation have a significant impact on Hungarian economic growth.

11.1.2 Risk-taking by banks

Excessive risk-taking – if not managed adequately – can exacerbate vulnerability to financial shocks. As witnessed in recent years, banking crises can have a severe, protracted negative effect on the stability of the financial intermediary system and economic growth. In addition, these negative impacts often contaminate other sectors, the labour market and other countries through foreign trade relations without discrimination. Before the crisis, bank balance sheets expanded to a significant extent and at a rapid pace on a global scale, but the banking system’s capital stock did not follow suit, broadly increasing the sector’s leverage. Due to the increased interconnectedness of financial systems, contagion also reached otherwise healthy banking systems, decreasing cross-border lending (Takats 2010). The loss of value of assets and the wave of sell-offs on the market of insufficiently liquid — 532 —

11. Present situation and outlook for the banking system in Hungary

financial products spread through a self-reinforcing process to the institutions funding market operation. This effect played an essential role in the spread of the crisis (Cifuentes–Ferrucci–Shin 2005). At the same time, the global deterioration of investor confidence in the banking system also contributed to this, exacerbated by the lack of transparency, as transparent operation would have enabled the assessment of the condition of banks. Parallel to a rise in liquidity and risk spreads and the mass closing of riskier positions, demand for safer investments grew significantly. The outflow from investments denominated in riskier currencies led to a substantial devaluation of these currencies, while creating an unsurmountable burden for borrowers through higher interests and weak aggregate demand, causing mass default on loans and thus swelling bank losses. The attempt to improve bank indicators and to restore confidence also impacted credit supply to healthy sectors due to higher aversion to risk. Banks’ risk aversion thus deepened the crisis by creating a negative recessionary spiral after the crisis. Distinguishing banks’ willingness and capacity to take risks is complicated and does not yield clear results. To investigate this topic, similarly to other central banks, the MNB attempted to identify the various supply components using a factor model.118 The most important information is expressed in two variables, referred to as factors. The value of the first factor is high when the credit risk of the existing credit portfolio is low, the interest and commission return on assets is high, the parent bank operates with high leverage and the ratio of liquid assets is low. When credit risks are low, banks have the opportunity to move towards riskier lending segments, while a higher level of the latter three indicators suggests that banks are willing to assume a larger lending volume and higher risks. Therefore, this factor is suitable for measuring willingness to lend. The level of the second factor increases when the ratio of liquid assets, the bank’s capital buffer and its interest and commission return on assets increase, and its leverage (both its own and the parent bank’s) decreases. Accordingly, this factor is 118

For more information see: MNB: Financial Stability Report, May 2015. Box: Lending capacity and willingness to lend – Supply factors at the banks

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Part I: International and national experiences in economic convergence

higher when the banks’ liquidity and capital position is more stable and their profitability is higher. Therefore, this factor is suitable for measuring lending capacity. The factor model reflects the overheated bank lending and risk-taking prevailing before the crisis, also reflected in negative lending capacity and the positive willingness to lend factor accompanying it (Chart 11-2). The accumulating risks were mainly concentrated in project financing, a subsegment of corporate lending, but were more generalised in household lending due to the high indebtedness and unhedged exchange rate risk. In the years following the crisis, banks’ lending capacity gradually improved, and the factor had become significantly positive by 2013, but was not followed by the willingness to lend factor. In other words, according to our results, willingness to lend restricts the expansion of credit on the supply side. Chart 11-2: Factors of the banking system 3

Willingness to lend

2015

2014

2013

2012

2011

2010

2009

2008

2007

–3

2006

–3

2005

–2

2004

–2

2003

–1

2002

–1

Lending capacity

Note: Factors measured in terms of number of standard deviations away from historical mean. Source: MNB estimate

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11. Present situation and outlook for the banking system in Hungary

As banks stepped on the brakes (in the form of shorter average maturities, stricter collateralisation requirements, a higher proportion of collateralised loans, the avoidance of expanding the existing customer base, and an increase in the available capital buffer and stocks of liquid assets) the cost of bank intermediation increased. The introduction of macroprudential rules also fundamentally increases the costs of bank intermediation, but these rules optimally become effective brakes during overheated phases of the economic cycle, playing a preventive role, and therefore do not deepen the recession during the cycle’s low periods. The crisis shed light on the crosscontaminations within the banking system and the systemic risks that remained concealed in bank balance sheets, in light of which bolstering the banking system’s general shock-absorbing capacity became even more important. In light of the experiences drawn from the crisis, the additional costs of carefully crafted rules incur far lower real economic losses in the long run compared to the potential crises that they endeavour to prevent (Borio 2010). At the same time, greater resilience improves predictability, allowing economic agents to make investment decisions based on more well-founded information, to more accurately plan the saving and borrowing phases of their activities, thereby improving economic performance. Sounder bank balance sheets and improved economic prospects in turn improve banks’ risk tolerance, and also restore financing capacity and willingness, which supports economic performance and will prevent the spread of alternative financing methods and primarily the “shadow banking system”. All of this, however, has not yet transpired in Hungary and many countries within the region, which are characterised by protracted balance sheet adjustment, which comes with severe real economic sacrifices, and the risk of a creditless recovery still persists.

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Part I: International and national experiences in economic convergence

11.1.3 Creditless recovery

Eight years after the onset of the crisis, many European economies have failed to attain their pre-crisis output and unemployment levels. The recovery appears extremely fragile in the near future, while rebuilding the decreased production capacities and exceeding the precrisis output level would require an increase in investment. In addition, the risk of deflation still entails significant uncertainty. Therefore, at present it is extremely important that banks and other institutions of the financial intermediary system be able to finance economic recovery. Growth of lending to the private sector could substantially contribute to a post-crisis upswing in economic growth, although it is not a necessary precondition for it. Calvo et al. (2006) examined emerging economies and identified the so-called Phoenix Miracle, where GDP growth recovers quickly following a significant fallback without any remarkable credit expansion or capital inflow. By contrast, Abiad et al. (2011) refute the Phoenix Miracle by establishing that creditless recovery is also possible, but GDP growth in such cases is one third lower on average than if accompanied by an upswing in lending. Creditless recovery characterises 20 per cent of crises, and is rendered more probable if the downturn was caused by a credit boom and bank crisis. On this basis, the recovery from the 2008 crisis may materialise even without a pick-up in lending, but this is not desirable in terms of growth: it would engender significant protracted real economic impacts, restrain economic recovery and increase unemployment for a sustained period (Felcser – Körmendi 2010). Credit scarcity may restrain economic activity significantly and even result in a decline or reduction of capacities. Lending constraints impact the smaller, more vulnerable SME segment to a greater extent, as they are more severely hit by banks’ risk aversion and have limited access to alternatives to bank financing. In Hungary, due to the lack of development, the capital market was not able to mitigate the negative real economic impacts stemming from commercial bank deleveraging, as opposed to France or Portugal, which have developed corporate bond markets. — 536 —

11. Present situation and outlook for the banking system in Hungary

In investigating the topic of a creditless recovery, the level of economic agents’ indebtedness prior to the crisis is a key aspect. In the following section, we show that overheated lending was not systemically present in Hungary, aside from foreign currency household lending and the project loans typical of the construction industry and real estate projects, consisting of commercial property loans, which would justify the current rate of deleveraging.

11.2 Banking system attributes fostering balanced growth 11.2.1 Lending processes in Hungary

Europe’s recovery from the economic recession remains fragile, which impacts the euro area’s financial intermediary system and thus indirectly, the stability of the Hungarian banking system. Systemic risks remain high in economies to which European banks have significant exposure. Deflationary risks, anaemic growth and write-offs stemming from nonperforming loans hold back improvements in bank profitability and a pick-up in lending. A pronounced and protracted decline in private sector credit took place in many European countries following the recession (Chart 11-3). Although this can be regarded as a natural reversal in certain subsegments, i.e. a recovery process following an overheated lending cycle, there is significant deviation in terms of its degree among the various countries. The rate of deleveraging was higher on average in countries with more external debt (Estonia, Latvia, Lithuania, Hungary), while in the Central and Eastern European region, the Czech Republic, Poland and Slovakia saw an expansion in private sector debt from October 2008 to December 2015. In these countries, private sector debt as a percentage of GDP exceeded the traditionally higher Hungarian figure. In Hungary, private sector debt as a percentage of GDP has shrunk substantially since 2009, with a significant “gap” thus

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Part I: International and national experiences in economic convergence

emerging compared to the sound level estimated by the MNB and considered as the equilibrium level. Chart 11-3: Private sector credit as a percentage of GDP in an international comparison 120

Per cent

120

Bulgaria Latvia Slovak Republic

Czech Republic Lithuania Slovenia

Estonia Poland

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

100

2004

100

Hungary Romania

Source: ECB

11.2.1.1 Corporate lending processes in Hungary

The Hungarian corporate sector can be regarded as underfinanced (Chart 11-4), as although debt as a percentage of GDP is broadly in par with the VisegrĂĄd Group average (which is low by international standards), the euro area average is 2.5-3 times higher than the Hungarian figure. The small securities market embodying Hungarian corporate debt confirms these facts. This underfinanced characteristic is a factor inhibiting growth mainly in industries more reliant on (nonequity) funding, which have lower capital accumulation capacity (low cash inflow), but their profitable operation calls for proportionately higher investments and developments. These sectors include machine manufacturing, agriculture, information technology, transportation and carriage, and the construction industry (European Commission 2013). â&#x20AC;&#x201D; 538 â&#x20AC;&#x201D;

11. Present situation and outlook for the banking system in Hungary

In terms of company size, small enterprises with limited possibilities to provide collateral would be the most affected by the negative impacts of bank deleveraging, but the Funding for Growth Scheme significantly improved financing opportunities for the SME sector. Chart 11-4: Corporate loans as a percentage of GDP and developments of the structural lending gap 50

Per cent

Percentage point

–30

–15

Long-term trend Structural lending gap (right-hand scale)

2015

–10

2014

–20

2013

–5

2012

–10

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

Corporate loan to GDP

Note: Estimation of the long-term trend with the use of multi-variable Hodrick-Prescott

Overheated rise in corporate lending characterised two sectors based on an analysis of growth dynamics before the crisis: the construction industry and the real estate sector. The volume of project loans, predominantly in the form of foreign currency-based financing, represented a significant portion of these two sectors. This dampened the return on completed projects through exchange rate risk. Before the crisis, the stock of project loans increased at a faster pace than the overall stock of corporate credit, and thus project financing substantially exacerbated the banking system’s procyclical behaviour. In the wake of the crisis, demand also dropped off substantially, which, coupled with — 539 —

Part I: International and national experiences in economic convergence

the negative outcomes of risky financing, resulted in many defaults on loans, reflected in the sectoral bankruptcy rates as well. The default rate on project finance loans continues to be relatively high, due to the difficult loan collateral enforcement generally characteristic of projects (Chart 11-5). Project loans are significantly restraining a turnaround in market lending through the stock of nonperforming loans and thus continuing to exacerbate procyclicality even after the crisis. The ratio of project financing loans in 2015 Q2 was 27 per cent of the total nonfinancial corporate loan portfolio, while nonperforming project loans accounted for 53 per cent of nonperforming corporate loans. Chart 11-5: Developments in the stock of commercial real estate loans by currency denomination 2,500

Billion HUF

Per cent

2,000

1,500

1,000

500

10 0

HUF

2015

2014

2013

2012

2011

2010

2009

2008

2007

–20 2006

–1,000 2005

–10

2004

–500

Growth rate (right-hand scale)

Source: MNB

Meanwhile, deleveraging by banks affected every industry. The stock of manufacturing industry credit as a percentage of value added shrank to nearly half (Chart 11-6) relative to 2009, despite already — 540 —

11. Present situation and outlook for the banking system in Hungary

being low by international standards at the time. The level of credit taken on by corporations also exhibits geographic heterogeneity. The stock of credit of various regions in Hungary reflects loan penetration inequalities when compared to their contribution to national GDP. The stock of credit in Northern Hungary and the Transdanubian regions is low relative to their economic weight, while Central Hungary absorbs a relatively large amount of credit. Chart 11-6: Outstanding loans as a percentage of GDP by industry 350

Per cent

350

300

250

200

150

100

2000

2002

2004

2006

2008

2010

2012

2014

Agriculture, forestry and fishing Mining, and utilities Manufacturing Construction Wholesale and retail trade, repair, accomodation and food service activities Transportation, storage Real estate activities Other activities Note: 4-quarter moving value added, 2000 = 100 per cent. Source: MNB

Positive signs of a turnaround in lending materialised towards the end of 2014. Credit conditions eased with the revival in competition, and interest rates on loans are decreasing as the key policy rate is cut further. Banksâ&#x20AC;&#x2122; credit conditions have broadly eased since 2014 Q4 (Chart 11-7), accompanied by a decline in the cost of finance. Among the factors contributing to this change, respondent banks mentioned market share objectives and the intensification of the competitive situation â&#x20AC;&#x201D; 541 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

in the highest ratio; at the same time, the improvement in economic prospects and the favourable liquidity and capital position of banks also contributed to easing. As competition rises, banks are gradually seeing a greater interest in increasing lending in order to retain their market share. However, the practice in Hungary is characterised by banks attempting to increase their loan portfolios through customers with sound creditworthiness who already had bank loans, and therefore the growing competition is not primarily reflected in new customer acquisition. Chart 11-7: Changes in credit conditions in the corporate segment Per cent

Per cent

100

2015Q1

2014Q1

2013Q1

2012Q1

–60

2011Q1

–60

–40 2010Q1

–40 Q3

–20

2009Q1

–20

2008H1

EASING

TIGHTENING

100

Spread of interest rates over cost of funds Premium on risky loans Collateralisation requirements Required credit score Maximum maturity Maximum size of credit line Changes in credit conditions Note: Net percentage balance of respondents tightening/easing credit conditions weighted by market share. Source: MNB, based on the answers of respondent banks

— 542 —

11. Present situation and outlook for the banking system in Hungary

The easing of lending standards adopted earlier by banks did not lead to a spectacular lending boom, also due to the fact that conditions are still far stricter compared to their pre-crisis level. This is also reflected in the default rate on loans granted after the crisis, which although contributes to the consolidation of the ratio of nonperforming loans, may also come at the price of growth sacrifices through low risk appetite. Developments in the reference interest rate strongly shape the interest burdens of corporate forint loans. This characteristically stems partly from the rapid repricing driven by the typically floating interest rate scheme, and partly – as interest rate spreads vary between 1 and 4 percentage points – from the high proportion of the reference interest within the overall interest. Thanks to the cycle of central bank base rate cuts begun in 2012, the interest rate on corporate forint loans has decreased substantially (Chart 11-8), which contributed to mitigating Chart 11-8: Interest rates on new corporate loans 14

Per cent

2 0

0 2008

2009

2010

2011

2012

Forint interest rate < 1M EUR Euro interest rate < 1M EUR Overdraft (HUF)

Source: MNB

— 543 —

2013

2014

2015

Forint interest rate > 1M EUR Euro interest rate > 1M EUR

Part I: International and national experiences in economic convergence

the negative impacts of the crisis through the channel of corporate lending. On the one hand, the decline in the interest rate level has a stimulating effect on the demand side through the improvement in the net present value of the project to be funded, on the other hand, it also shapes the supply side, making a larger number of enterprises creditworthy given the low interest rate level. Thanks to the low interest rate level, the average cost of finance for enterprises in Hungary can be regarded as favourable even by regional standards. Based on growing demand, there are also credit supply side obstacles to an increase in outstanding credit. According to the banks participating in the Lending survey, growing demand continues to be focused on forint loans, coupled with a decrease in demand for foreign currency loans. A significant portion of respondent banks revealed a perceived pick-up in demand for long-term loans (Chart 11-9). Among the banks, a higher ratio of respondents anticipated an increase in demand from small and micro enterprises. An increase in European tender opportunities may contribute to rising demand in the near future through advance funding and the financing of own contributions. However, there is a risk that a substantial portion of corporations, which currently fail to meet a sufficient level of creditworthiness, are unable or unwilling to contribute with their credit demand to the market. An improvement in business prospects and a more pronounced easing of credit conditions could lead to a broader upturn in demand. With the easing of price and non-price terms and conditions and the trend-like rise in loan demand, the credit growth rate still falls substantially short (Chart 11-10) of the value required for convergence, although signs suggesting a positive turn have been seen. There are also substantial credit supply constraints to an increase in the stock of credit. In addition, with the phasing out of the FGS, fully marketbased lending must assume a sustained growth trajectory in order to enable banks to support the economy through their credit supply. In its discussion paper entitled the “Hungarian Banking System in Transition” (MNB 2013a). — 544 —

11. Present situation and outlook for the banking system in Hungary

Chart 11-9: Changes in loan demand in the corporate segment Per cent

Per cent

100

–100

Long-term loans Short-term loans

2015

–80 2014

–60

–80 2013

–60

2012

–40

2011

–40

2010

–20

2009

–20

2008

WEAKER

STRONGER

100

Long-term loans – expectations Short-term loans – expectations

Source: MNB, based on the answers of respondent banks

the MNB determined that the annual growth rate of the stock of credit capable of supporting sustainable economic growth is around 6 per cent and 7 per cent in the household and the corporate segment. As a longterm target, the 6-7 per cent growth rate seems perhaps excessively high in light of the growth rate of previous years, but if we increase the horizon under review, the figure is roughly on par with the average growth rate of earlier years. Looking back to examine an alternative case where the stock of credit as a percentage of GDP moves along the trajectory of the long-term trend, i.e. no overheated lending materialises on the basis of the credit gap, a 6-7 per cent growth rate could also be sustainable. To sustain an optimal credit growth rate, a supportive environment and balanced economic growth is necessary. Incorporating these factors, assuming the materialisation of the potential economic output, the average growth rate adjusted by the inflation target of the past 10 years would meet the set growth objective.

— 545 —

Part I: International and national experiences in economic convergence

Chart 11-10: Growth rate of credit to the corporate sector overall and to the SME sector

2015Q1

2014Q3

2014Q1

2013Q3

2013Q1

2012Q3

2012Q1

2011Q3

2011Q1

2010Q3

2010Q1

2009Q3

Per cent

2009Q1

2008Q3

Per cent

2008Q1

6 5 4 3 2 1 0 –1 –2 –3 –4

24 20 16 12 8 4 0 -4 -8 -12 –16

Corporate sector (MFI, Quarter on quarter) Corporate sector (MFI, Year on year, right-hand scale) SME sector (banking sector, Year on year, right-hand scale)

Note: In the case of the corporate sector, the time series is ions, while the SME data is based on estimated transactions from Q4 2013. Source: MNB

11.2.1.2 Household lending processes in Hungary

The pre-crisis period of household lending in Hungary was characterised by the accumulation of risks. The widespread rise of foreign currency based indebtedness, which presents a higher probability of default (Balás et al. 2015), is linked to 2004, on account of the extraordinarily rapid spread of CHF-based loans. Due to the historically stable HUF and CHF exchange rate, Hungary’s high base rate, expansionary fiscal policy and high, optimistic income expectations, exchange rate risk was broadly underestimated. The discontinuation of state interest subsidies on housing loans further contributed to demand for low interest loans. The spread of foreign currency loans did not only have a crowding-out effect; the stock of household credit also swelled substantially during this period (Chart 11-11). Due to overheated lending, the household segment became — 546 —

11. Present situation and outlook for the banking system in Hungary

severely indebted, departing from the equilibrium level, and all of this was coupled with the unforeseen risks of exchange rate fluctuations. Chart 11-11: Household loans as a percentage of GDP and developments of the structural lending gap 50

Per cent

Percentage point

2015

2014

2013

2012

2011

2010

2009

2008

2007

–15

2006

–30

2005

–10 2004

–20 2003

–5

2002

–10

Household loan to GDP Long-term trend Structural lending gap (right-hand scale)

After the crisis, the situation of household lending has been shaped by the significant realised exchange rate risk found on households’ balance sheets. Foreign currency loans amounted to 55 per cent of the total household loan portfolio in late 2014, while the majority of households was unable to naturally hedge their exposure to exchange rate risk. Following the forint’s depreciation against the Swiss franc, the ratio of nonperforming households slowly rose from 8 per cent in early 2010 to peak at 19 per cent during the second half of 2014, primarily due to higher payment-to-income ratios (Chart 11-12) and owing to the fact that during the period of large volume lending, the market situation created competition in terms of both price and non-price conditions that prompted banks to conclude contracts with less creditworthy — 547 —

Part I: International and national experiences in economic convergence

customers. The higher debt servicing burden of households grew into a financial stability risk, as banks had to write off substantial losses, and their portfolio quality deteriorated along with their profitability. Lending ground to a halt: borrowing conditions tightened while the appetite to borrow also fell substantially. Chart 11-12: Average maturity, LTV and initial estimated PTI ratios of new housing loans Per cent

Per cent

EUR lending

80 76 72 68 64 60 56 52 48 44 40

2015

2014

2013

2012

2011

2010

2009

HUF lending

2008

2007

2006

CHF lending

2005

30 28 26 24 22 20 18 16 14 12 10

PTI, payment to income (per cent) LTV, loan to value (right-hand scale) Maturity (years) Note: Maturity and PTI are 3 quarter moving averages. PTI is approximated with average wages and original instalments. Source: MNB

Numerous state measures were introduced in an effort to mitigate householdsâ&#x20AC;&#x2122; debt burden and to resolve their financial situation; these include the Early Repayment Programme, an extension of the moratorium on evictions, a restriction on foreclosures, the exchange rate cap scheme, the settlement and conversion, and the institution of personal bankruptcy introduced in September 2015. Unhedged exchange rate risk, as the most significant risk to stability, was removed from household balance sheets through forint conversion. In accordance with the act on settlement and conversion, foreign currency mortgage loans were converted to forint in 2015 Q1, and unilateral â&#x20AC;&#x201D; 548 â&#x20AC;&#x201D;

11. Present situation and outlook for the banking system in Hungary

contract amendments were pronounced null and void. As a result, the ratio of foreign currency loans shrank to less than 5 per cent of the total household loan portfolio, further reduced by the forint conversion of vehicle loans, to finally approach 1 per cent (Chart 11-13). Chart 11-13: Ratio of foreign currency loans in the household loan portfolio 80

Per cent

Czech Slovakia Bulgaria Republic

Poland Romania Hungary Austria

2004 2008 2014 After car loans FX-conversion

Croatia *in 2010

March 2015

Source: MNB, and other central banks

In addition, early 2015 saw the introduction of significant regulatory changes geared towards establishing fair and prudent household lending and mitigating the related macroprudential risk. In the set of conditions for prudent lending, the MNB Decree on the debt cap regulation came into force on 1 January 2015 in an effort to prevent excessive household indebtedness in the future. Based on the regulation, the payment-to-income ratio (PTI) of forint loans of over HUF 200,000 at the time of contract conclusion is capped at 50 per cent for incomes of under HUF 400,000, and at 60 per cent for incomes over HUF 400,000. The decree also stipulates that the loan amount of mortgage loans cannot exceed 80 per cent of collateral value (LTV). Banks’ lending experts have confirmed the MNB’s position that the impact of the above rules has so far not been very effective in restraining lending, — 549 —

Part I: International and national experiences in economic convergence

as the collateral and minimum credit score requirements applied in practice are stricter than required by the decree, and therefore the entry into force of the regulation did not result in a higher volume of rejected loan applications. Looking forward, as a preventive tool, they create an effective obstacle to sound lending developing into excessive debt in the future. Chart 11-14: Changes in credit conditions in the household segment Per cent

Per cent

100

–100

Housing loans Consumer loans

2015

–80 2014

–80 2013

–60

2012

–60

2011

–40

2010

–20

–40

2009

–20

2008

EASING

TIGHTENING

100

Housing loans – expectations Consumer loans – expectations

Source: MNB, based on the answers of respondent banks.

Household interest rates on loans decreased substantially in the wake of key policy rate cuts and the introduction of the act on fair banking (Chart 11-15). The interest burden of loans converted to forint were thus also reduced, while predictability and certainty improved on a systemic level. However, the premium on housing loans still remains relatively high by international standards, due in large part to the high default ratio and banks’ restricted foreclosure options.

— 550 —

11. Present situation and outlook for the banking system in Hungary

Chart 11-15: Annual percentage rate of charge on new household loans 36

Per cent

Percentage point

2008

2009

2010

2011

2012

2013

2014

2015

Housing loans APR Home equity loans APR Other consumer loans APR Housing loans spread (right-hand scale) Home equity loans spread (right-hand scale) Note: Quarterly average of interest rates on newly disbursed loans. Source: MNB

The depreciation of the forint against the Swiss franc materialised in the form of growing repayment instalments and rising outstanding debt, which together put many households in a precarious position. As a natural process, a broad swathe of the population developed hostility towards borrowing, as confirmed by banks’ perceptions expressed in the lending survey. Starting from the second half of 2013, a recovery process can be observed in this regard, with loan demand exhibiting trend-like growth based on banks’ responses to the quarterly survey (Chart 11-16).

— 551 —

Part I: International and national experiences in economic convergence

Chart 11-16: Changes in loan demand in the household segment

WEAKER

STRONGER

100

Per cent

100

–20

–40

–60

–80

–100

2008

2009

2010

Housing loans Consumer loans

2011

2012

2013

2014

2015

–100

Housing loans – expectations Consumer loans – expectations

Source: MNB, based on the answers of respondent banks

The household loan portfolio has been undergoing erosion since 2010 on a transactional basis, but the negative trend in the shrinking of the portfolio reversed in 2013: eliminating the impact of settlement, the rate of erosion exhibits a slow improvement. On this note, we can observe that repayments on the mounting (until forint conversion) foreign currency denominated loan portfolio drive this reduction, while a gradual expansion in forint credit may materialise. Households’ aggregate indebtedness has normalised, but many remain in a precarious situation, due to their excessive indebtedness. Given the cautionary stance taken by both banks and clients, we cannot expect lending to regain its previous vigour over the short term, but the growing trend of newly granted credit can be interpreted as a positive sign in terms of the pickup in household lending (Chart 11-17). The continuous rise in demand and the low cost of finance are facilitating recovery, although the currently low interest environment also carries interest rate risk – albeit far lower than the earlier exchange rate risk — 552 —

11. Present situation and outlook for the banking system in Hungary

– for household borrowers, as the portfolio consists predominantly of floating rate forint loans. In the longer run, the recently introduced macroprudential rules also foster prudent lending. Chart 11-17: New household loans in the entire credit institution sector 700

Billion HUF

700

600

500

400

300

200

100

2005

2006 2007

2008

Housing loans Other consumer loans 4 quarter average

2009

2010

2011 2012

2013 2014

2015

Home equity loans Loan refinancing (early repayment scheme)

Source: MNB

11.2.2 Factors ensuring sound banking system risk-taking

In order for the banking system to adequately discharge its financial intermediation functions and to sustainably support the real economy, it must be systemically sound. The characteristic features of an ideal banking system are summarised in the special keynote paper of the MNB Occasional Papers119, entitled the Hungarian Banking System in Transition (MNB 2013a) according to the 10 points listed below, and compliance with them should be ensured not only at the systemic level, but also preferably at the level of individual banks. It is therefore in this 119

MNB (2013a): Átalakulóban a magyar bankrendszer (the Hungarian banking system in transition). A keynote paper for developing a consensus-based vision for the Hungarian banking system, MNB Occasional Papers, Special Issue.

— 553 —

Part I: International and national experiences in economic convergence

framework that we look at the factors that have shaped Hungarian lending developments and the processes that led to the accumulation of risks in Hungary, and the prospects for the banking system.

Based on estimates by Kiss et al. (2006), with a potential growth rate of 2-3 per cent and with inflation set at 3 per cent, the sustainable, sound annual trend growth of nominal credit capable of supporting growth would be in the 6-7 per cent range. In the long run, this would require similar growth of capital within the banking system in order to comply with capital requirements and to ensure stability. A profit level ensuring capital accumulation without any external capital raising also depends on the dividends paid out. For the long term, overly modest profits are just as disadvantageous as excessive returns. If profits are too low, banks become unable to generate enough capital and their resilience to shock will suffer. High profitability could be linked to a bankâ&#x20AC;&#x2122;s dominant position in certain market segments but, over a shorter horizon, could also be the result of excessive assumption of risk. Fair profit must cover the cost of capital invested into the sector in accordance with market operation, while ensuring prudent operation. This conclusion can be drawn from the yields derived from the stock market prices of banks in parent bank countries, and the Hungarian country risk and banking system premium. On the basis of the foregoing, in its paper entitled the Hungarian Banking System in Transition (MNB 2013a), the MNB estimated the return on equity that supports the development of the Hungarian economy, covers expected return by shareholders and enables balanced banking system growth at 10-12 per cent. In the years before the crisis, the Hungarian banking system boasted returns on equity upwards of 20 per cent, which was high even by international standards. In the years preceding the crisis, foreign banks also re-invested a very high rate, more than 70 per cent of their annual earnings in Hungary. It is important to use the additional

â&#x20AC;&#x201D; 554 â&#x20AC;&#x201D;

11. Present situation and outlook for the banking system in Hungary

capital thus generated for sustainable lending, but the growing capital stock in Hungary fuelled unsustainable lending. However, the crisis period, characterised by a low profitability, prevented the sector from functioning soundly. Deteriorating bank profitability may have indirectly been a significant factor in the restriction of lending in Hungary in recent years. Low profitability – partly resulting from the banking sector levy and fiscal burdens – increased the opportunity cost of operations in Hungary in recent years, which countered the expansion of the lending in the context of strategic decisions. While return on equity was positive in all Central and Eastern Europe countries in 2014 (Chart 11-18), in Hungary the improvement sustained for two years turned into a loss once again, primarily due to the settlement, the stock of nonperforming loans, the low interest environment and the replenishment of the reserves of the National Deposit Insurance Fund and the Investor Protection Fund. The interest margin decreasing effect of the act on fair banking will also contribute to this in the near future. Profitability prospects – along with individual sovereign risks – may play a significant role in the capital and funding allocation decisions of foreign parent banks. Bank profitability may be restored in the medium run with the gradual phasing out of the banking sector levy, the discontinuation of the exchange rate cap and positive economic growth. At the same time, return on equity within the sector will be lowered by international standards, due to the Basel III rules on capital requirements in the upcoming years. Banking system and branch profitability exhibited significant improvement in 2015 Q2 relative to the results of previous quarters, burdened by settlement. Sectoral cumulative profit will turn positive in the second quarter. The impact of settlement started disappearing from 12-month rolling profitability indicators by 2015 Q3, bringing return on equity to –0.5 per cent and return on assets to 0.0 per cent, from –18 and –1.8 per cent in March (Chart 11-19). In order to ensure fair profits in the banking sector, a competing and efficient banking system is required, one in which interests and fees are generated in a transparent way.

— 555 —

Part I: International and national experiences in economic convergence

Chart 11-18: Banking system ROE between 2008–2014 in an international comparison 30

Per cent

–5

–10

–10 –41

2008

–15

2009

2010

2011

2012

2013

Hungary

Slovak Republic

–20

Czech Republic

Poland

Croatia

Slovenia

–90

Bulgaria

Latvia

Lithuania

–44

Romania

–56

–20

Estonia

–15

2014

Source: ECB

Chart 11-19: 12-month rolling pre-tax ROE and ROA indicators of the banks and branches 30

Per cent

3.0

2.5

2.0

1.5

1.0

0.5

12 month cumulated, moving ROA (right-hand scale) 12 month cumulated, moving ROE

Source: MNB

— 556 —

July

Jan. 2015

July

Jan. 2014

July

Jan. 2013

July

Jan. 2012

July

Jan. 2011

July

–2.0

Jan. 2010

–20

July

–1.5

Jan. 2009

–1.0

–15

July

–10

Jan. 2008

0.5

July

0.0

Jan. 2007

0 –5

11. Present situation and outlook for the banking system in Hungary

11.2.2.2 A well-capitalised banking system

Adequate levels of capitalisation in the banking system contribute to lending capacity, and improve its resilience to shocks and its predictability. Capital held by banks also plays an important role in protecting depositors and creditors – and ultimately the state – from incurring losses in times of crisis when significant institutional losses become widespread. It thereby counters procyclicality and contributes to sustaining trust in the banking system. Hungarian banks were well-capitalised both before and after the crisis. Until 2010, positive profitability was prevalent and foreign banks had the bulk of their profits re-invested in their operations, both of which helped improve the capital adequacy ratio. After the onset of the crisis, however, the number of profitable banks dropped sharply, and with capital adequacy requirements only being met during this period through capital injections by owners and balance sheet adjustments, the latter entailing a reduction in lending and lower risk-taking. Chart 11-20: Capital adequacy ratio of the banking system 30

Per cent

CRR/CRD IV regulation 25

0 2008

2009

2010

2011

2012

Total Capital Adequancy Ratio Additional Tier 1

Source: MNB

— 557 —

2013

2014

Common Equity Tier 1 (CET1) Tier 2 Capital

Part I: International and national experiences in economic convergence

On a systemic level, capital adequacy remains satisfactory, with all banks having registered CAR values above 8 per cent at the end of June 2015 (Chart 11-20) and meeting the Pillar 2 (SREP) capital requirement. Banks’ capital stock remains adequate, but free capital buffers are highly concentrated, which carries a moderate risk.

When outstanding credit undergoes a significant expansion in terms of both the growth rate or the volume of growth, the stock of deposits is often unable to provide sufficient financing on the bank liabilities side due to the slower processes characteristic of deposits or due to domestic saving trends. Accordingly, the loan-to-deposit (LTD) ratio represents the extent to which demand for credit in a country can be met from deposits. An increase in the ratio in excess of 100 per cent can be used as a sort of indicator on the overheatedness of lending, excessive risk-taking and the accumulation of risks. With a ratio of above 100 per cent, lending activities must in part be financed from the market, and this implies rollover risks and adds to the vulnerability of the banking system. Greater dependency on external funding increases the central bank reserve requirement, which also pushes up central bank expenses. In the upward phase of a financial cycle, cheap external funding increases the propensity to take risks and feeds procyclical behaviour, as during crises, external funding may become far more expensive or dry up suddenly. Significant risks accumulated in Hungarian lending, reflected in the elevated loan-to-deposit ratio (Chart 11-21). This was followed by significant deleveraging, with the loan-to-deposit ratio shrinking substantially from January 2012: in January 2012 it still stood at 152 per cent, while in 2015 it approached 100 per cent. At the same time, there is a great deal of asymmetry among banks, as several larger institutions continue to operate with loan-to-deposit ratios of well over 100 per cent. Since the onset of the crisis, the amount of banks’ foreign funding has fallen considerably in Hungary, shrinking by nearly 50 per cent. From 2013, the dynamics of outflow slowed within the entire banking system — 558 —

11. Present situation and outlook for the banking system in Hungary

and came to a halt from June 2014. The forint conversion of foreign currency loans from 1 February 2015 resulted in an even more intense outflow once again. In the near future, the low interest environment will hold back an expansion in the stock of deposits, also rendered more difficult by the intense competition from the state for household savings. However, the banking system is currently not struggling to obtain financing, and its capital and liquidity supply exceeds the level required for its operation, making the majority of bank assets available for conversion into credit. Chart 11-21: Developments in the loan-to-deposit ratio and external liabilities 180

Per cent

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

100

2005

2004

120

2003

2002

140

2001

2000

160

Loan-to-deposit Foreign liabilities within total liabilities (right-hand scale) Source: MNB

11.2.2.4 A liquid banking system

Banks must have sufficient liquidity on hand to ensure that their core functions can be performed even in an adverse macroeconomic scenario. A bank is considered liquid when it is able to repay deposits and pertaining interests and can extend loans. Systemic liquidity risks arise when the banking system is faced with significant liquidity shortages, or there is a risk thereof. In this case, financial institutions are â&#x20AC;&#x201D; 559 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

unable to operate undisturbed and cannot mediate financing. After the onset of the global financial crisis, maintaining sufficient liquidity levels became an issue for a number of banks, as interbank liquidity dried up. Before the crisis, little attention was paid to the banking system’s liquidity risks both in Hungary and on a global level. Before the crisis, Hungary saw the share of liquid assets diminish and was subjected to multiple liquidity strains during the crisis. In response to the global crisis, the Bank for International Settlements (BIS) enacted a significantly tightened set of regulations on capital and liquidity. They include the LCR120 (Liquidity Coverage Ratio), set to be introduced as part of the Basel III framework. The LCR ratio is intended to bolster resilience to short-term turmoil. The LCR ratio shows the ratio at which an institution’s liquid assets cover the expected net cash outflows over a 30-day stressed period, and the requirement ensures that financial institutions are able to meet their obligations in the short run even under severe stress conditions. Compliance with the EU-level requirement began on 1 October 2015 from 60 per cent, and will reach 100 per cent by 1 January 2018 in the baseline scenario. The MNB, by virtue of its discretionary right granted by the effective regulation, opted for accelerated phasing-in, pursuant to which the liquidity coverage requirement will be 100 per cent by April 2016. In addition, the foreign funding adequacy ratio (FFAR) and foreign currency equilibrium ratio (FCER) indicators introduced by the MNB attempt to ensure a continuous supply of liquidity within the banking system. The FFAR was introduced by the MNB in July 2012. The regulation compares long-term receivables and liabilities in each currency. Initially, at least 65 per cent of long-term foreign currency assets must be financed from long-term funds. The FFAR was amended on 7 July 2015. With the tightening of the FFAR indicator, outstanding swap contracts cannot be taken into account as stable funding from 2016, and the required FFAR level rose to 100 per cent. The decree 120

The indicator comes into force by virtue of the CRR and the CRD IV Directive of the European Parliament and the Council.

— 560 —

11. Present situation and outlook for the banking system in Hungary

on the introduction of the FCER was also adopted on 7 July, and also came into force on 1 January 2016. The new FCER regulation limits the currency mismatch on the balance sheet to 15 per cent of the balance sheet total, thereby reducing banks’ excessive reliance on the swap market. The Hungarian financial system’s resilience to shocks is strong both in terms of capital position and liquidity, having been reinforced going forward with the newly introduced regulations. The benefits of this have already been felt this year. Although the turbulent international environment may have caused problems, Hungary’s external vulnerability decreased substantially (thanks in large part to the forint conversion of foreign currency loans), ensuring the Hungarian banking sector’s safety over the recent period. Chart 11-22: Liquidity reserve and regulatory liquidity requirements 8,000

Billion HUF

8,000

Liquidity reserve Regulatory requirement (blance-sheet coverage) Regulatory requirement (deposit coverage) Note: As of 1 January 2015, the minimum LCR expected is 65 per cent. Source: MNB

— 561 —

Aug. 2015.

May 2015.

Feb. 2015.

Nov. 2014.

1,000 Aug. 2014.

2,000

1,000 Jun. 2014.

2,000

Mar. 2014.

3,000

Dec. 2013.

4,000

3,000

Sep. 2013.

4,000

Jun. 2013.

5,000

Mar. 2013.

5,000

Dec. 2012.

6,000

Sep. 2012.

7,000

6,000

Jun. 2012.

7,000

Part I: International and national experiences in economic convergence

An efficient banking system functions with low operating costs and features a proper risk management framework, which in turn allows for the use of lower margins. Banks of appropriate size function with lower per-unit-costs, and therefore, their profitability is also higher. Unit costs can be reduced not only by efficiencies of scale but through the efficiency of scope – whether in terms of core operations or business profiles – as well. Another possible form of enhancing efficiency could be for banks to improve the allocation of their inputs or produce more output per input than before. Cost-efficiency used to be low in Hungary, partly due to the small size of its banking system and also because of a higher cost ratio required for expansion. Parallel to the growth in assets – i.e. a rise in efficiencies of scale – the cost ratio gradually improved. By international standards, the operating expense-to-assets ratio stands at 3 percent, which is notably higher than the European average of 1 to 2 per cent and the approximately 2 per cent that is characteristic of the Visegrád countries (Chart 11-23). This is vastly due to the significant weight of financial enterprises and foreign subsidiaries of Hungarian banks, all of which tend to operate in markets with poor cost-efficiency. In terms of operating expense to income, the Hungarian banking system now performs relatively better. At the same time, the interest margin in Hungary is very high, primarily due to the high interest rate spreads in the household segment. In other words, instead of indicating cost-efficiency, it only shows that, given the banks’ dominant position, the banking system has managed to pass on its burdens. Finally, for this indicator, the banking sector levy distorts the result.

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11. Present situation and outlook for the banking system in Hungary

3.5

Per cent

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.5 2007

2008

2009

2010

2011

Hungary

2012

2013

2014

Note: Distribution of values for European countries. Boxes represent the 20–40 percentiles and the line marks the 60–80 percentiles. The line marked with a V indicates averages of the Visegrád countries in the review period, excluding Hungary. Source: ECB

The Hungarian banking system’s low cost-efficiency is linked to the number of branches and employees. In many countries across Europe, including some of those in the region, banks operate far fewer branches than in Hungary. At the same time, employee headcount is below average, which may stem from smaller branch sizes and less intensive investment activity. On the whole and by international standards, there is still room for improvement in terms of cost-efficiency. Systemic cost-efficiency may also be improved through mergers, for instance if a more effective bank applies the business operation methods and infrastructure that function more perfectly to the business processes of the merged financial institution. This allows more efficient risk management, development of banking infrastructure, improvements — 563 —

Part I: International and national experiences in economic convergence

in the service level, broadening of the product and service scale and improvements in management quality. The synergy gained from mergers may be the greatest if they involve banks with similar geographic location and activity, which may allow the shedding of surplus capacities. By and large, the financial conglomerates created by bank mergers (until a certain degree of concentration) may also foster competition, as long as none of the players gains a monopoly. Looking at the level of market concentration in 2015, there is still room for mergers among the larger players, even in a manner that could stimulate competition. 11.2.2.6 A transparent and responsible banking system

Information asymmetry between the buyer and the seller is more pronounced in case of financial product sales, and there are numerous other limits to rational and optimal customer decisions. It is therefore particularly important to disclose product pricing and the associated risks to consumers. A fundamental condition of transparency is to supply information materials on the products offered for sale that address these topics. During the 2000s, Hungaryâ&#x20AC;&#x2122;s banking system lacked transparency and sufficient responsibility, which was mainly reflected in the foreign currency household lending boom. At the same time, consumers were presumably inadequately informed of the burden of exchange rate risk on foreign currency products, which gave rise to opinions in support of disregarding the results of the exchange rate risk they undertook. Because the population failed to adequately factor in exchange rate risk when concluding the loan contracts, while overestimating the lower cost of finance in the short run, consumers failed to hedge their position and thus with the unexpected depreciation of the forint in the aftermath of the crisis, the drastic rise in repayment instalments impacted a large portion of households very severely. The fact that banks had the opportunity to unilaterally raise interest rate spreads and thus the applicable loan interest rates, as well as various fees put many households in a difficult situation. To remedy this situation, the â&#x20AC;&#x201D; 564 â&#x20AC;&#x201D;

11. Present situation and outlook for the banking system in Hungary

act on transparent pricing was enacted, stipulating a fixed interest rate or a fixed margin pegged to the reference rate for new loans. Had this law been in force already before the crisis, the burden on customers would have been far smaller (Chart 11-24). Chart 11-24: CHF outstanding mortgage loans APR and its hypothetical

Per cent

0 July

0 Jan. 2014

1 July

Jan. 2013

July

Jan. 2012

July

Jan. 2011

July

Jan. 2010

July

Jan. 2009

July

Jan. 2008

July

Jan. 2007

APR with fix spread Mortgage loans (factual APR) CHF LIBOR 3m Note: The band illustrates how APR would have performed on outstanding loans with a spread Source: MNB

11.3 Summary In Hungary, the weight of bank funding in financing the economy outstrips even the traditionally high European average. In addition, the small, underdeveloped capital market is extremely concentrated, and consequently except for a few bigger players, capital market financing â&#x20AC;&#x201D; 565 â&#x20AC;&#x201D;

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is not an alternative for corporations. Therefore, the risks perceived by banks, the risk-taking capacity and risk appetite associated with bank lending and the cost of intermediation have a significant impact on Hungarian economic growth. Excessive risk-taking, if not managed adequately, may exacerbate vulnerability to financial shocks. Before the crisis, the Hungarian credit institution system was characterised by the accumulation of risks stemming from the spread of corporate project finance and foreign currency household loans, which contribute substantially to the economy’s vulnerability. These risks materialised broadly during the crisis, pushing the loss-making banking system towards deleveraging and restricting its risk tolerance and activity. This led to protracted adjustment, which resulted in severe growth sacrifices primarily through the corporate sector, as lending constraints and a credit scarcity may result in a significant restriction of economic activity or even a decline or reduction of capacities. Following a long process of restoring stability, by late 2014 some positive signs suggesting a turnaround in lending appeared with the moderate easing of loan supply constraints and interest rate cuts, but the banking system does not yet adequately support a real economic upswing through its credit supply. The main factors holding back credit growth are the stock of nonperforming loans remaining in bank balance sheets and systemically weak profitability. When managing the crisis, numerous state measures were taken, some of them aimed at improving stability and guaranteeing it in the future, while others attempted to develop the banking system’s lending capacity and incentive system. Along with efforts to establish prudent and fair banking, and to eliminate risks affecting systemic portfolio quality, measures were also introduced in 2015 to mitigate the losses suffered by the banking system due to the recession. The institution of personal bankruptcy, aimed at restoring some nonperforming household loans, and the creation of MARK Zrt., which establishes a market for receivables from nonperforming project finance loans are measures intended to clean bank balance sheets, allowing commercial banks in Hungary to once again start expanding their credit portfolios. — 566 —

11. Present situation and outlook for the banking system in Hungary

Paper entitled the Hungarian Banking System in Transition121 Goals 1. Competitive banking system

Target variable

Value before the crisis

Current value

Taget value

Share of the 3 largest banks (total assets) Spread (corporate loans) Spread (mortgage loans)

45% (2007)

41% (Sep–15)

50% maximum

1.5 percentage points 4.5 percentage points

1.6 percentage points 4.4 percentage points (2015 Q3.) –0.5% (Sep–15)

1–2 percentage points 3–4 percentage points

non applicable

50%

ROE

3. Keeps profit in Hungary 4. Self-financing banking system 5. Growth supporting, prudent corporate lending 6. Sound household lending 7. Efficient and innovative banking system

Share of re–invested profit Loan–to–deposit ratio Annual growth rate

156% (Mar–09) 17% Nov-08/Nov-07

90.5% (Sep–15) –4.4% (Sep–15/Sep–14)

100% approximately 6–7%

Annual growth rate Operating cost/ total assets

30% Nov-08/Nov-07 2.6% (2008)

–4.5% (Sep–15/Sep–14) Consolidated 3.5% Non–consolidated 2.1% (Dec–14)

6–7%

8. Transparent and responsible banking system 9. Highly liquid banking system

Non–quantifiable

FFAR

N. A.

LCR

N. A.

NPL (overdue more than 90 days) CAR

3.7%

125% (Sep–15) 186% (Sep–15) 13.4% (Sep–15)

10. Wellcapitalized banking system

21% (2003–2008 average) 73%

10–12%

2. Derives fair profit

12.9% (2008)

20.7% (Sep–15)

1.5–2%

100% 100% under 5%

10% constantly above

Note: Interest rate spreads in Q3 on the basis of new contract conclusions. Cells emphasized by bold are meant to indicate that further steps are necessary to reach the corresponding target value. Source: MNB, ECB 121

The Hungarian Banking System in Transition A keynote paper for developing a consensus-based vision for the Hungarian banking system, MNB Occasional Papers, Special Issue 2013.

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A pickup in lending is a necessary prerequisite for achieving dynamic post-crisis economic growth, and therefore this is a key focus of economic policy. The reduction of the banking sector levy and other positive incentives concurrently alleviate banksâ&#x20AC;&#x2122; burdens on their profitability and place them at the service of boosting lending activity. The results of the measures may materialise in the near future in the return of credit to a growth trajectory as soon as bank profitability stabilises and the stock of nonperforming loans decreases. The task during the second half of the decade is to achieve credit expansion capable of supporting growth, after the state assistance to banks, attainable through the lifting of borrowing constraints, also taking into account compliance with the rules of prudent lending.

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11. Present situation and outlook for the banking system in Hungary

References Abiad, A. – Dell’Ariccia, G. – Li, B. (2011): Creditless recoveries, IMF Working Paper 2011/58. Balás T. – Banai Á. – Hosszú Zs. (2015): Modelling probability of default and optimal PTI level by using a household survey, MNB Occasional Papers No. 117, 2015. Borio, C. (2010): Implementing a macroprudential framework: Blending boldness and realism, BIS. Calvo, G. – Izquierdo, A. – Talvi, E. (2006): Sudden Stops and Phoenix Miracles in Emerging Markets, American Economic Review Papers and Proceedings, vol. 96.(2). Cifuentes, R. – Ferrucci, G. – Shin, H. S. (2005): Liquidity Risk and Contagion, Journal of the European Economic Association, Vol. 3. No. 2–3, pp. 556–566. Csáky K. (2015): MNB https://www. mnb.hu/letoltes/dr-csaky-krisztian-tokepiaci-unio-ujabb-lepesek-az-egyseges-europai-tokepiac-fele.pdf downloaded: 4 November 2015. European Commission (2013): Quarterly report on the euro area, European Commission, Volume 12 October 2013. Felcser D. – Körmendi Gy. (2010): International experiences of banking crises: management tools and macroeconomic consequences, MNB Bulletin, June 2010. Univariate and multivariate filters to measure the credit gap, MNB Occasional Papers No. 118. Kiss G. – Nagy M. – Vonnák B. (2006): Credit Growth in Central and Eastern Europe: Convergence or Boom? MNB Working Papers 2006/10. Komáromi A. (2007): The effect of the monetary base on money supply – Does the quantity of central bank money carry any information? MNB http://www.mnb.hu/letoltes/szemle-2007jun-komaromi. pdf downloaded: 4 November 2015. Langfield, S. – Pagano, M. (2015): Bank bias in Europe: effects on systemic risk and growth, ECB Working Paper, No. 1797, May 2015. McLeay, M. – Radia, A. – Thomas R. (2014): Money creation in the modern economy, Bank of England Quarterly Bulletin, 2014 Q1. MNB (2013a): Átalakulóban a magyar bankrendszer (the Hungarian banking system in transition). A keynote paper for developing a consensus-based vision for the Hungarian banking system, MNB Occasional Papers, Special Issue. Noyer C. (2015): The financing of the economy in the post-crisis period: challenges and risks for financial stability, Banque de France Financial Stability Review, No. 19, April 2015, pp. 7–11. Takats E. (2010): Cross-border bank lending to emerging market economies, BIS background paper in “The global crisis and financial intermediation in emerging market economies”, BIS Paper, No. 54, December. http://www.bis.org/publ/bppdf/bispap54.htm downloaded: 4 November 2015.

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performance János Ádám – Dávid Berta – Zsolt Lovas – Gábor P. Kiss

Fiscal policy can affect competitiveness and potential growth via several channels. The most important channel is the stabilisation function of the government. The allocation and redistribution functions of the budget can also contribute to long-term growth. Within the allocation function, education, healthcare, and research and development are of key importance. At the same time, redistribution causes distortions in economic decisions and this should be minimised through the optimal design of taxation. The stabilisation function was unable to operate properly during 1990–2015, as countercyclical fiscal policy was often prevented in “bad times” because of the high level of public debt. Persistently high deficit in the 2000s was caused by both optimistic budgetary planning and inappropriate fiscal policy decisions. Fiscal policy was not able to decrease the cyclical volatility of the economy, but increased it instead. These lessons can help to prevent the government from repeating the same mistakes in budgetary planning and execution. Amongst other measures, the establishment of a Budgetary Council, the debt rule enshrined in the Fundamental Law and the new approach to budgetary planning have contributed to the permanently low deficit. One of the causes of procyclical policy was the high government debt: the high debt prevented fiscal policy from stimulating growth using countercyclical policy during times of economic downturn. The high debt-to-GDP ratio was inherited from the previous regime and its correction was not supported by the commitments of the government or proper fiscal frameworks. A gradual

— 570 —

adjustment of the public debt was achieved in recent years and this positive development can increase competitiveness over the medium term. The structure of government debt has also changed positively, with a significant decline in the foreign currency ratio and an improvement in ownership structure, mitigating Hungary’s vulnerability. In the past, the revenue and expenditure structure of the budget did not meet the requirement of contributing to sustainable growth, but progress has been made in many areas over the past few years. The tax-to-GDP ratio has decreased, and its structure has also improved: the share of taxes on labour has decreased, while the share of taxes on consumption has increased. This type of shift in the Hungarian tax structure is in line with international trends, and is favourable for employment and growth. Public sector spending is high by regional standards, but a declining trend has been achieved in recent years in both allocation and transfer-type expenditures. Spending on healthcare and education has decreased, with the former being somewhat lower than the regional average, and the latter being roughly on par with the average of the Visegrád countries. Social spending was far higher in Hungary compared to the Visegrád countries, mainly in the area of disability pensions and housing expenditures, but this difference has narrowed in recent years. Interest expenditures have fallen significantly, partly due to the MNB’s monetary easing cycle.

12.1 An Introduction to the Analysis of Fiscal Policy Fiscal policy can have a considerable impact both on short-term and long-term economic growth. While the influence of the measures focused on by annual budget reviews is often limited to changes in the economic output of the given year, the structure of revenues and expenditures, the features of the tax regime, the quality of public services and numerous other factors also exert a significant impact on potential growth. This study is dedicated to the latter aspect, in order to gain insight into the ways in which fiscal policy contributes to long-

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Part I: International and national experiences in economic convergence

term, sustainable growth in Hungary. As it is extremely problematic to accurately quantify this contribution, the analysis essentially relies on qualitative aspects to reflect on developments in individual dimensions of fiscal policy using time series and international comparisons. Even from the perspective of long-term economic growth, it is important to distinguish, as customary, between the three main functions – allocation, distribution, and stabilisation – of the general government and to examine each of these factors separately. The allocation function means the rendering of government services; the adequate level, structure and quality of these services (for example, in the fields of education, healthcare, public administration and jurisdiction) is critical to the long-term growth potential of the economy. In its narrow sense, the distribution function is the reallocation of income between economic agents in form of taxes and financial transfers, which also contributes to sustainability and growth. Finally, the stabilisation function is designed to smooth the cyclical fluctuations of aggregate demand, which supports sustainability by preventing overheated growth in the economy and the subsequent cyclical recessions. Chapter 2 summarises the most important findings in the literature on the relationship between fiscal policy and sustainable growth. Chapters 3 and 4 examine developments in the borrowing requirement and public debt and the implementation of the stabilisation function in Hungary. Chapters 5 and 6 address the structure of revenues and expenditures. Developments in this regard are extremely important as their impact on economic performance can be markedly different depending on the way in which the allocation and the distribution functions are put into effect.

The role of fiscal policy, in particular, its effect on economic growth, competitiveness and economic stability has received a great deal of — 572 —

attention in international literature in recent years and decades. On the one hand, the analyses focus on aggregate fiscal indicators (deficit, redistribution, debt), and on the other hand, they address the structure (for debt, expenditures and revenues) and ultimately, the efficiency of these indicators and the adequacy of their planning. This analysis presents the evolution of the Hungarian budget and its current status, concentrating on the first two levels (aggregate data and structural issues). At the aggregate level, one of the most prominent functions of fiscal policy is to safeguard stability, partly by smoothing out the effects of business cycle fluctuations and partly by ensuring that fiscal policy itself does not become a source of cycles or crises. Empirical evidence suggests that the volatility of output strongly depends on economic stability, especially in developed countries; consequently, stability may foster and boost growth in the medium term (Afonso â&#x20AC;&#x201C; Jalles 2012). In an environment characterised by substantial risks, low-income, developing countries should give appropriate priority to building up fiscal buffers which may leave room for pursuing a countercyclical economic policy should the need arise (IMF 2015). As debt increased significantly during the crisis, the persistently high debt ratios reduce the fiscal leeway under countercyclical fiscal policies, and consequently the need often arises for measures which can be implemented without increasing the deficit. Countries with limited policy leeway can promote growth by adopting structural reforms and reallocating expenditures. With respect to fiscal policy instruments aimed at fostering economic growth, the importance of institutional frameworks has come into focus in recent years. In numerous countries, this recognition led to the adoption of fiscal rules and the establishment of autonomous institutions independent of the government (fiscal councils) with the aim of monitoring the sustainability of the budget. Fiscal frameworks are intended to anchor fiscal policy expectations and set medium and â&#x20AC;&#x201D; 573 â&#x20AC;&#x201D;

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long-term targets (Blanchard et al. 2010). According to the international literature, the development of an institutional background for fiscal purposes is especially desirable for countries faced with high public debt or an aging society. Regarding the structure of the budget, most studies concentrate on the expenditure side, although the literature on tax regimes has also expanded significantly over the past decade. With respect to expenditures, in essence, the IMF emphasises the significance of three instruments in achieving persistent economic growth (IMF 2014). First, it calls for more rational social spending and a focus on the government wage bill. The effects of these two items are related to expenditure-side measures which are most likely to have a lasting effect and to facilitate economic growth. The second focus is on improving the efficiency of spending, especially in areas subject to the allocation function of the state, such as education and healthcare. The third item highlighted by the IMF is the role of the fiscal institutional framework within which the expenditure reforms are implemented. Expenditure rules can prevent overspending and support the sustainability of the budget; in addition, expenditure reforms are more likely to be successful and durable if enforced by adequate institutional regulations. Nevertheless, on the expenditure side, numerous analyses attribute key importance to spending on human capital as a driver of long-term growth. Human capital does not influence economic output immediately and directly, but since it has a significant impact on productivity, it affects economic growth indirectly (Gerson 1998). Another important pillar of improving productivity is the promotion of technological progress and innovation via research and development incentives. Adequate, efficient transformation of the tax regime could also yield good results by stimulating the economy and improving competitiveness. The decisions of economic agents are also shaped by the tax regime and any changes in the system prompt stakeholders

â&#x20AC;&#x201D; 574 â&#x20AC;&#x201D;

to change their behaviour. According to the theoretical literature as well as international organisations, a shift toward consumption taxes would be desirable with a parallel reduction of taxes imposed on labour and in particular, on capital. Taxes on capital distort the saving and investment decisions of economic agents, which weighs on capital accumulation and ultimately, impedes the improvement of economic growth and productivity. Taxes on labour distort the adequate allocation of labour and leisure, the accumulation of human capital and distort business decisions. Consumption taxes are the least harmful to growth as they only slightly influence saving decisions due to expectations. These considerations have been generally evident in the past decade, including the practice of developed countries on the back of the tax reforms adopted since the crisis, and the tax regime of Hungary also developed in line with the changes observed at the international level. The reduction of tax evasion could also exert a significant impact on economic growth prospects. Lower tax evasion allows for the application of a broader tax base and lower tax rates; consequently, at least the same, or a rising amount of revenues can be collected from a higher number of taxpayers who nevertheless pay less taxes individually. By contrast, with higher tax evasion a higher tax rate is needed to maintain the same tax revenue level, which imposes an excessive burden on compliant taxpayers, leading to a thriving hidden economy (Balog 2014). It should be noted that the level of public expenditures and revenues is not indicative of economic performance and competitiveness and even the international literature concurs that the efficient distribution of public resources is an important aspect. Examining the volume of tax revenues (tax-to-GDP ratio) and government spending we find that there is no universal solution: different countries have applied different strategies to implement their fiscal policy (with varying degrees of success) in an effort to boost economic growth.

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transparency The deficit can be divided into two parts: a permanent and a temporary component. The permanent, i.e. structural component indicates the trend value of the deficit, while the temporary part reflects the actual difference from the trend. Experience shows that governments’ preference of fiscal stimulus in an effort to mitigate the effect of an economic downturn and their reluctance to restrain overheated economic activity by contractionary, deficit-reducing measures often contribute to the accumulation of an unsustainable deficit. This asymmetry may be exacerbated further by election cycles: the accumulation of a deficit accelerates in election years, but this is not necessarily followed by the required adjustments. Pursuing a fiscal policy of cyclical tightening/easing may lead to excessive fluctuations of the economy where overheated periods are followed by steep downturns. Downturns, however, may entail the permanent loss of economic resources, which may undermine long-term growth potential. Therefore, sustainable growth and the adequate functioning of fiscal policy may be ensured by a fiscal framework that keeps the balance on a sustainable path over the medium term, averts fiscal policies that amplify economic fluctuations and at the same time, leaves room for the stabilisation function. Hungary’s example over the last few decades demonstrates the reasons behind the need for fiscal discipline and transparency. It took twenty years between 1995 and 2014 to bring the borrowing requirement below the sustainable, 3 per cent threshold. One of the negative implications of this lag in achieving the adequate fiscal balance was a steep rise in public debt. Another negative consequence was the fact that, without fiscal balance, fiscal stabilisation also failed to materialise: changes in the actual deficit diverged significantly from the changes warranted by the business cycle. This can be best illustrated by constructing a hypothetical deficit path that shows the ways in which

— 576 —

the balance would have changed between the initial 1995 level and the current endpoint in the case of a continuous improvement, and comparing the results to the annual deficit levels recorded at selected points of the business cycle (Chart 12-1). Obviously, the trend is a purely hypothetical construction that does not suggest that the Hungarian budget would have proceeded on such a direct path. The chart below indicates the differences compared to the hypothetical path.

trajectory (1995–2014) 6

Percentage of GDP

6 4

4 Fiscal balance according to ESA methodology applicable in 2011

–2

–4

–6

–8

–10

1995

1997

1999

2001

2003

2005

Linear trendline

2007

2009

2011

2013

–10

ESA deficit

Source: MNB calculations

Although not shown by the chart above, it should be stressed that the differences were not warranted by the business cycle; in fact, the developments observed indicate the opposite. Before turning to the relationship between the budget and the business cycle, changes in the cyclical position of the Hungarian economy since the mid-1990s should be examined. The output gap was negative after the regime change,

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Part I: International and national experiences in economic convergence

but then began to close from 1996, and turned positive in 2002 and widened continuously until 2006; in other words, economic performance temporarily surpassed its potential level. From 2007, growth slowed and reversed to a severe downturn from 2009, with GDP falling significantly below its trend. As regards the balance, it was only between 1998 and 2000 that the pick-up in growth was coupled with an improvement in the balance; subsequently, the fiscal position deteriorated – with a short interruption – until 2006.122 The realignment of the unsustainable 2006 fiscal position commenced in 2006–2007; nevertheless, no room was left for a considerable deficit increase following the abrupt economic downturn. This was because, as sources of finance dried up, Hungary obtained funds from international organisations subject to the condition of curbing the deficit. After a sharp deterioration caused by one-off factors in 2011,123 the balance started to improve once again from 2012 in line with the upswing in economic activity. Calculations can reveal the extent to which the divergence of the deficit from its long-term trend as illustrated above relates to the path that would have been expedient and desirable to follow amid the cyclical fluctuations of the economy. In reality, the fluctuation of the deficit was sharply different from what would have been required by the functioning of the stabilisation function, which indicates that economic fluctuations were amplified by a procyclical fiscal policy. Between 1996 and 2002 the deficit was better than its long-term trend, and the difference was larger than would have been justified by the economic position, leading to a remarkably faster reduction of public debt and more ample fiscal reserves. The period of 2002–2006, however, saw a sharp reversal: the actual deficit deteriorated significantly despite the fact that the favourable economic position would have warranted an Partly because the temporary acceleration of economic growth was mistaken for a favourable trend. 123 The deficit growth reflected the negative impact of the court decision regarding the VAT refunds, and was also boosted by the amount of the real yields payable as a result of the pension reform. 122

— 578 —

improvement in the balance. As recession set in from 2009, the pressure on fiscal policy resulted in an improvement of the budget balance. Since then, the fluctuation of the actual balance around its long-term trend has not deviated considerably from the extent warranted by the business cycle, although the difference was fairly noticeable in certain years. The deficit path was obviously affected by a number of factors on which the discretionary decisions of fiscal policy had no effect. Such factors included the interest balance, the tax implications of the business cycle, the effect of planned and surprise inflation on revenues and expenditures (P. Kiss 2007) and one-off items such as natural disasters and court decisions (Hoffmann – P. Kiss 2010). Although a more detailed discussion of these items falls outside of the scope of this paper, the section below describes the impact of the interest balance. Net interest expenditures are largely determined by debt dynamics, which therefore imply an important feedback from stocks toward the balance of flow items. The decline observed in the budget balance since the 1990s can be mainly attributed to a commensurate decline in interest expenditures; but deficit did not precisely follow interest expenditures. While the improvement in net interest expenditures was accompanied by a decline in deficit until 2000 – in other words, there was only a slight change in the primary surplus – between 2001 and 2006 the decline in interest spending was coupled with rising deficits, which led to the accumulation of a substantial primary deficit (Chart 12-2). After 2007, the ratio of interest expenditures to GDP started to increase with a parallel downward shift in the deficit – with the sole exception of 2011 – giving rise to a primary surplus once again.

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Part I: International and national experiences in economic convergence

(1995–2014) 6

Percentage of GDP

6 4

4 Fiscal balance according to ESA methodology applicable in 2011

–2

–4

–6

–8

–10

1995

1997

1999

2001

2003

2005

Interest balance

2007

2009

2011

2013

–10

ESA deficit

Source: MNB calculation

It is important to assess the probability of the recurrence of the negative trend observed in 2001–2006, when a deficit far higher than warranted by the business cycle realised even in the face of an improvement in the interest balance. This raises the question of how this exceptionally high deficit emerged during the period in question. In the period concerned, raising the deficit was not planned by the government; indeed, its objective was to gradually lower the deficit level. However, it was not even close to achieving this goal until 2007. In view of the relatively high GDP growth – the driver of tax revenues – and the downward shift in interest expenditures prompted by investors’ high risk appetite, for the most part, this may have been the result of planning errors and intra-year decisions and, to a lesser degree, of unforeseen events/ developments and methodological issues.

— 580 —

Chart 12-3: Objectives of convergence programmes vs. actual performance 6 4

Percentage of GDP

–2

6 4

More realistic base years, but plans are optimistic

2 0

Percentage of GDP

Fiscal balance according to ESA methodology applicable in 2011

Base years, thus, plans are optimistic

0 –2

–4

–6

–8 –10 –12

More realistic plans

Difference in plans and facts due to the crisis and change in methodology

–8 More realistic plans

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 CP 2012

CP 2013

CP 2014

–10 –12

ESA 2010

Source: Eurostat, convergence programmes, MNB calculations

As shown by Chart 10-3, it caused a substantial error in planning in the period of 2003–2005 in itself that the deficit of the “base year” was estimated with a significant, 2 per cent error on average in the spring of the given year. In addition, revenues were overestimated by 1.1–1.5 per cent of GDP for 2003–2005. In 2006, in turn, while the balance for 2005 was more realistic, the appropriations for 2006 were unfounded, with the difference amounting to nearly 4 per cent of GDP. 40 per cent of this can be attributed to methodological problems, and 60 per cent was due to overspending on the expenditure side. In general, therefore, the failure to achieve the objectives can be explained by two reasons. • On the one hand, the objectives were set on the basis of an excessively loose methodology, including the temporary recognition of private — 581 —

Part I: International and national experiences in economic convergence

pension funds, the “outsourcing” of road construction projects, or the recognition of the lease contracts of the Gripen jets in 2006. • On the other hand, the deficit proved to be worse than expected even regardless of the methodology. In 2001–2002 a substantial amount of revenue surplus accumulated, but after having increased in 2002, expenditures exceeded the surplus significantly. The period between 2003 and 2005 saw continuous revenue overshoots; in the election year of 2006 deficit rose once again as expenditures surpassed the appropriations. The lesson to be drawn from this is that the existence of a fiscal framework does not suffice in itself; it must also be operated in a transparent and controllable way. The Fiscal Council can point out the planning errors in revenues and expenditures, while an adequately sized Country Protection Fund can manage unexpected deviations. From the perspective of transparency and fiscal discipline, it is particularly harmful that the methodology of deficit reporting, as well as its application and interpretation is too lenient on occasion. A comparison of preliminary ESA data with final, ESA2010 data, the presumably robust analytical indicator of the MNB and the augmented (SNA) deficit124 leads to the following conclusions (Chart 12-4): • After Hungary’s accession to the EU, a marked shift can be observed between the first disclosure and the final ESA number. The difference reflected, for the most part, the correction of methodological problems (2004–2005) and changes in the methodology itself (2011 pension) and, to a lesser degree, it could be attributed to the clarification of accrual accounting data. In 2014, for instance, after the new set of rules of the ESA2010 methodology were put into effect, the 2011 fiscal 124

This indicator has been calculated by the MNB since the mid-1990s and published since 1998. Its objective is to recognise expenditures and revenues as their actual economic effect occurs. Thus, the expenditures of the Railways Company (irrespective of whether they are covered by the budget) and PPP investment projects are recognised on a continuous basis rather than subsequently, upon presentation in the budget (debt assumption, instalment). For more detail, see: P. Kiss (2011).

— 582 —

balance changed ex post, from the former 4.3 per cent surplus to a 5.5 per cent deficit. According to the former methodology, transactions from the assets taken over from private pension funds improved the fiscal balance in the given year, namely in 2011. However, according to the new statistical rules, the transfer of assets from private pension funds could not be considered as revenues, hence the 5.5 per cent deficit. At the same time, the fiscal deficit without one-off items stayed unchanged at a level of 2.4.

methodology 4

Percentage of GDP

–2

–4

–6

–8

–10

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

–10

Maastricht deficit target ESA deficit/GDP first data release (as of spring 2004) ESA deficit/GDP ex post data Augmented (SNA) deficit ESA deficit/GDP Source: Eurostat and MNB calculation

• The augmented (SNA) indicator is close to the final ESA data on average, but it exhibits less fluctuation, as it distributes certain financial-type capital revenues and capital expenditures. Its information content is important in this context, as it shows the worse

— 583 —

Part I: International and national experiences in economic convergence

balance in advance, rather than subsequently (2004â&#x20AC;&#x201C;2005, 2011).125 Since the purpose of the corrections is to recognise items that have a real economic impact, the indicator is suitable for examining the actual deficit path, eliminating the bias caused by purely funding operations.

The indebtedness of the general government (i.e. the government debt-to-GDP ratio) was already a severe problem in Hungary at the time of the regime change; consequently, the reduction of public debt should have been one of the most important priorities of any economic policy maker since the political changes. Although nearly 25 years have passed since the regime change, the containment of indebtedness and the reduction of public debt were only defined by the economic policy as first priorities from the mid-1990s and subsequently from 2010. It was this recognition that led to the establishment of the Government Debt Management Agency in the mid-1990s with a view to implementing a transparent system for debt management and budget financing. Starting in 2010, the turnaround in economic policy enshrined the framework of public debt reduction in the Fundamental Law, laid down the rules pertaining to the debt level in the Act on economic stability and developed an institutional system for their enforcement.

12.4.1 Developments in gross public debt

In assessing indebtedness it is important to investigate the historic trends in the public debt ratio, the underlying reasons for its changes, changes 125

The continuous differences in level between 1998 and 2010 stem from the fact that the nearly 10 per cent adjustment effect of the 2011 pension reform (which is recognised in future periods based on the ESA 2010 approach) is recognised in this period, i.e. at the time when contributions were paid to the private pension funds. This is because this cannot be considered a reduction of contributions; it had no effect on demand; therefore, it is justified to improve the deficit with this item in such a manner as if the fully funded pension system had not been in place.

â&#x20AC;&#x201D; 584 â&#x20AC;&#x201D;

in debt structure, and the implications of all these factors on other areas of the economy. There are several channels through which high government debt has an impact on the economy; however, its effects are difficult to quantify. Besides the debt level, the structure of the debt and the economic outlook of the country are also relevant for identifying the impacts of the debt ratio. The 2008–2011 global money market crisis and subsequently, the sovereign debt crisis in Europe underscored the significance of public debt in assessing the risks of individual countries, and imposed tighter limits on fiscal policy than before. Gross public debt plays a critical role in the assessment of a country’s vulnerability and the sustainability of its fiscal policy. This indicator constitutes a part of the Maastricht criteria and it is a central element of the regulatory systems adopted across the EU. The fiscal regulatory system enshrined in the Fundamental Law in 2011 and in the related Stability Act is also built on gross public debt. Gross government debt plays a central role in view of the fact that this indicator can be produced quickly and its market valuation is not impaired by evaluation problems. Chart 12-5: Gross Hungarian public debt 100

Percentage of GDP

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: MNB

— 585 —

Part I: International and national experiences in economic convergence

Each budgetary policy decision affects the gross debt ratio either directly or indirectly; in addition, the indicator itself exerts an impact on several economic processes. With some simplification, trends in the debt ratio can be almost entirely captured by changes in four macroeconomic indicators. Changes in the debt-to-GDP ratio are determined by the combined effect of the following factors: the primary balance of the government sector; the real interest payable on outstanding debt; real exchange rate and inflation developments; and nominal economic growth rate126 (Baksay et al. 2013). It should be noted that, in addition to these factors, in some cases the government may have financial claims and incur debts irrespective of the budget balance, such as revenues from privatisation. Accordingly, in a growing economy, the debt ratio can decrease even without a nominal decline in public debt; indeed, as long as the income generated in the economy (GDP) grows faster than nominal public debt, the debt ratio declines. If the general government’s primary balance shows a persistent surplus, the real interest payable on outstanding debt decreases and the economy steps on a higher potential growth path, the decline in the debt ratio will be sustainable.

12.4.2 Main phases in the evolution of gross public debt

In accordance with Chart 12-5, changes in gross public debt can be divided into four distinct phases. Phase 1 – a surge in public debt. From 1990 to 1994, the indebtedness of Hungary rose by nearly 25 percentage points. To a large degree, this reflected the economic downturn stemming from the slump in external demand coupled with the transformation (for example, bank, credit and debtor consolidation) crisis.

126

Real growth rate cannot be calculated relying on CPI as it can differ significantly and enduringly from the GDP deflator.

— 586 —

Phase 2 – moderation of high indebtedness. Between 1995 and 2001, the gross government debt indicator fell by more than 30 percentage points. The contraction in public debt can be attributed to the combined effect of several factors. Privatisation activity was particularly intensive at the beginning of the period, and some of the revenues went toward debt reduction. The primary balance was adjusted for the spending cuts and the reduction of expenditures in real terms (through the effect of surprise inflation). Thanks to the credibility of the new monetary regime, the risk premium on forint and foreign currency debt financing declined. The fall in the general government’s debt ratio was also supported by the moderate appreciation of the real exchange rate throughout the period. Phase 3 – loss of credibility and financial crisis. Between 2002 and 2009 public debt moved onto an upward trajectory. By 2009, gross government debt had risen to 78.1 per cent of GDP from the 51.9 per cent level recorded in 2001. The rising debt ratio can be primarily attributed to the upward drift in the deficit and the emergence of a negative primary balance. The unsustainability problems of the budget put upward pressure on the sovereign risk premium, pushing up the debt ratio through interest payments. By 2006 it was evident that the country’s indebtedness had become an unsustainable process. The government’s fiscal adjustments in 2006 were partly aimed at raising inflation on a temporary basis; in addition, the economy suffered a shock as a result of increased tax burdens. GDP growth decelerated and falling domestic demand was not offset by an increase in external demand. Owing to the imbalances of in the economy and the government sector, national savings were scarce, increasing Hungary’s reliance on foreign investors. It was under these circumstances that the economy was hit by the 2008 financial crisis, and the stagnation of the economy turned into recession. As the budget’s sources of finance dried up, the government was forced to borrow from international organisations to finance the budget deficit and to refinance maturing debts. Consequently, in 2008 and 2009 both the loans from international organisations and the economic recession boosted the debt ratio. — 587 —

Part I: International and national experiences in economic convergence

Phase 4 – stabilisation followed by declining indebtedness. From 2010 the debt ratio stabilised and starting from 2012, the ratio of government debt to GDP moved onto a downward trajectory. Initially, the debt reduction was primarily associated with the withdrawal of government securities transferred to the state budget from the private pension fund’s portfolio and with the sale of additional financial assets. In addition, the primary balance of the budget improved significantly thanks to the extra revenues channelled to the budget on the back of the tax reforms and transformation of the pension scheme. As the credibility of the budget was restored and the MNB’s easing cycle was launched, the financing costs moderated, which, in turn, reduced the debt ratio through the budget balance. Meanwhile, as a contrasting process, the state bolstered its financial wealth considerably by corporate acquisitions and by increasing its financial instruments (share purchases, recapitalisation). Consequently, the decline in gross public debt was not as pronounced as would have been justified by the change in the primary balance, the takeover of private pension fund assets and the growth rate of the economy. 12-1 Box: Loans from the IMF and the EU

It was not long before Hungarian money markets were hit by the repercussions of the financial crisis. In part, this was a consequence of the vulnerability stemming from the country’s high foreign currency exposure, but the European confidence crisis also contributed significantly to the drying-up of the government securities market. Besides the liquidity shortage, the shortening of the maturity structure also caused problems in the financing of the budget; in addition, forint-based government securities were not accepted by the ECB as eligible collateral for loans serving liquidity purposes. This sparked fire sales by foreign investors in the government securities market as foreign investors jettisoned their holdings of government bonds. In this market environment, there was waning demand at government securities auctions. The issue of government bonds

— 588 —

had to be suspended temporarily and the government was forced to seek assistance from international organisations. From the EUR 19 billion credit line available to Hungary, the budget took recourse to EUR 12.9 billion, while the MNB borrowed EUR 1.4 billion. The drawdown of the first tranche prompted a spike in gross public debt at the end of 2008. Net debt, however, rose to a lesser degree, as the budget deposited some of the surplus with the central bank or lent the funds further to Hungarian-owned commercial banks. In 2009–2010, the debt manager used some of the funds deposited in foreign currency to finance the deficit and refinance maturing debt; thus, the increase in gross public debt in these two years was 1 percentage point smaller in each year than would have been warranted by the deficit level.

12.4.3 Overview of the indebtedness of other countries in the region

In order to gauge the convergence prospects of the Hungarian economy, it is worth looking at Hungary’s public debt ratio in an international comparison (Chart 12-6). A high debt ratio can influence the vulnerability of the economy, the room for fiscal manoeuvre, and the extent to which savings can be geared towards private sector developments. With one of the highest government debt-to-GDP ratio in the region (surpassed only by Croatia), the initial situation of Hungary is not favourable. At the same time, trends in debt are more favourable in Hungary than in most EU Member States. In the past four years, within the region only Poland and Hungary saw a decline in the GDPproportionate indebtedness of the government sector, while the EU average rose by 10 percentage points (Chart 12-7). Based on the trends unfolding in the recent past, the relative position of Hungary has improved markedly. This may suggest that the cost of debt financing will also drop below the EU average, supporting the convergence of the economy and expanding the room for policy manoeuvre to improve the competitiveness of Hungary. — 589 —

Part I: International and national experiences in economic convergence

Chart 12-6: GDP, PPS per capita vs. gross government debt in 28 Member States of the European Union (at 2014 current prices) 180 EL

Public debt in percentage of GDP

160 140 BE

LV 20

MT SK

100

120

BG EE 20

100

120

140

GDP, PPS per capita (EU28 average = 100%) Source: Eurostat

Chart 12-7: Gross public debt in the European Union and the region 100

Percentage of GDP

100

2010

2011 Romania EU27

2012 Czech Republic Hungary

Source: Eurostat

— 590 —

2013

2014 Slovakia Poland

12.4.4 Structure of gross government debt

The financing structure of public debt is crucially relevant to a national economy’s vulnerability level. Due to the scarcity of national savings and/or debt management considerations, the financing of government debt may revert to an increase in the country’s external financing requirement, exacerbating its vulnerability. This may raise the share of foreign currency debt in total public debt if the financing is increasingly provided by foreign currency-denominated debt components (foreign currency loans, FX-based government bonds). This process translates into the exacerbation of public debt’s sensitivity to exchange rate shocks and to the increased vulnerability of the country. This process materialised during the period between 2006 and 2010, but then reversed course in 2011, with a steep decline in the share of foreign currency debt (Chart 12-8). The ownership structure of debt also provides important information about vulnerability, as demonstrated by the unfolding of the financial crisis in 2008 (Chart 12-9). Chart 12-8: Structure of gross Hungarian government debt 90

Percentage of GDP

Foreign currency Source: MNB

— 591 —

HUF

2014

2013

2012

10 2011

10 2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

Part I: International and national experiences in economic convergence

It appears that from 2002 the increment in public debt was largely financed from nonresidents’ savings up until the turnaround in 2012, when the objectives of the government were to scale back the share of foreign currency debt and to mitigate vulnerability. Within gross public debt, by 2011 the share of debt to nonresidents surged to 67 per cent from 48 per cent in 2006–2007 before it embarked on a steep decline, dropping to 51 per cent by 2015 Q1. The drawdown of the EU/IMF loans resulted in a spike in the ratio of public debt to foreign owners, while in 2011 this ratio rose in response to the increase in nonresidents’ demand for forint-denominated government bonds (the latter implies a lesser degree of vulnerability). As of 2012, in line with government objectives, the government securities held by households started rising perceivably. Chart 12-9: Distribution of gross public debt by ownership

HUF debt owned by households Other domestic HUF debt Domestic foreign currency debt (PEMAK, loans) HUF debt raised abroad IMF/EU loans Foreign currency debt raised abroad Source: MNB

— 592 —

Sep. 2015

Sep. 2014

Sep. 2013

Sep. 2012

Sep. 2011

Sep. 2010

Sep. 2009

Percentage of GDP

Sep. 2008

Sep. 2007

Sep. 2006

Percentage of GDP

Sep. 2005

90 80 70 60 50 40 30 20 10 0

In addition to ownership and currency structure, the maturity structure of public debt is also a critical factor. It indicates the maturity at which the debt management organisation renews outstanding debt and shows whether the financing of the budget takes place at shorter or longer maturities. One benefit of long maturity structures is that the repricing of outstanding public debt is less pronounced in short crisis episodes; large-amount maturities are less concentrated and the diversification of borrowings entails lower financing costs. In the period between 2002–2006, the average maturity of debt increased significantly. In part, this reflected the new public debt strategy, which gave priority to longer debt maturities and boosted government security supply at the longer maturities of the yield curve. Between 2008 and 2010, maturities shortened in response to the financial crisis; indeed, the newly disbursed IMF/EU loans also represented short-term funding. As a result of the crisis, demand picked up only gradually along the longer maturities of the yield curve. In the two years following 2010, the average maturity of new issues increased; however, the average maturity of the total stock remained essentially unchanged, for two reasons: on the one hand, by nature, the withdrawal of government securities after the takeover of private pension fund assets primarily affected longer-term government bonds. On the other hand, the lowering of the foreign currency debt ratio began in earnest in 2012, and maturing long-term foreign currency bonds were partly replaced by shorter-term forintdenominated government securities purchased by households. The increase in average maturities in 2014 is the consequence of a systematic debt management decision – the role of treasury bills in financing declined with a parallel increase in the weight of forint-denominated bonds and long-term securities offered to households.

The high debt ratio exerts a direct negative impact on the budget, as the interests on debt boost the expenditure side of the budget. Moreover, interests payable to non-residents deteriorate the country’s balance of — 593 —

Part I: International and national experiences in economic convergence

payments. High interest payments – as well as the intention or pressure to reduce debt – considerably limit the room for fiscal manoeuvring and reduce the funds available for expenditures more conducive to economic growth (e.g. investment, education, healthcare, employment). In the 1990s, the interest burden on the Hungarian budget stood out in comparison to the interest expenditures of the other Visegrád countries, particularly as a result of the substantial outstanding debt inherited from the period preceding the regime change. By 2001, owing to the reduction of public debt, the spectacular difference observed at the initial stage moderated significantly (Chart 12-10). Starting from 2002, due to climbing debt, the interest burdens of the Hungarian budget remained stuck above 4 per cent of GDP despite the favourable international yield environment, while the interest payments of the rest of the Visegrád countries stabilised at lower levels. As a result of the differences between debt ratios, the financing costs of Hungarian gross public debt exceed those of Hungary’s Visegrád peers by 2–2.5 percentage points. Consequently, Hungary’s convergence to the more developed region of the European Union may receive a boost if the country’s indebtedness is pushed below 50 per cent of GDP. Gross interest payment fluctuated around the 4 per cent level for nearly a decade, which was the combined result of a number of factors: first, the share of foreign currency debt – with interest rates lower than those on forint-denominated instruments – started to increase. Second, the pace of Hungarian inflation decelerated, putting downward pressure on the nominal interest rate. Third, the maturity structure of public debt was lengthened and the inverted yield curve resulting partly from the convergence game127 rendered the financing of debt relatively less expensive.

127

In an effort to meet the criteria of accession to the euro area, governments attempt to bring macro indicators more in line with the expected values, which creates a more predictable environment for foreign investors with a perceivable impact on yields.

— 594 —

Chart 12-10: Interest expenditures of the 9

Percentage of GDP

Czech Republic

Slovakia

Hungary

2015*

2014

2013

0 2012

1 2011

1 2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

Poland

* forecast Source: AMECO

The crisis intensified the negative effects of the high level of indebtedness. In an environment of risk avoidance, the surge in real yields was accompanied by even more severe financing problems in the government securities market. However, this did not initiate a drastic increase in financing costs because of the relatively low interest rate on the foreign currency loans received from international institutions (on the other hand, the interest expenditures of the MNB were boosted by the increase in the MNBâ&#x20AC;&#x2122;s sterilisation portfolio as a result of the loans granted by the international organisations). After 2010 interest expenditures rose temporarily in an unfavourable international environment before they started to decline once again from 2013 as the European debt crisis abated, Hungarian inflation decreased and the MNB launched its easing cycle (which resulted in savings amounting to nearly 1 per cent of GDP in 2015).

â&#x20AC;&#x201D; 595 â&#x20AC;&#x201D;

Part I: International and national experiences in economic convergence

12.5 An analysis of the tax revenues and expenditures of the Hungarian budget In assessing the role of the state in the economy, it is indispensable to examine the measures of implicit taxes and redistribution by the state. The scope of the Hungarian budget is relatively large by European Union standards. Exceeding the EU average, the expenditures of the Hungarian state stood at around 50 per cent of GDP in 2014, while the expenditures of the Visegrád Three (Czech Republic, Poland and Slovakia) are even lower than the latter. As regards tax-to-GDP ratio, the situation is similar: Hungarian tax revenues amounted to around 39 per cent of GDP, which surpasses the average of both the European Union and the Visegrád Three. Such a comparison of aggregate indicators, however, might lead to erroneous conclusions, mainly because revenues and expenditures are inter-related, especially in view of the tax content of public sector spending. With that in mind, in the next section we apply methodological corrections in order to gain more comparable results from the data available. However, it should be borne in mind from the start that neither the various aggregate indicators, nor the inspection of the detailed expenditure/revenue structure presented in the next chapter provide sufficient grounds for the evaluation of the impact of fiscal policy, which would require a far more in-depth analysis of efficiency. In this section, we present changes in GDP-proportionate, adjusted expenditure and revenue items between 1998 and 2014 in Hungary, the Visegrád countries and the EU27 as follows: • private tax revenues: tax revenues less taxes paid by the state. • net primary expenditure: taxes paid by the state (labour taxes, VAT) and non-tax revenues (fees and EU receipts) are deducted from

— 596 —

expenditures reduced by the net interest expenditures. It shows the amount of expenditures channelled by the state toward the private sector in the form of services and cash transfers. By deducting non-tax revenues, we filtered out services that are paid immediately by the user or covered by EU assistance. • cash transfers. • allocation function: net primary expenditures less cash transfers. This can be used to capture the extent to which the state finances services (for example, healthcare, education, public administration, defence, public transportation) for the private sector. For the sake of better comparability, the methodology of private taxes and net primary expenditures henceforth is consistent with the method applied by P. Kiss and Szemere (2010).128 Taxes are discussed in greater detail in the next chapter; this section is limited to highlighting trends.

128

The original method filters out the tax content of public sector expenditures both on the revenue and on the expenditure side. In addition, it excludes the fluctuations of the benchmark – GDP – by way of cyclical adjustments, and the swings in capital expenditures by moving averages. The method presented here is different in certain regards. For the purposes of this paper, the tax burden on social benefits was estimated in accordance with the publication of Eurostat and the European Commission entitled “Taxation Trends in the European Union”. The method performs further netting with non-tax revenues, as they are partly payments by the users of services and partly grants from the EU. Interest expenditures are excluded from expenditures. These corrections are easy to perform based on the statistics available. In the case of the adjusted primary expenditure/GDP indicator, a moving average was used to perform smoothing in a single step. As regards tax revenues, the cyclical adjustment of GDP would not be effective, given that most tax revenues are associated with wages and consumption, which followed the decline in GDP with a lag; therefore, as a simple solution, we applied the moving average again.

— 597 —

Part I: International and national experiences in economic convergence

Chart 12-11: Tax revenues from the private sector (left panel) vs. net primary expenditures (right panel) (moving averages; as a percentage of GDP) 34

Per cent

Hungary

2014

2012

2010

2008

2006

2004

2002

2000

1998

2014

2012

2010

2008

2006

2004

2002

2000

1998

EU27

Source: MNB calculation

With respect to the ratio of private taxes to GDP, a moderate reduction was seen in Hungary in the first half of the 2000s, which was followed by a substantial realignment from 2006 in the form of tax hikes. The crisis was followed by a period of tax restructuring, which also entailed a parallel reduction of GDP-proportionate tax burdens (Chart 10-11, left panel). As a result, by 2014 tax revenues reached the levels prevailing in the early 2000s. Meanwhile, the EU27 average remained largely stable, hovering below the Hungarian data throughout the period. In the same period, as a result of a downward trend the V3 average fell short of the EU27 by 3 percentage points, but began to grow again at the end of the period. The net primary expenditures of the Hungarian budget rose markedly until the crisis: this period was characterised by high deficits with no adjustments on the expenditure side; only a stabilisation process â&#x20AC;&#x201D; 598 â&#x20AC;&#x201D;

took place in 2006 (Chart 10-11, right panel). During the years of the crisis a steep downward trajectory emerged. This is because Hungary was forced to implement a procyclical fiscal policy: after the outbreak of the crisis, the deficit had to be reduced significantly, which was achieved, in part, via expenditure cuts. By contrast, most EU Member States were able to respond to the crisis by easing their fiscal stance, thereby mitigating the negative effects on the economy (countercyclical economic policy). The Visegrád countries saw a downward trend, but they also responded to the crisis in a countercyclical manner, by increasing expenditures and cutting revenues. Within net spending, it is worth examining allocation expenditures and cash transfers. The former includes broadly interpreted expenditures on (non-market) services provided by the state (including non-profit and quasi-fiscal expenditures), while the latter, by definition, represents social benefits provided in cash. The allocation indicator, therefore, excludes from total expenditures all cash benefits that can be spent freely by the beneficiaries and accordingly, total spending only includes expenditures for specified purposes (e.g. education, healthcare, defence). As regards the EU27, only the smaller half of the net spending growth affected state-provided services; the increase in household transfers was higher (Chart 12-12). The allocation spending of the V3 gradually declined during the period; however, after the crisis the level of transfers rose to the previous value; in other words, Visegrád countries, as well, attempted to offset the impact of the crisis by stepping up benefits. The decline in allocation expenditures was more substantial in Hungary and started earlier than the reduction of transfers, which means that, compared to the mid-2000s, spending on services decreased more significantly than in the case of benefits (such as pensions). By 2014, Hungary’s allocation expenditures were below both EU and Visegrád levels, which points to tight financial management in itself, but investigating the details is important nevertheless. Indeed, spending cuts do not necessarily have a positive impact on competitiveness; — 599 —

Part I: International and national experiences in economic convergence

the structure and utilisation efficiency of expenditures need to improve as well (the next chapter provides more details in this regard). Within expenditures, after 2002, cash transfers – which mainly comprise social benefits and pensions – increased even more spectacularly in Hungary than allocation expenditures. The resulting expenditure structure was not conducive to long-term economic growth, did not provide an incentive for seeking employment and, in many cases, created unreasonably early retirement opportunities. Due to the expenditure cuts necessitated by the financial crisis, the hike in such expenditure types came to a halt at a cyclically inopportune time before the expenditures moved onto a downward trajectory from 2011–2012 as the previous measures (raising of the retirement age) took hold and the measures envisaged in the Széll Kálmán Plan (tightening of early retirement) were implemented. The average of the EU27 and that of the Visegrád Three increased. Chart 12-12: Estimated expenditures on allocation (left panel) and cash transfers (right panel) (moving averages; as a percentage of GDP) 20

Per cent

Hungary

Source: MNB calculation

— 600 —

EU27

2014

2012

2010

2008

2006

2004

2002

2000

1998

2014

2012

2010

2008

2006

2004

2002

2000

1998

12.6 Structure of the Hungarian budget 12.6.1 Revenue side

With a view to facilitating economic growth, since the outbreak of the global economic crisis economic policymakers have shifted their attention to the transformation of the tax regime as a key priority. This is because the profound effect of the crisis and the ensuing economic downturn were coupled with deteriorating growth prospects and, in many countries, a surge in the debt ratio. Chart 12-13: Percentage share of taxes on consumption, labour and capital in total tax revenues in Hungary and in Visegrád countries 55

Percentage point

2006

2007

2008

2009

2010

Taxes on labour HU Taxes on consumption HU Taxes on capital HU * MNB estimate Source: Eurostat and MNB calculation

— 601 —

2011

2012

Taxes on labour V3 Taxes on consumption V3 Taxes on capital V3

2013*

Part I: International and national experiences in economic convergence

It is an important objective to prevent, to the extent possible, the tax regime from distorting the decisions of economic agents. The substantial decline in the weight of labour taxes was offset by a corresponding increase in consumption taxes: in both cases, Hungary saw a shift of around 5 percentage points (Chart 12-13). Following the processes starting in 2008, the downward shift in labour taxes continued after the government change in 2010 as well. The new flat rate income tax system, the restrictions on and subsequent elimination of supergrossing, the adoption of the family tax allowance and the launch of the job protection action plan all pointed in this direction. These processes may continue in the near future: in 2016 the flat rate personal income tax will be reduced by 1 percentage point to 15 per cent from 16 per cent. The increased share of taxes on consumption can be primarily attributed to the raise in the standard VAT rate, the excise tax hike and the introduction of certain special sectoral tax types. The share of taxes on capital incomes relative to total tax revenues can be considered low even by regional standards, amounting to about two thirds of the European Union average. The share of taxes on capital remained essentially unchanged; however, the distribution of payments has been altered. Tax burdens increased in sectors dominated by large corporations and decreased in the sector of small and medium-sized enterprises. The former is associated with some of the special sectoral taxes, while the latter can be attributed to the introduction of small taxpayersâ&#x20AC;&#x2122; itemised lump sum tax (KATA) and the small business tax (KIVA), as well as to the reduction of the corporate income tax rate to 10 per cent. These measures were geared toward the development of small and medium-sized enterprises. Improving the competitiveness of the Hungarian SME sector is also justified by the fact that the sector provides work to two thirds of Hungarian employees and half of the investment projects are also realised in this segment. The Hungarian corporate sector exhibits a certain kind of duality in that it consists of a developed, competitive and profitable large corporation sector and a less developed SME sector mainly producing for the domestic market. In the case of greenfield investment, large firms may enjoy â&#x20AC;&#x201D; 602 â&#x20AC;&#x201D;

tax allowances or even tax exemption, which, while favourable from a competitiveness perspective, puts the SME sector at a disadvantage. Through their international relations and foreign parent companies, large corporations tend to take recourse to tax optimisation, which, for the most part, is not an option for small and medium-sized enterprises. Instead, SMEs often opt for tax evasion through un-invoiced performance, unregistered labour or the manipulation of expense reporting. From the aspect of competitiveness, therefore, the structure of the Hungarian tax regime has been subject to significant adjustments and continues to adjust to international trends and expectations; in fact, the magnitude of changes is often more robust than that of its European competitors. Of the Visegrád countries, Hungary boasted the largest share of consumption taxes in 2012 – 40 per cent – while the same tax category varied within a range of 33–36 per cent in the rest of the region. The weight of labour taxes shifted downward in the 2010s, and is now more in line with the regional average even with the current level of employer’s social contributions, which is considered high not only by regional but also by European Union standards. At 13.5 per cent, Hungary has the lowest share of taxes on capital within total tax revenues in the region. For the assessment of competitiveness, it is important to examine the degree of tax-to-GDP ratio. During the global economic crisis GDPproportionate tax revenues fell sharply in all four Visegrád countries, but after a minor adjustment they nearly returned to pre-crisis levels by 2012 (Chart 12-14). Most countries under review saw only a minor, 0.8–1.3 percentage point decline between the two years, only Poland faced a more robust, 2.3 per cent contraction. The share of consumption taxes grew perceivably both in the Czech Republic and Hungary, with a parallel, steep decline in the share of taxes on labour and capital. Although the share of the latter also faltered in the other two countries of the V4, in Slovakia and in Poland the growth in labour taxes typically offset the GDP-proportionate decline in consumption taxes. — 603 —

Part I: International and national experiences in economic convergence

Chart 12-14: Consolidated revenues from taxes on consumption, labour and capital in Visegrád countries 45

Percentage of GDP

2007

2012

Hungary

2007

2012

Poland

Taxes on consumption

2007

2012

Czech Republic Taxes on labour

2007

2012

Slovakia Taxes on capital

Source: Eurostat

Based on the processes described above, changes in the Hungarian tax regime were broadly in line with international trends; however, these changes took place faster or more frequently, which undermined stability and predictability. The predictability of the business environment is not a negligible factor in competitiveness: it provides important guidance to companies not only for the planning of day-today operations, but also for the evaluation of long-term investment decisions. Frequent changes to the tax regime undermine this predictability and may entail negative real economic consequences. A step forward has also been taken in this regard, as testified by the surveys of the German Chamber of Commerce in Hungary, which found that the proportion of unsatisfied respondents among corporations decreased substantially between 2013 and 2014. In 2015, it was the explicit intention of the government to develop and approve next year’s budget as soon as possible in order to leave more time to understand

— 604 —

and implement the current tax policy changes, which were not nearly as numerous as in previous years.

12.6.2 Expenditure side

As regards expenditures, competitiveness can be supported primarily by spending on human capital, i.e. education and healthcare, along with expenditures geared toward the stimulation of innovation and R&D activities. Several other expenditures contribute indirectly to competitiveness, including adequate infrastructure, safety and highquality public administration services. According to the classification of the previous chapter, they principally belong to allocation expenditures rather than cash transfers. The structure of the expenditure side was examined in two five-year periods, expressed as a percentage of GDP. The first period covers the pre-crisis years (2004–2008) and the second encompasses the period following the onset of the crisis (2009–2013).129 In Hungary, healthcare expenditures amounted to 5.6 per cent of GDP on average from the year of the country’s accession to the European Union to the outbreak of the crisis, comprising one of the largest items on the expenditure side of the budget (Chart 12-15, left panel). During the next five years GDP-proportionate healthcare expenditures fell by 0.6 percentage points on average, pushing the value of this item below any other value observed in the other countries of the region. 129

GDP-proportionate expenditures are largely influenced by the marked differences between individual countries regarding gross domestic product before and after the crisis. The period before 2008 was characterised by rapid growth, whereas in 2009 and in subsequent years most Visegrád countries experienced a sharp downturn. With that in mind, before examining the data we adjust expenditure items for the deviation from trend GDP. The Annual Macro-Economic Database (Ameco) published by the European Commission calculates the gap between trend and real GDP for each Member State on an annual basis. We rely on this information to revise the data of our analysis – performing a kind of smoothing – to ensure that the expenditure data expressed as a proportion of GDP – far above its trend before 2008 and below its trend after the downturn in 2009 – are as unbiased as possible.

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Part I: International and national experiences in economic convergence

Chart 12-15: Expenditures on healthcare (left panel) and education (right panel) in Visegrád countries 8

Percentage of GDP

2004–2008

SK 2009–2013

2004–2008

2009–2013

Source: Eurostat and MNB calculation

It should be noted with respect to healthcare expenditures that their composition is different in each Visegrád country. Even inside the V4, a duality can be observed: while in Hungary and in Slovakia the difference between the expenditures on services and products is roughly twofold, it is far more pronounced in the Czech Republic and especially in Poland (Chart 12-16). In Poland, the reimbursement of medicines and pharmaceutical products represents an almost negligible expenditure item. Hungary spends less on outpatient, hospital and public health services than its peers; on the other hand, only Slovakia spent more on the reimbursement of pharmaceutical products than Hungary.130 The issue of efficiency is particularly important in the case of these reimbursements as, according to certain studies, this might 130

This category includes various pharmaceutical products, medical aids and appliances. These items represented more than 1 per cent of GDP in Hungarian expenditures.

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encourage excessive drug consumption. Of course, the opposite is also problematic when patients have no access to the medication they need even in justified cases. Chart 12-16: Expenditures on healthcare services and medical products in Visegrád countries 7

Percentage of GDP

2004–2008

2009–2013

2004–2008

Services Czech Republic

2009–2013

Products Hungary

Poland

Slovakia

Note: The “healthcare services” item is the total amount spent on outpatient and hospital services and public health services. Source: Eurostat and MNB calculation

Of the expenditures allocated to human capital, education spending amounts to around 5 per cent of GDP per year (Chart 12-15, right panel). In the second half of the 2000s Hungary recorded the second highest education expenditures in the region ranging between 5.5–6.5 per cent of GDP, but by 2013 Hungarian education expenditures faltered in international comparison, although they are still roughly in line with the regional average.

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Part I: International and national experiences in economic convergence

Within the education system, the highest difference between the Visegrád Four is observed in higher education (Chart 12-17, right panel). Between the pre-crisis period and the period following the crisis, spending on higher education declined everywhere in the region except in Slovakia. While higher education expenditures accounted for around 17 per cent of total education spending between 2004 and 2008, this figure rose to 19 per cent between 2009 and 2013. This is because education spending declined at a faster rate and thus the share of higher education in total education spending increased overall. In the subsequent period, the corresponding value in the Czech Republic, Poland and Slovakia is 13, 27 and 23 per cent, respectively. Based on the total amount of education expenditures, proportionally, Hungary’s spending is in line with the regional average. Chart 12-17: Expenditures on research and development (left panel) and higher education (right panel) in Visegrád countries 1.5

Percentage of GDP

1.5 2.0

1.0

2.0

1.5

1.0

0.5

1.0

0.5

0.0

Percentage of GDP

0.5

2004–2008

0.0 0.0

2009–2013

2004–2008

Source: Eurostat and MNB calculation

— 608 —

SK 2009–2013

0.0

As regards state expenditures on research and development, Hungarian spending surpassed the expenditures of Poland and Slovakia on R&D in previous years; however, Czech values were higher than the corresponding Hungarian values (Chart 12-17, left panel). On the upside, the R&D spending of Hungary increased on average between the two periods. On the expenditure side of the budget, the R&D item represented 0.64 per cent of GDP in 2013. By 2013, Slovakia doubled its 2006 and 2009 value of 0.5 per cent and spent 1 per cent of GDP on research and development in 2013. The Czech Republic allocates the largest amount to R&D in the region: 1.3 per cent of GDP on average in the period of 2009–2013. Chart 12-18: Components of social protection expenditures in Visegrád countries 18

Percentage of GDP

2004– 2009– 2008 2013 Czech Republic

2004– 2009– 2008 2013 Hungary

Sickness and disability Old age pension

2004– 2009– 2008 2013 Poland* Family and children Unemployment

2004– 2009– 2008 2013 Slovakia

Housing Other

Note: the “Other” item includes survivors, social protection research and development, * In the case of Poland, the chart presents the gross value of old-age pensions, i.e. 2–3 per cent of GDP. Source: Eurostat and MNB calculation

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Part I: International and national experiences in economic convergence

Social expenditures are intended to eliminate social disparities and to strengthen social security and social cohesion. In some cases, however, they can be counter-productive: in the absence of a suitable tax regime, they may provide incentives for staying away from the labour market. In both periods, Hungarian social expenditures exceeded the amounts spent on these purposes elsewhere in the region (Chart 12-18). On the whole, these expenditures amounted to 17.8 per cent of GDP before, and 16.6 per cent after the global economic crisis. In Poland, old-age pensions are presented at gross value; their inclusion in the chart may be somewhat distorting. Hungarian pensions have been affected by several factors in recent years: the retirement age has been gradually raised, indexation has changed and 13th month pension benefits have been eliminated. On the expenditure side, all of this was partly offset by permitting women to retire after 40 years of employment. The social spending of individual countries reveals structural differences as well. Hungarian social housing expenditures (for example, housing benefits, benefits-in-kind, state tenement flats) and disability expenditures surpass the corresponding expenditures of the other three countries substantially. Between the two five-year periods, it was precisely these two items that were subject to the most pronounced decline. The item aimed at social housing expenditures decreased by around 45 per cent between the two periods. The downturn in disability spending mainly resulted from the eligibility reviews of recent years. As a result of the GDP-proportionate decline, in the 2010s Hungarian sickness and disability expenditures approached the regional average. In proportion to GDP, Hungary spent the highest amount on general public services of all Visegrád countries in 2013: 5.4 per cent compared to 3.1–3.5 per cent recorded in the rest of the countries (Chart 1219). This high value may reflect, among other things, the level of decentralisation; in other words, that the number of municipalities is very high relative to the population and the size of the country (P. Kiss – Szemere 2012). Decentralisation has moderated markedly in

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recent years, for example, in the areas of education, healthcare and public administration; therefore, the chart showing Hungary’s values converging to the GDP-proportionate values of its peers also indicates a considerable decline. Chart 12-19: Primary general public service expenditures in Visegrád countries 7

Percentage of GDP

2004–2008

2009–2013

Source: Eurostat and MNB calculation

12.6.3 Structure of the Hungarian budget by age group

The distribution function of the budget can be also examined for age groups, a rather interesting, albeit less widespread, dimension of budgetary analyses. Dividing the population into three age groups (the young, working age and elderly population) and distributing the main revenues and expenditures between them provides an opportunity to make estimates regarding the net position of individual age groups visà-vis the budget. Unfortunately, no such analyses have been prepared in — 611 —

Part I: International and national experiences in economic convergence

Hungary in the recent past; the last analysis of this kind was published by P. Kiss and Szemere in 2009. In their study, they distributed 2007 expenditures and revenues among the age groups.131 The beneficiaries of the redistribution between age groups are the young (through education, healthcare and family allowances) and the elderly (through pensions and healthcare expenditures). In a regional comparison, in 2007 the elderly’s share in net expenditures was the second smallest in Hungary, while Hungary allocated the largest portion of the expenditures to the youth in the region (Chart 12-20). In the years since 2007 there have been several changes in the tax structure and budget balances of individual countries that override the findings of this earlier study. For lack of detailed and updated TARGEN generation data, we are unable to perform a new analysis, but by presenting a summary of individual revenue/expenditure items we can give an insight into the direction of the changes throughout the years. As mentioned above, the tax structure has shifted toward consumption taxes in Hungary, while the share of labour taxes has been on the decline for years. This means that tax burdens on the working age population decreased, while the tax burdens on the other two generations – the age groups contributing to the revenue side of the budget by consumption taxes – increased. Between 2007 and 2012, Hungarian consumption taxes rose to 15.7 per cent of GDP from 14.6 per cent. As a proportion of GDP, the drop in labour taxes amounted to almost 2 percentage points between 2007 and 2012, compared to a 0.1 and 0.9 percentage point increase in Poland and Slovakia, respectively. From another perspective, in the period since 2007 the Hungarian budget deficit has fallen significantly (in contrast to the increase observed at Hungary’s regional competitors), with the decline resulting from the reduction of the expenditures allocated to the young and 131

The authors produced the age groups by using the results of TÁRKI’s Database and Statistical Indicators for Intergenerational Resource Reallocation and Lifestyle Finances (TARGEN).

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the elderly which, however, was somewhat offset by the concurrent moderation in the tax burdens of the working age population. Chart 12-20: Distribution of net expenditures by age group in 2007 and the direction of the changes (2007–2014) 22

Percentage of GDP

–2

–6

–10

–14

PL Older

Young

Active

–14

Deficit

Note: the arrows indicating the changes between 2007 and 2014 are not an indication of the magnitude of the change, only its direction. Source: P. Kiss – Szemere (2009) and MNB calculations

12.7 Summary Fiscal policy exerts an impact on competitiveness through various channels, the most important of which is stability. For the most part, fiscal policy was unable to ensure this stability during the time elapsed since the regime change. Misguided planning and poor economic policy responses led to the accumulation of a high budget deficit. Consequently – except for a temporary period between 1997 and 2001 — 613 —

Part I: International and national experiences in economic convergence

– public debt could not decline significantly. The fiscal turnaround after 2010 put fiscal discipline into focus, and as a result, the deficit stabilised below 3 per cent. Owing to the low deficit level, public debt has been steadily declining since 2011 and the continuation of this process may result in a public debt ratio that is consistent with the level of economic development which, coupled with a favourable currency and maturity structure, may contribute significantly to an improvement in Hungary’s competitiveness. Additional channels supporting competitiveness manifest themselves through the structure of revenues and expenditures. In this regard, it is important to stress that the turnaround after 2010 was supported by three factors: the tax reform, the transformation of the expenditure structure and the moderation of interest expenditures. The easing cycle of the MNB also played an important role in the latter. With respect to tax-to-GDP ratio and public sector spending, Hungary still exceeds the levels seen in the rest of the Visegrád region, but it has achieved a marked decline in recent years nevertheless. As regards the tax regime, there was an increase in the share of tax types that are less suitable for distorting business decisions. However, regional comparison indicates that, despite recent cuts, there is still room for the further reduction of labour taxes. Expenditures were characterised by an inadequate structure: high transfers coupled with the unfavourable tax structure did not provide an incentive for seeking employment. Healthcare expenditures fall short of the regional average, but education spending is more in line with the values observed in the region. While social expenditures contracted (reflecting, among other items, the revision of the disability retirement system), the rationalisation of the institutional system may have contributed to the reduction of expenditures on general public services.

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References Afonso, A . J. – Jalles, T. (2012): Fiscal Volatility, Financial Crises and Growth. Applied Economics Letters, 19/18. Baksay G. – Berki T. – Csaba I. – Hudák E. – Kiss T. – Lakos G. – Lovas Zs. – P. Kiss G. (2013): Developments in Public Debt in Hungary Between 1998 and 2012: trends, reasons and effects. MNB Bulletin, Special Issue 2013. Balog Á. (2014): Tax Evasion and the Shadow Economy in Hungary. Society and Economy, Journal of the Corvinus University of Budapest, Volume IX, Issue 4. Blanchard, O. J. – Dell’Ariccia, G. – Mauro, P. (2010): Rethinking Macroeconomic Policy. Journal of Money, Credit and Banking, Vol. 42. Csomós B. – P. Kiss G. (2014): The Transformation of the Hungarian Tax Structure After 2010. Society and Economy, Journal of the Corvinus University of Budapest, Volume IX, Issue 4. Eurostat and European Commission (2014): Taxation Trends in the European Union – Data for the EU Member States, Iceland and Norway. Luxembourg. Gerson, P. (1998): The Impact of Fiscal Policy Variables on Output Growth. IMF Working Paper 98/1. Hoffman M. – P. Kiss G. (2010): From those Lying Facts to the Underlying Deficit. MNB Bulletin, December 2010. International Monetary Fund (2015): Fiscal Monitor – Now Is the Time: Fiscal Policies for Sustainable Growth. Washington, April. International Monetary Fund (2015): Fiscal Monitor – Public Expenditure Reform: Making Difficult Choices. Washington, April. P. Kiss G. (2007): Pain or Gain? Short-term Budgetary Effects of Surprise Inflation – the Case of Hungary. MNB Occasional Papers 61, May 2007. P. Kiss G. – Jedrzejowitz, T. – Jirsákova, J. (2009): How to Measure Tax Burden in an Internationally Comparable Way? National Bank of Poland Working Paper, 56. P. Kiss G. – Szemere R. (2009): Apples and Oranges? A Comparison of the Public Expenditure of the Visegrád countries. MNB Occasional Papers 99, November 2011. P. Kiss G. (2011): Moving Target Indication: Fiscal Indicators Employed by the Magyar Nemzeti Bank. MNB Occasional Papers 92, May 2011. P. Kiss G. – Szemere R. (2012): Comparison of the Redistribution Level and Structure of Functional Expenditure in the Visegrád Countries. Public Finance Quarterly, 2012/1.

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Part II

Competitiveness reforms

Overview of draft reforms on competitiveness Based on the experiences compiled in part one, the second part of Competitiveness and Growth identifies the areas in which Hungarian economic competitiveness could be improved. It also formulates recommendations on how to better and more efficiently use stilldormant resources. These recommendation may form a basis for the preparation of a third Széll Kálmán Plan focusing on competitiveness. Part one thus lays the theoretical foundations, while part two applies this theory. Many of the recommendations also directly affect budgetary expenditures or revenues, as expenditures shifted towards physical infrastructure or human capital accumulation to bolster productivity, or tax reforms that shift the emphasis to less distortionary taxes can greatly contribute to a country’s competitiveness. In addition, steps that incur no direct costs also matter a great deal, first and foremost in terms of how well-planned, effective and synergistic these expenditures and revenues are. The scope of investigated topics is broader than this, because, as presented in part one, there are dimensions to competitiveness that go beyond traditional economic policy, including demographics, human capital and the institutional framework. A separate chapter is dedicated to the competitiveness of the labour force (the labour market), corporations, the state, human capital, the banking system and the utilisation of European Union transfers, as well as other key topics. We therefore grouped the topics primarily based on the determinant of competitiveness that they impact, although overlaps naturally arise because the determinants of competitiveness intertwine to form a complex system. Quantitative and qualitative developments in labour market conditions are pivotal in terms of competitiveness and economic growth. In the years leading up to the crisis, one of the most acute structural issues faced by the Hungarian economy was low labour market — 619 —

Part II: Competitiveness reforms

activity and employment, which hampered the economy’s growth potential. Thanks to the reforms undertaken since the crisis, activity and employment rates have increased, but still remain low by international standards. Some of the tools that may prove to be effective in boosting activity and employment include further labour tax cuts, development of the public sector employment scheme, reinforcement of the pension system elements that contribute to workers remaining longer on the labour market and the promotion of atypical forms of employment. Dynamic economic growth which is sustainable in the long run relies on the smooth operation of the private sector. In a middleincome country such as Hungary, this requires growing, effective and competitive corporations which are able to become sufficiently innovative in order to attain this objective. Another condition for the development of these enterprises is rapid capital accumulation and its adequate structural composition. The quality of productive private investments is mainly determined by corporate management capabilities, but state regulation and incentives may also promote the focused implementation of investments that are able to increase economic output in the long run. Developing a tax regime which is more conducive to investments, fighting tax evasion, simplifying the tax regime, fostering research and development, narrowing geographic differences and creating a predictable business environment could contribute to higher output in the long run as well. A central aspect of the recommendations for boosting the Hungarian economy’s competitiveness is improving competitiveness through tax cuts. However, these tax cuts should serve specific economic policy objectives instead of taking the form of generalised tax reduction. The tax cuts included in the recommendations can be classified into three groups: • labour tax reduction, • conditional tax reduction (linking a reduction in the bank tax to lending),

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. Overview of draft reforms on competitiveness

• targeted reduction (expanding the Job Protection Action Plan, incentivising saving). In the stricter sense, the functioning of the state itself plays a decisive role in shaping competitiveness. The rules established by the state are binding for all economic agents; in advanced economies the state collects one third to one half of incomes in the form of taxes, which are then redistributed by the budget. Additionally, the state is also the largest employer, producer and service provider, with public services playing a key role in competitiveness (infrastructure, education, healthcare). Besides the fact that the quality of these elements strongly determines the entire economy’s performance, how effectively the state can perform them is also important, as the utilised resources are necessarily drawn from the private sector. It is important to note that the total level of public sector expenditures and revenues is not indicative of economic performance or competitiveness. Examining both the quantity of tax revenues (tax centralisation) and the degree of state redistribution, we can state that there is no simple best practice, and successfully converging countries have shaped their fiscal policies and attempted to stimulate their economic growth by applying different strategies. Thus, it is not the amount of government revenues and expenditures, but their adequate structure that matters for competitiveness. The quality and quantity of human capital are key determinants of economic competitiveness and convergence. Human capital is one of the fundamental determinants of long-term growth potential: countries with larger stocks of human capital are able to achieve more robust economic growth. The quality of human capital can be advanced by improving the education and healthcare systems. Education impacts economic growth through several channels: it improves labour productivity and also enhances the innovative performance of the economy. An improvement in the population’s health condition also

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Part II: Competitiveness reforms

contributes to better economic performance, as it impacts labour market activity and contributes to the accumulation of physical capital. While this book mainly addresses structural matters, we must bear in mind that the most fundamental contribution of economic policy to competitiveness might be to ensure stability by smoothing out the cyclical fluctuations in the economy, and by not acting, in and of itself, as a source for such cycles or crises. Empirical findings show that the volatility of output depends greatly on the economyâ&#x20AC;&#x2122;s stability, primarily in developed countries, and thus stability may foster and promote growth over the medium term (Afonso & Jalles 2012). Countries facing numerous risks and characterised by an unfavourable fiscal position should therefore treat the creation of a fiscal buffer as a priority, as this can provide leeway for conducting countercyclical economic policy if needed (IMF 2015). Debt ratios, which peaked during the global economic crisis and still remain elevated, restrict fiscal policy leeway in the context of countercyclical policies, and accordingly in many instances action that does not entail an increase in the deficit is called for. Countries with less leeway can foster growth through structural reforms and by reallocating expenditures. Sustaining fiscal stability is therefore paramount when implementing competitiveness reforms. The interventions in the areas discussed herein have fiscal implications in many cases, as the majority of recommendations affect budgetary expenditures and revenues. Therefore, measures should be chosen which are possible according to the circumstances and preferences. That said, the improvement in the fiscal balance achieved in recent years has opened up leeway to implement measures which may incur a fiscal cost in the short run and only yield a return in the longer run (for these types of reforms, see for instance Matolcsy 2015). Based on international experience, the fundamental criterion for improving competitiveness in the medium term is to achieve social consensus in this regard, and to have the broadest possible â&#x20AC;&#x201D; 622 â&#x20AC;&#x201D;

. Overview of draft reforms on competitiveness

range of stakeholders take part in its elaboration, implementation and oversight. Based on this lesson, it appears vital for Hungary that the four affected stakeholders — the Government, the MNB, the business sector and the banking system — cooperate in implementing competitiveness-enhancing reforms. An institutionalised body (e.g. a Competitiveness Council) overseeing the implementation of these reforms should therefore be established, comprising representatives of the aforementioned stakeholders. This body would monitor the implementation of competitiveness-boosting measures, alongside Hungary’s progress and its position in terms of various competitiveness indicators across various sectors.

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Part II: Competitiveness reforms

References Afonso, A. – Jalles, J. T. (2012): Fiscal Volatility, Financial Crises and Growth, Applied Economics Letters 19/18. International Monetary Fund (2015): Fiscal Monitor – Now Is The Time: Fiscal Policies for Sustainable Growth, Washington, April 2015. Matolcsy György (2015): Egyensúly és növekedés, Kairosz Kiadó.

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Labour market competitiveness In the years leading up to the crisis, one of the most acute structural issues faced by the Hungarian economy was low labour market activity and employment, which hampered the economyâ&#x20AC;&#x2122;s growth potential. In the aftermath of the reforms undertaken since the crisis, the activity rate has increased, but remains low by international standards. Looking ahead, developments in quantitative and qualitative labour market conditions are crucial aspects in terms of economic growth. In this chapter, we summarise the objectives and potential tools of the state to support quantitative conditions on the labour market, i.e. improvement in the employment and activity rates. Some of the tools that may prove to be effective include further labour tax cuts, improvement of the public work scheme, reinforcement of the pension system elements that contribute to workers remaining longer on the labour market and the promotion of nonstandard forms of employment. The objectives of further labour tax cuts can be classified into two groups depending on whether we focus on groups more closely tied to the labour market, characterised by higher activity rates, or groups more loosely linked to the labour market. In the case of the former, the objective of the tax cuts is to boost labour intensity and combat the concealment of income by reducing tax rates on labour. In the case of the latter group, the objective is to boost labour market activity and employment, attainable through targeted incentives. Employment can be improved more efficiently from a fiscal perspective through targeted tax cuts. The public work scheme has succeeded in integrating previously inactive and unemployed groups into employment, and helps groups that are currently unable to find work in the labour market. However, there are still reserves in the capacity of public work programmes to incorporate these groups into the â&#x20AC;&#x201D; 625 â&#x20AC;&#x201D;

Part II: Competitiveness reforms

open labour market. Therefore, more focus on education and a stronger role for the private sector are warranted in the public work system. Increasing the activity rate of workers soon to enter retirement and those reaching pensionable age should be linked to elements incentivising work before and after the pension system’s age limit. Working beyond retirement age may carry significant benefits for both employees and the budget. Non-standard forms of employment – remote and part-time work – may also contribute to increasing activity and employment. These forms of employment have not become widespread in Hungary compared to the rest of Europe, and are able to make work easier in many life situations.

13.1 Reduction of taxes on labour The goal is to increase participation and employment by cutting taxes on labour. This can be achieved by the further reduction of the general rate of personal income tax, which may stimulate the labour market from both the supply and the demand side.

In recent years, there has been a substantial realignment in the structure of taxes in Hungary. As a result of the measures implemented since 2010, the weight of taxes on labour has dropped considerably, which was mainly offset by the growing significance of consumption and turnover-type taxes. Compared to the most developed Member States of the European Union, the volume of revenues from taxes on labour relative to GDP is moderate, but it can still be considered high in a regional comparison (Chart 13-1). The amount of revenues from taxes on capital is still regarded as being low, and the principal reason for this is that the upper rate of corporate tax in Hungary is among the lowest in an EU context.

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13. Labour market competitiveness

Chart 13-1: Revenues from individual tax types in 2012 50

Percentage of GDP

Finland

Austria

Tax on capital

Hungary Tax on labour

Czech Republic

Poland

Tax on consumption

Note: No comparable international data can be found on Eurostat for the period after 2012. Source: Eurostat

This kind of realignment in the tax structure has been observed in several European Union countries in the recent period. This is linked to the fact that during the crisis growth-friendly fiscal consolidation, and in particular the possibilities for transforming tax systems while stimulating the economy became central issues. Of course, there is no universal solution that can be employed in every country, but all of the proposals both in the theoretical literature and by international organisations (OECD, IMF, European Commission) deem it necessary to reduce the taxes in the tax regime that exact the greatest toll on economic growth, i.e. taxes on labour and capital. In order to preserve fiscal stability, this can be financed by increasing less harmful revenue sources such as consumption and turnover-type taxes and taxes on detrimental externalities. Such a tax realignment can foster the

â&#x20AC;&#x201D; 627 â&#x20AC;&#x201D;

Part II: Competitiveness reforms

economic growth, employment and competitiveness of a country over the long term.132 These proposals are based on the general approach that the negative impact of the tax regime on economic growth is due to the fact that the obligation to pay taxes distorts the decisions of economic agents. The taxes levied reduce the profits on economic activities, and therefore labour supply and demand, investments and consumption may be lower than optimal, which results in less goods produced and services provided. From this perspective, the most harmful are capital income taxes. The greatest drawback of such taxes is that they distort savings and investment decisions, therefore hamper capital accumulation, thereby hindering productivity growth. The second most harmful tax type from the perspective of economic growth can be considered taxes on labour such as personal income tax and contributions, which distort the allocation between work and leisure, business decisions and decisions on human capital accumulation. Taxes on consumption are considered to be the least restrictive of the major tax types. Their advantage is that they do not distort the saving and investment decisions of economic agents, and they usually entail relatively low administrative costs. Another important feature of such tax types is that they exert less influence on the competitiveness of companies producing for export. The measures implemented since 2010 have considerably reduced the weight of taxes on labour, but in certain groups the tax wedge is still higher than in the case of Hungary’s regional peers, primarily on account of the large burden caused by employers’ and employees’ social contributions (Chart 13-2). Thanks to the family tax allowances introduced in 2011, the tax burden on families with children is now close to the regional level (Chart 13-3).

132

On the efficiency of the tax regime and the effect of the main tax types on economic growth see OECD (2010) and Prammer (2011).

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13. Labour market competitiveness

Chart 13-2: Composition of the tax wedge in 2014 for average income earning, single taxpayers without children 60

Percentage point

Austria

Hungary

Finland

Personal income tax Contributions paid by employers

Czech Republic

Poland

Contributions paid by employees

Source: OECD

Chart 13-3: Composition of the tax wedge in 2014 for average income earning, single taxpayers with two children 50

Percentage point

–10

Austria

Finland

Hungary

Personal income tax Contributions paid by employees Contributions paid by employers Source: OECD

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Czech Republic

Poland

Family benefits Total

–10

Part II: Competitiveness reforms

The continued reduction of taxes on labour may contribute to boosting participation and employment in Hungary, which should be achieved by cutting the general rate of personal income tax as well as the targeted allowances detailed below. On the one hand, this further strengthens the economic policy goal of shifting the focus of taxation from taxes on labour which hamper growth towards consumption and turnover-types taxes, and on the other hand, from a fiscal standpoint, employment can be effectively improved via targeted tax cuts.

13.2 Encouraging work among the least actively employed groups The goal is to provide incentives for work to groups characterised by low employment. This can be facilitated by the expansion of the Job Protection Action Plan to employeesâ&#x20AC;&#x2122; social contributions, which would boost labour supply in the least actively employed groups.

In assessing the Hungarian labour market, it is important to identify the social groups in which the participation rate and employment lags significantly behind the average. Among the low-skilled, low employment figures can be observed in all of the countries in the region. In this respect, Hungary has demonstrated remarkable improvement since 2008, and the 25 per cent figure for 2014 was outstanding in the region. The public work programme contributed considerably to growth, which can be seen from the fact that without the workers employed in public work programmes, this proportion would have been around 21 per cent in 2014. The region lags far behind the EU average, as the corresponding figure in the EU28 was 36.2 per cent in 2014. The employment rate of persons before retirement has improved in recent years, for example due to the targeted Job Protection Action Plan and the tightening of the eligibility criteria for early retirement benefits, however, Hungary still has much catching up to do in this field. â&#x20AC;&#x201D; 630 â&#x20AC;&#x201D;

13. Labour market competitiveness

The average in the EU28 was 51.8 per cent in 2014, while the Hungarian figure was 41.8 per cent. Youth employment shows a similar picture: the figure has improved, amounting to 23.5 per cent in 2014, but the difference between that and the 32.5 per cent EU average is still substantial. With respect to the proportion of middle-aged women in employment, there has also been an improvement in recent years, and the country lags behind the average by less: Hungary’s figure is 67.1 per cent, while the EU average is 69.9 per cent (Chart 13-4). Chart 13-4: Employment rate in certain key social groups 80

Per cent

Primary education (15–74)

Employees before retirement (55–64) 2008

Young (15–24)

2014

Slovakia

Poland

Hungary - without public employees

Czech Republic

Slovakia

Poland

Slovakia

0 Czech Republic

Slovakia

Poland

Hungary - without public employees

Czech Republic

Slovakia

Poland

Hungary – without public employees Hungary – without public employees

Czech Republic

Middle aged women(25–39)

EU28 – 2014

Source: Eurostat

Supporting the employment of low-skilled groups is especially important due to their large size: in 2014, on average 1.45 million people belonged to this category in Hungary. The low-skilled group accounted for 14.7 per cent of the total population, which is higher than the figures — 631 —

Part II: Competitiveness reforms

characteristic of neighbouring countries: the proportion was 8.3 per cent in the Czech Republic, 10.3 per cent in Poland and 10.8 per cent in Slovakia. By contrast, the EU28 average is higher, at 17.7 per cent, which can be mainly attributed to the Italian and Spanish figures. Based on the above, incentives for these group should be introduced on the labour supply side as well. The current employers’ social contribution allowance and the Job Protection Action Plan boosts labour demand, but does not act as an incentive on the labour supply side in the short run. Therefore, extension of the allowance to employees’ social contributions should be considered, as it may result in higher net wages with the same gross wages, thereby further boosting labour supply on the extensive margin. The extension of targeted allowances to employees’ social contributions may increase employment more effectively than an across-the-board reduction in contributions, as targeted allowances provide benefits to groups more loosely linked to the labour market that react to allowances more strongly. In addition, the measure’s demand-side effect may also be substantial, as the consumption rate of these social groups is higher than average.

13.3 Lifting the upper limit of the Job Protection Action Plan Similar to the previous point, the goal is to increase employment in the groups covered by the Job Protection Action Plan. This can be facilitated by raising the upper limit where the targeted employer’s social contribution allowances provided through the Job Protection Action Plan can be claimed, at least to the level of the minimum wage.

Employment has expanded significantly in Hungary in recent years, but the participation rate still lags behind the EU average and the level of Hungary’s regional peers (Chart 13-5). The targeted allowances — 632 —

13. Labour market competitiveness

introduced in the framework of the Job Protection Action Plan played a central role in boosting employment. This is because these allowances target groups (the young, the old, the low-skilled, the long-term unemployed, mothers returning after childbirth), whose participation rate was especially low in Hungary compared to the EU average, and these groups react more strongly to financial incentives, and thus also to tax allowances, when making their decisions about entering the labour market. It should also be pointed out that, from a fiscal perspective, targeted allowances are more effective in expanding employment than across-the-board tax cuts.133 Chart 13-5: Participation rate in various social groups

Primary education (15–74)

Employees before retirement (55–64) 2008

Young (15–24)

2014

90 80 70 60 50 40 30 20 10 0

Slovakia

Poland

Hungary

Czech Republic

Slovakia

Poland

Hungary

Czech Republic

Slovakia

Poland

Hungary

Czech Republic

Slovakia

Per cent

Poland

Hungary

Per cent

Czech Republic

90 80 70 60 50 40 30 20 10 0

Middle aged women (25–39)

EU28 – 2014

Source: Eurostat

In order to preserve the effectiveness of the targeted allowances accessible within the framework of the Job Protection Action Plan, the upper limit may have to be indexed, for example linked to the minimum 133

On the effectiveness of targeted allowances, see Baksay and Csomós (2014).

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Part II: Competitiveness reforms

wage. At present, the targeted allowances can only be claimed for gross incomes of up to HUF 100,000. Raising the upper limit may contribute to the expansion of employment, which may lead to an increase in households’ income and consumption. In addition, this measure may also improve the competitiveness of exporting companies by reducing wage costs. Based on the 2015 data, this step would reduce the wage costs of approximately 800,000 employees.

13.4 Developing the public work scheme: education and incentives for market employment The goal is to improve the employment opportunities in the private sector for those engaged in public work. This could be achieved on the one hand by improving training, and on the other hand by providing financial support for employment in the private sector, which would manifest itself in the state covering labour costs for a fixed period.

Of the two large groups of labour market subsidies, active instruments are recommended by both the EU and the OECD, as current experiences show that these are more effective from a labour market perspective. The literature agrees that public work schemes are useful in crisis periods and in their aftermath, but are costly in the long run. Therefore, they should be combined with other programmes that increase the time spent on finding work and help people return to the labour market. A summary study based on 207 of the studies published on active labour market programmes so far (Card et al., 2015) presents three main findings with respect to the proportion of labour market participants guided back to the open labour market by the individual programmes. First, the typical active labour market instruments do not have shortterm effects, and the first results emerge after about 1–2 years. Second, the impact of the individual programmes largely depends on the type of instruments applied. The most successful programmes are coupled with training and private sector employment. Third, the individual — 634 —

13. Labour market competitiveness

instruments have varying effects on participants: they exert a more marked effect on women and the long-term unemployed, while they affect the old and the young less. In Hungary, the proportion of passive and active expenditure in the 2015 budget is 13 and 87 per cent respectively, and three quarters of the active instruments are spent on public work programmes. The public work programme is successful, as it integrates previously inactive and unemployed groups into employment, helps groups that are currently unable to find work on the open labour market, and also has a social function. However, the proportion of those transitioning from public work to the open labour market is quite low for the time being: 180 days after leaving public employment, only 13 per cent of public workers continue to work on the open labour market (Chart 13-6). In the context of accelerating economic growth, a higher rate should be targeted. Chart 13-6: Distribution of those leaving public employment by status after 180 days 7%

46%

13%

34%

Working in the open labour market Public employee

Registrated unemployed Not registrated, not employed

Note: In the case of persons who took part in public employment in 2011 or 2012. Source: Cseres-Gergely and Molnár (2014)

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Part II: Competitiveness reforms

In line with the above reasoning, more weight should be attached to education within the public employment system, and fostering more active private sector engagement may also contribute to the improvement in efficiency. This can be implemented in a unified system in which the market employer – which has a better grasp of the necessary knowledge – educates employees and employs them at the same time. In order to encourage this, the state may finance the total labour costs of the employees from the funds previously spent on public work for a certain period, under the condition that after that the market employer continues to employ the workers for at least the same amount of time.

13.5 Strengthening the elements of the pension system which encourage workers to remain on the labour market The goal is to expand employment in age groups close to the retirement age by giving extra weight to the length of service in excess of 40 years when calculating the initial old-age pension. This would provide more incentives to employees close to retirement to continue working.

Due to the tightening of the eligibility criteria for early retirement benefits effective from 2012, and the gradual raising of the old-age retirement age between 2014 and 2022, the gradual increase in the effective retirement age and the participation rate of the old is expected to continue in the coming years. Despite these developments, the overall participation rate of the old still lags behind the EU28 average. The participation rate of workers close to retirement is low in international comparison. In the 55–59 age group, the Hungarian participation rate is 4 percentage points lower than the EU average. The country lags far behind in the case of the 60–64 age group, the participation rate of which is merely 21 per cent, while the average figure in EU Member States is 40 per cent (Chart 13-7). In the 60–64 age group, labour market participation drops dramatically compared to the — 636 —

13. Labour market competitiveness

55–59 age group. This suggests that when reaching the retirement age, most workers decide to retire and do not remain on the labour market. Chart 13-7: Participation rate of the working age population and the workers close to retirement in 2014 100

Per cent

80 60 40 20

15–64 ages

55–59 ages EU28

Terciary education

Secondary education

Primary education

Total

Terciary education

Secondary education

Primary education

Total

Terciary education

Secondary education

Primary education

Total

60–64 ages

Hungary

Source: Eurostat

In the case of workers close to retirement and those who have already reached retirement age, raising the participation rate should be coupled with various pension incentives. Working beyond retirement age has several benefits for employees, employers and the budget. On the one hand, the income of the employee does not decrease: in international comparison, the Hungarian replacement ratio is high, but since it is lower than 100 per cent, retirement inevitably entails a drop in income. According to the pension recommendations of the OECD, working beyond retirement age can contribute significantly to providing the appropriate level of pensions (OECD 2013), because as the number of years in service increase, workers are entitled to higher pensions. In addition, employment in older age may also play an important role in maintaining health (mental health). Keeping the experienced employees who have already received the necessary training may also be advantageous for employers. Working beyond the retirement age — 637 —

Part II: Competitiveness reforms

has a clear positive impact on a given year’s budget, as the workers’ number of years paying contributions increases, which means revenue for the budget, while at the same time no pension has to be paid to such workers. It may encourage employment close to and beyond the retirement age if the percentage of net income used for calculating old-age pensions was higher in the case of the years in excess of the 40-year service period. At present, the old-age pension amounts to 80 per cent of the average wage after 40 years in employment, which increases by 2 percentage points after 40 years. Raising this rate may provide an incentive for working beyond the retirement age. Ceteris paribus, due to the increase in the years spent on the labour market and the decrease in the years spent in retirement this measure is not expected to have a substantial impact on the budget balance.

13.6 Promoting non-standard forms of employment The goal is to expand participation and employment by promoting nonstandard forms of employment such as remote and part-time work. These forms of employment may facilitate work in several situations, but in European comparison, they are rarely used in Hungary.

With respect to non-standard forms of employment – which include fixed-term employment, remote work, part-time work, student work and temporary agency work – Hungary and the other Visegrád countries all lag behind. Non-standard employment has several benefits: it provides flexibility to the employer during periods of increased and reduced workload, and places less burden on permanent and full-time employees, which leads to less working hours lost and less sick pay. It also helps the employment of mothers with small children, young people and students, and can be used in the case of a permanent illness, during the vacation period and for substituting for employees on parental leave (gyed or gyes). — 638 —

13. Labour market competitiveness

Chart 13-8: Proportion of part-time employees relative to total employees 25

Per cent

2005

2006

2007

Hungary Slovakia

2008

2009

2010

Poland EU28

2011

2012

2013

2014

Czech Republic

Source: Eurostat

Introducing measures for raising the proportion of part-time employees should be considered. The new Labour Code was a step forward in this regard, and thus the legal conditions are in place. However, there are few incentives for employers and employees.

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References Baksay G. – Csomós B. (2014): Az adó- és transzferrendszer 2010 és 2014 közötti változásainak elemzése between 2010 and 2014 using a microsimulation model). Köz-Gazdaság, Special issue on tax policy, Volume IX, Issue 4. Card, D. – Kluve, J. – Weber, A. (2015): What Works? A Meta Analysis of Recent Active Labor Market Program Evaluations. National Bureau of Economic Research, Working Paper No. 21431. Cseres-Gergely Zs. – Molnár Gy. (2014): Munkapiaci helyzet a közfoglalkoztatásból való kilépés után (Labour market situation after leaving public employment). Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences. OECD (2010): Tax Policy Reform and Economic Growth. OECD Tax Policy Studies 20. Paris: OECD Publishing OECD (2013): Pensions at a Glance 2013: OECD and G20 Indicators, OECD Publishing. http://dx.doi.org/10.1787/pension_glance-2013-en Prammer, D. (2011): Quality of Taxation and The Crisis: Tax Shifts from a Growth Perspective. Taxation Papers 29.

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Corporate competitiveness Sustainable and dynamic economic growth over the long run may only stem from the proper operation of the private and the corporate sector. In a middle-income country such as Hungary, this requires growing, effective and competitive corporations that are able to become sufficiently innovative in order to reach this objective. Another condition for the development of these enterprises is rapid capital accumulation and its adequate structural composition. The quality of productive private investments is mainly determined by corporate management capabilities, but state regulation and incentives may also promote the focused implementation of investments that are able to increase the economic output level over the long term. This chapter summarises the objectives and potential tools with which the state can play a significant direct role in boosting the competitiveness of corporations. Such areas may include creating a more investment friendly tax regime, fighting tax evasion, streamlining the tax regime, fostering research and development, reducing geographic differences and creating a predictable business environment. In order to institute a tax system that better supports productive investments, the current distortive characteristics of income taxes (such as corporate income tax) on investment and savings decisions should be reduced. As taxes on income are imposed again on returns gained through the investment of taxed income, they reduce economic agentsâ&#x20AC;&#x2122; propensity to save and invest, which slows capital accumulation and thus the improvement of productivity within the economy.

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A reduction in tax evasion could also have a significant impact on economic growth prospects. Businesses finding ways of tax avoidance gain an unearned competitive edge, which distorts competition and the effective allocation of capital. Lower tax evasion results in a broader tax base, which allows the application of a lower tax rate, allowing a greater number of taxpayers to pay less taxes while seeing tax receipts rise. The simplification of the tax regime can also significantly boost corporate competitiveness. The Doing Business survey reveals that companies may spend up to 277 hours per year on tax-related administration, which far exceeds the OECD average. Abolishing the tax advance supplementation could help simplify the corporate tax regime, and thus reduce administrative burden for corporations while improving intra-year budgetary planning. The technological development and innovation stemming from research and development largely contribute to improving competitiveness and productivity, laying the foundations for sustainable economic growth. In order to cultivate an environment promoting R&D activity, microlending should be supported and more focus placed on scientific and engineering domains within higher education, in order to ensure the fundamental human capital condition needed for research and development. Besides the foregoing, taking into account in regional economic characteristics and geographic location is particularly important in the case of Hungary, as it is characterised by marked geographic and social differences. Therefore, decreasing geographic differences and developing the lagging regions may be an important objective.

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14.1 Mitigating tax evasion The goal is to approximate the size of the hidden economy to the regional average by raising the minimum income (profit), expanding the National Tax and Customs Administration’s (NAV) set of instruments, promoting electronic payment methods and rationalising the current tax burden on letting property. Combating the hidden economy may not only boost budget revenues, but also reduce the effects distorting competition.

According to international surveys, the size of the hidden economy between 2003 and 2015 may have hovered around 22–25 per cent of GDP (HUF 6,000–7,000 billion) in Hungary, and therefore the potential profits from reducing the hidden economy may be substantial (Schneider 2015). According to analyses employing direct methods, the proportion of concealed employment has been around 7–10 per cent in Hungary since the turn of the millennium, while studies using indirect methods show it to have been around 10–17 per cent. In his analysis based on European countries’ 2008–2009 data from the European Social Survey, Hazans (2011) estimates that the proportion of workers employed informally (without a contract) in Hungary is 9.4 per cent. This figure is lower than the approximately 12 per cent estimated for Central and Eastern European countries (Czech Republic, Romania, Slovakia) but is higher than in the Baltic states (Latvia, Lithuania). The questionnaire-based survey by Eurobarometer on the size of concealed employment134 produced similar results for Hungary: 7 per cent of the respondents performed undeclared work in the previous 12 months, and 8 per cent of employees received at least part of their income undeclared (European Commission 2007).

134

The survey considers undeclared work to be a legal economic activity that is concealed from the tax authorities, and for which the employee receives payment in cash or in kind (European Commission 2007).

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Part II: Competitiveness reforms

Chart 14-1: Estimated size of the hidden economy in European Union countries in 2003 and 2015 40

Per cent

40 35

Bulgaria Romania Estonia Lithuania Cyprus Malta Latvia Poland Slovenia Greece Hungary Italy Spain EU27 average Portugal Belgium Czech Slovakia Sweden Finland France Germany Denmark Ireland United Kingdom Netherlands Luxemburg Austria

2003

2015

Source: Schneider (2015)

Based on pension insurance contributions, Augusztinovics and in Hungary was around 10 per cent in 2001. According to Elek et al. (2009), the share of workers employed informally may have been higher, around 16â&#x20AC;&#x201C;17 per cent, between 2001 and 2005, and this did not change considerably during the period under review despite a substantial minimum wage increase in 2002. In examining the distribution of informal employment, the authors found that informal employment was higher among the self-employed than among employees, more common among men than women, more widespread in certain profession groups such as construction, and more common among the young. Unfortunately, there is no similar estimate for recent years that would show the changes over time in informal employment measured with this method, and the current extent of this kind of employment.

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The hidden economy can exert an unfavourable impact on the economy through various channels: • The hidden economy causes revenue losses, as the workers participating in the hidden economy pay only a part of their taxes and contributions or none at all, while at the same they use state services. • Businesses exploiting the various means of tax evasion gain an undue competitive edge, which distorts competition and thus the effective allocation of capital. For example, by avoiding the taxes on labour, companies engaged in tax evasion can pay wages – that create the labour market equilibrium – even when they utilise labour much less efficiently. Meanwhile, due to the loss in tax revenues, the tax burden on taxpayers operating legally has to be increased, and as a result, the companies operating more efficiently and generating greater value added but not engaging in tax evasion are driven out of the market. • The hidden economy distorts the economic indicators necessary for economic policy decision-making. In addition to distorting the statistics that decisions are based on, the hidden economy may also modify the intended results of economic policy measures, for example the expected effect of measures impacting certain income groups. Therefore, reducing the hidden economy may make decision-making more effective and increase the precision of targeted measures. • Informal employment reduces the social and legal security of employees. In the case of informal employment, employees are not entitled to health insurance benefits in cash or in kind, and they may be ineligible for state pension or may be only eligible for a lower pension. If employees participate in the formal economy, their financial and legal security is strengthened through the enforceability of contracts. Reported employment enables employees to take out loans, and thus reducing the hidden economy may contribute to the expansion of borrowing. In addition, reported employment requires

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Part II: Competitiveness reforms

employers to provide the statutory rights and the appropriate working conditions to employees. The combating of tax evasion may be supported by raising the minimum income (profit) introduced in corporate taxation. In essence, if taxpayers’ profits or tax base are below this minimum, they can choose whether to pay the corporate tax on the minimum income (profit) or to attach a supplementary form to their tax return, based on which the tax authority chooses taxpayers – in whose case there are reasonable grounds to believe that the reported profits of the company are the result of the concealment of revenues or irregular practices in cost accounting – for checking whether they paid certain tax liabilities. The veracity and realisation of the economic events deemed suspicious by the tax authority, as well as the fact that the costs (expenses) were incurred in the interest of the company, should be proven by taxpayers. According to a recent study, the introduction of the minimum income (profit) may have contributed to the reduction of the hidden economy without influencing the production decisions of companies (Mosberger 2015). This suggests that it may be useful to raise the minimum income (profit) further from its current level of 2 per cent. Moreover, combating tax evasion may be supported by the more frequent application of so-called horizontal monitoring, which is widespread in several Western European countries. In this approach, the tax authority does not inspect companies’ tax returns subsequently, but consults with taxpayers about problematic transactions even before they file their returns. This would not only reduce tax evasion, but would also be advantageous for medium-sized and large enterprises playing by the rules, since this approach would cut the number of resource-intensive inspections.

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14. Corporate competitiveness

The further spread of electronic payment methods may also contribute to the reduction of the hidden economy. Hungarian households’ use of electronic payment methods is still below the EU average, and even though the direction of developments is encouraging, their pace is unsatisfactory. There is also room for improvement with respect to paying for purchases electronically, but in an EU context Hungary lags the most conspicuously behind with regard to electronic bill payments. The share of electronic – mainly card – purchases in households’ consumption was below 15 per cent in 2014, while the corresponding EU average was 28 per cent. Since for the time being the penetration of innovative electronic payment methods is low in Hungary, electronic purchases are basically limited to card payment transactions. Accordingly, there is considerable room for improvement in this field, and progress may be promoted by the spread of new payment methods such as contactless card technology, or the introduction of mobile payment services. With respect to the electronic payment of utility bills and other services, Hungary performs considerably below the international average. In 2014, one quarter of all bills were paid electronically by Hungarian customers, while the corresponding figure in the EU was 70 per cent. The 25 per cent share of electronic bill payments is also extremely low because in the majority of the cases electronic payment options are already available in the form of direct debit. The proportion of electronic bill payments may be increased through the enhancement of payment services offered at post offices, the higher penetration of electronic bill management and payment solutions, as well as the introduction of certain innovative bill payment solutions to the market (Table 14-1).

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Part II: Competitiveness reforms

Table 14-1: Householdsâ&#x20AC;&#x2122; use of electronic payment instruments in Hungary and the EU Indicator

Calculation Method

Credit transfers

Annual value of credit transfers / GDP

Hungary

European Union

2013

2014

2013

15.8%

16.1%

17.2%

Electronic payment of Annual value of payments made retail purchases by payment cards and other electronic solutions / Annual household consumption

12.8%

14.9%

27.9%

Electronic payment of Estimated annual value of direct utility bills and other debits and other electronic bill service charges payments / Estimated annual value of bill payments

24.3%

25.4%

70%

Source: MNB (2015)

The rationalisation of the tax burden on letting property may also contribute to reducing tax evasion. In line with the current regulations, income from letting property is taxed, up to HUF 1 million, at the 16 per cent personal income tax rate. However, if such income exceeds HUF 1 million, the total amount is taxed at the 16 per cent personal income tax rate and an additional 14 per cent healthcare contribution is to be paid. This results in a controversial situation because the net income realised with HUF 1 million (HUF 840,000) can be earned next with HUF 1.2 million. The currently effective tax regulation does not encourage the reporting of income from letting property and also reduces personal income tax revenues, since owners, if they report their income from letting property at all, are better off setting a lower price in this band. Therefore, the healthcare contribution levied on letting property should be reformed so that in the case of incomes exceeding HUF 1 million, the 14 per cent healthcare contribution is only levied on the portion in excess of HUF 1 million. This change can encourage the reporting of incomes from letting property and the reduction of the hidden economy. The losses from the healthcare contribution can be offset by the surplus tax revenue collected from the higher number of legally â&#x20AC;&#x201D; 648 â&#x20AC;&#x201D;

14. Corporate competitiveness

rented properties, and, in the case of already reported properties, the surplus personal income tax revenue resulting from the reporting of the actual (higher) incomes.

14.2 Simplifying the payment of the corporate tax The goal is to reduce the administrative burden on companies and to improve the intra-year predictability of the budget through the elimination of the tax advance top-up.

In accordance with the current regulation, companies are required to supplement (“top up”) their corporate income tax advance paid during the tax year by 20 December to the expected amount of the tax liability, if their net sales revenue exceeded HUF 100 million in the year preceding the current year.135 The regulation on the tax advance top-up has an adverse impact on companies, the predictability of the budget and the intra-year distribution of budget revenues. Nevertheless, it is practically neutral from the perspective of the budget balance, as it only influences the intra-year distribution of revenues. The advance top-up system imposes a considerable extra administrative burden on companies and the tax authority. Companies are required to prepare their final annual accounts and based on that their corporate tax returns by the last day of the fifth month following the business year. Therefore, at the deadline for the advance top-up, companies are forced to estimate the profits for the final period of the year, and to fulfil their advance top-up obligation based on that. In addition to causing a substantial extra administrative burden for companies at the end of the business year, there are several external factors profoundly influencing the life of businesses that cause 135

A similar top-up requirement is set out in the case of the innovation contribution and the income tax of energy providers.

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Part II: Competitiveness reforms

uncertainty in estimating annual profits and the tax liability. Such factors are the fluctuations in exchange rates at the end of the year, or a delay – due to external reasons – in a workflow planned to be finished and billed by the end of the year. These factors can swing the planned annual profits and thus also the tax liability of a company in either direction to a great extent. Inaccurate performance of the advance top-up obligation in either direction has negative consequences for the company. If companies underestimate their tax liability, they are required to pay a penalty, and if they overestimate it, the fact that they can only apply for a refund of the overpayment after their annual tax return has been filed may cause liquidity problems. From a budgetary standpoint, the top-up system has a negative effect on predictability and the even distribution of revenues. Due to the advance top-up obligation, the forecast of annual corporate tax revenues involves considerable uncertainty until 20 December (Chart 14-2). This makes it difficult to predict the annual deficit and to manage government debt and the state’s liquid deposits. If the top-up requirement were to be abolished, an accurate projection could be prepared on the volume of corporate tax revenues in the middle of the year, when the annual tax returns are filed. Chart 14-2: Monthly developments in corporate tax revenues 250

Billion HUF

250

200

150

100

50 0

2013

2014

Source: Hungarian State Treasury

— 650 —

2015

December

November

–50 October

August

July

June

May

April

March

February

January

–50

September

14. Corporate competitiveness

Abolition of the top-up system would cause a one-off revenue loss for the budget in the year of the measure’s introduction, which may be close to HUF 200 billion. In view of the size of the amount, which corresponds to 0.5 per cent of GDP, two possible solutions could be considered for a gradual phase-out over several years: • A staggered decrease in the ratio of the 90 per cent rule applied in the penalty (currently companies are only required to pay the penalty if the sum of the tax advances and the tax advance top-up is less than 90 per cent of the actual tax liability). • A gradual reduction in the scope of companies required to top up by increasing the current sales revenue limit of HUF 100 million.

14.3 The approximation of the corporate tax towards The goal is to create a tax regime that supports productive investments, and to this end, the distortive characteristics of income taxes (such as the corporate tax) on current investment and savings decisions should be reduced. This may be facilitated by the approximation of the corporate tax towards “cash-flow” taxation.

The greatest drawback of the taxes on capital income (such as the corporate tax) is that they distort saving and investment decisions, and therefore hamper capital accumulation, which hinders productivity growth in the economy. As taxes on income are imposed again on yields gained through the investment of after-tax income, they reduce economic agents’ propensity to save and invest.

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Part II: Competitiveness reforms

In addition, taxes on income create a considerable administrative burden, and they also distort the decisions of economic agents in other ways, inducing further productivity losses (Nobilis and Svraka 2014): • It is a conceptual problem in the case of the corporate tax that the tax base is the accrual-based profit, the legal definition of which leads to several difficulties. This is primarily due to the fact that when calculating the accrual-based profit, non-realised profits also need to be taken into account, which requires a detailed and complex regulation. Moreover, the rules governing corporate taxation and accounting are different. An example for this is depreciation, which, when calculating the corporate tax base, should not be taken into account with the rates defined in the accounting policy of the company, but using the rates in the Corporate Tax Act. • In general, corporate taxes are neutral with respect to the funding structure of companies. In this case, the distorting effect stems from the fact that interest expenses can be recognised as costs, and therefore they reduce the corporate tax liability and thus also the cost of loan financing (this is the so-called “tax shield”). Dividends, however, are paid from after-tax profits, so there is no similar opportunity in this case. This encourages companies to shift their funding structure towards loan financing. • Another disadvantage of the corporate tax being based on the accounting profit is that it is calculated from the nominal profit of the company and does not take inflation into account. In such a scenario, it is possible that a company which is making losses in real terms is liable to pay corporate tax. The theoretical literature provides several possible solutions for eliminating the distortions caused by profit taxes (OECD 2007). One

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14. Corporate competitiveness

such solution is cash-flow taxation, which calculates the tax base from the cash flow rather than from the accounting profit. In this approach, the companyâ&#x20AC;&#x2122;s expenses (and therefore also its investments) can already reduce the tax base in the year when they are accrued, which encourages companies to reinvest their profits. This stands in contrast to the corporate tax, as in the case of that, the total value of an investment is integrated into the tax base through depreciation over the course of several years. Thus, cash-flow taxation is especially favourable for new businesses, as in their case, thanks to this solution, the tax liability only arises after the initial investments generate returns. Since capital income is not taxed when it is reinvested into the company, such taxes do not distort investment decisions. This is because capital income is only taxed once, and thus the present value of the tax liability does not depend on when the income is withdrawn from the company. According to the theoretical literature, the tax base in cash flow terms can be determined in various ways. One of the special methods for calculating the tax base is to only include the cash flow between the company and the owner in the tax base. This solution is exemplified by the Estonian dividend tax, which is only levied on the dividend withdrawn from the company (and other profits withdrawn from the company by the owners). However, Nobilis and Svraka (2014) point out that in Estonia the income from issuing shares cannot be deducted from the tax base. Therefore, such a tax is only neutral with respect to the marginal investment and financing decisions in companies where investments can be financed from profits reinvested in the firm. In the case of a new, expanding company that requires new capital, this neutrality does not hold.

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Box 14-1: Small enterprise tax

In Hungary, the tax type closest to cash-flow taxation is the small enterprise tax (KIVA), which was introduced in 2013, within the framework of the Job Protection Action Plan.136 The KIVA is an alternative form of taxation that can be chosen by companies with up to 25 employees and an annual turnover and balance sheet total below HUF 500 million. Choosing this type of tax instead of the corporate tax is especially advantageous for companies that have a higher wage bill and/or plan larger investments in the near future. This tax type eases the burden on companies with high employment costs, and at the same time fosters the expansion of employment, as the tax base for the 16 per cent tax is made up of the company’s profit in cash flow terms plus labour income, and this tax replaces corporate tax, the social contribution tax and the vocational training contribution. Moreover, as a result of the consolidated tax base, in the case of companies that generate profits in cash-flow terms, increasing wages does not cause an additional burden for the employer in terms of taxation, since the extra wages decrease the profits in cash flow terms and thus also the tax base for the KIVA. The KIVA also stimulates investments through the fact that the tax base is calculated with the cash-flow accounting system. The advantage of the tax base in cash-flow terms is that it can be immediately reduced by the amount of income reinvested for developments, in contrast to the corporate tax, as in that case, the total value of an investment is integrated into the tax base through depreciation over the course of several years. Furthermore, companies’ tax liability only arises in relation to already paid invoices, as in cash-flow accounting the invoiced but not yet received revenue is not recorded. 136

Act CXLVII of 2012 on the Fixed-Rate Tax of Low Tax-Bracket Enterprises and on Small Business Tax.

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14. Corporate competitiveness

The small enterprise tax was chosen in early 2013 by 7,500 companies, and this number has basically not changed until 2015. The relatively low number of companies opting for the KIVA may be explained by the fact that the transition is hampered by the learning costs associated with cash-flow accounting. The understanding of the regulation is perhaps also hindered by the fact that calculating the tax base required companies to record some tax base adjustment items, which did not arise in the case of the vast majority of businesses, but these were necessary to avoid corrupt practices.

Although cash-flow taxes have positive long-term effects, the transition from the corporate tax based on accounting profit can only be implemented by navigating complicated transition rules and incurring substantial revenue losses, which is problematic. In addition to the immediate changeover to cash-flow taxation, the following solutions could be considered that would approximate corporate taxation to cash-flow taxation, but would not require a fundamental overhaul of the tax regime: • Increasing the depreciation rates applied in the corporate tax regime. The largest difference between profits calculated according to the accounting method and the cash-flow method is that the value of investments is recorded in profits over the course of several years and not at the time of investment. The Corporate Tax Act defines the depreciation rate that should be applied for each asset type when calculating the tax base. Should this rate be raised, the accounting profit could be approximated to the profit in cash-flow terms. In such a case, the value of investments would decrease the tax base by more in the year when the investments are realised, and therefore this would foster investments. • Relaxing the conditions of choosing the KIVA and simplifying the transitional rules. The KIVA is a form of taxation that is close to cash-flow taxation, which is already present in the Hungarian tax regime. By relaxing the conditions of choosing this tax type and by simplifying the transitional rules, the number of companies opting for this tax type may be increased. — 655 —

Part II: Competitiveness reforms

14-2: Expanding the targeted investment tax allowance in the corporate tax regime

Currently, in the corporate taxation scheme, allowances can be claimed by small and medium-sized enterprises on 60 per cent of the interest expenses of investment loans. By raising the tax allowance to 90 per cent of the interest expenses, investment loans’ marginal cost would be zero in the case of companies operating in the SME sector. As interest expenses decrease the tax base, the corporate tax liability of companies is reduced by 10 per cent of the interest expenses (provided that companies have a positive tax base and that the tax base does not exceed HUF 500 million). If – in addition to this – 90 per cent of the interest expenses could be deducted from the tax, it would reduce companies’ corporate tax liability by 100 per cent of the interest expenses when taking out a loan. Accordingly, increasing the tax allowance could further boost investment activity and loan demand. Moreover, it would facilitate economic growth and help to restart lending. However, the expansion may further increase the distortionary effect of the corporate tax on companies’ funding structure.

14.4 Regular assessment of existing tax allowances The goal is to expand tax bases through the regular assessment and review of the major allowances in the tax regime, while also taking into account the predictability of the business environment. In contrast to budget expenditure, the amount of tax allowances is not explicitly approved each year when the budget is discussed.

In general, the major tax allowances, tax base-reducing items and preferential rates present in the tax regime should be regularly reviewed and assessed in order to avoid the excessive narrowing of tax bases. From a fiscal standpoint, tax allowances can also be considered expenditures compared to the situation without tax allowances (that is why the allowances are also called “tax expenditures” in the literature). — 656 —

14. Corporate competitiveness

Quantifying these “expenditures”, however, is not easy, especially due to behaviour effects, the interaction with other taxes and various other methodological issues. According to the annex to the 2016 Budget Act, the value of the major tax and contribution allowances may be close to HUF 800 billion in 2016. This amount, however, does not include the effects of preferential tax rates (e.g. the preferential VAT rates or the taxation of fringe benefits). The reduction or elimination of tax allowances may create funds for reducing the general tax rates and for the further, growth-friendly transformation of the tax regime’s structure. Nevertheless, before introducing such a measure, one should always take into account whether the negative economic effects of reducing allowances are offset at the level of the national economy by the positive impact of the tax cuts financed from the resulting available extra funds, and whether it results in an excessive extra burden for certain sensitive social groups. One argument for the regular assessment and review is that – in contrast to budget expenditures – tax allowances are not included in the budget explicitly, and no decision is taken on them annually. Therefore, they are more difficult to identify and control than expenditure items (Kalyva et al. 2014). The importance of the business environment’s predictability must also be underlined in connection with the regular assessment and review of tax allowances. According to certain studies, the stability and predictability of incentives may be more significant from the perspective of the effects affecting the volume of realised investments than the amount of incentives (Serven 1997). Both the theoretical literature and empirical studies claim that frequent changes in the business environment and the tax regime reduce the volume of investments (Scharle et al. 2010). For companies, the lack of predictability manifests itself primarily in the lack of reliable planning. This not only hinders the planning of day-to-day operations, but also the planning and implementation of necessary and desirable investments. Should the uncertainty be too great, in the case of irreversible investments the — 657 —

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benefits of delaying increase, which results in investments being postponed, abandoned or transferred to another country. The results in the 2014 Growth Report prepared by the German– Hungarian Chamber of Industry and Commerce also show the link between the predictability of the business environment and the propensity to invest. According to the results of the study, 43 per cent of the companies which are satisfied with the predictability of the economic policy plan more investments than in 2013, while only 5 per cent of them plan to invest less. By contrast, in the case of companies not satisfied with predictability we can see that a mere 23 per cent of firms would spend more on investments, while 27 per cent would retrench in this field.

14.5 Increasing R&D funding The goal is to increase the R&D spending of the corporate sector by creating an institutional, business and market environment more conducive to research and development.

Technological development and innovation stemming from research and development contributes greatly to improving competitiveness and productivity, laying the foundations for sustainable economic growth. In 2013, in Hungary R&D spending from state, corporate and foreign funds amounted to 1.4 per cent of GDP, which fell substantially short of the 2 per cent average in the European Union. In the same year, per capita R&D spending amounted to EUR 143, while the EU average was almost four times as high (Chart 14-3). The aims of the Europe 2020 strategy include raising the average R&D spending in the EU to 3 per cent, and to this end Hungary undertook to increase its total R&D spending to 1.8 per cent. The corporate sector’s share within the distribution of R&D spending by the sources of financing is 47 per cent, which is lower than the 55 per cent EU average or the financing share of over 60 per cent — 658 —

14. Corporate competitiveness

characteristic of the Nordic countries and Germany. Meanwhile, the Hungarian public sector’s share is 36 per cent, which is higher than the 33 per cent EU average (Chart 14-4). Public funds include direct funds such as the investment grants awarded with the individual decisions of the government, as well as the incentives in the tax regime (development tax allowance, the double deduction of R&D expenses, the contribution allowance of researchers, the 50 per cent tax base reduction for royalty income). In recent years, the ratio of direct funding and public financing through tax incentives has shifted towards direct funding. While the proportion of direct funding was below 40 per cent in 2006, by 2012 it was more than 54 per cent (OECD 2013). Chart 14-3: R&D spending as a percentage of GDP (top), per capita R&D spending in EUR (bottom)

1,600 1,400 1,200 1,000 800 600 400 200 0

Finland Sweden Denmark Germany Austria Slovenia Belgium France EU28 Netherlands Czech Republic Estonia Norway UK Hungary Portugal Italy Spain Luxembourg Lithuania Poland Malta Slovakia Croatia Greece Bulgaria Latvia Cyprus Romania

Percentage of GDP

Per capita expenditure in euro

Sweden Denmark Norway Finland United States Austria Germany Luxembourg Belgium Netherlands France Ireland EU28 UK Slovenia Italy Czech Republic Spain Estonia Portugal Malta Hungary Greece Slovakia Lithuania Cyprus Poland Croatia Latvia Bulgaria Romania

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

2013

2006

Source: Eurostat

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EU 2020 Targets

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Chart 14-4: Sources of R&D funding by sectors 100

Per cent

90 80 70 60 50 40 30 20 0

Germany Slovenia Sweden Finland Switzerland Denmark France EU28 Ireland Netherlands Hungary UK Spain Portugal Italy Malta Austria Norway Croatia Estonia Slovakia Czech Republic Poland Romania Greece Lithuania Latvia Bulgaria Cyprus

Non-profit + higher education Public sector

Non-resident Corporate sector

Source: Eurostat, most recent available data (2011, 2012, 2013)

Chart 14-5: Sources of R&D funding by sectors 3.5

Percentage of GDP

3.5 3.0

2.5

2.0

1.5

1.0

0.5

0.0

Finland Sweden Denmark Switzerland Germany Austria Slovenia France EU28 Netherlands Czech Republic Estonia Norway UK Ireland Hungary Portugal Italy Spain Lithuania Poland Malta Slovakia Croatia Greece Bulgaria Latvia Cyprus Romania

3.0

Non-profit + higher education Public sector

Non-resident Corporate sector

Source: Eurostat, most recent available data (2011, 2012, 2013)

â&#x20AC;&#x201D; 660 â&#x20AC;&#x201D;

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In addition to the corporate and the public sector, 17 per cent of the funds come from abroad, 90 per cent of which are R&D funds provided by foreign-owned companies to their Hungarian subsidiaries, and the rest is granted by international organisations.137 The data show that encouraging the corporate sector can be key in increasing R&D spending, as the funds from companies only amount to 0.66 per cent of GDP, while the EU average is 1.1 per cent (Chart 14-5). Creation of the appropriate institutional, infrastructure, market and business environment contributes greatly to encouraging R&D spending in the corporate sector. However, according to the Global Innovation Index, Hungary is ranked 20th among the 28 Member States of the European Union.138 The compilers of the index use several countryspecific factors to calculate the innovation input index, which shows how conducive a certain country’s institutional, infrastructure, market and business environment is to innovation, and whether the country’s stock of human capital sufficiently fosters research and development. Hungary performs the worst in the category of market environment, as it brings up the rear among EU countries. This is largely influenced by the very small number of microloans, the inadequate protection of investors, low market capitalisation and the low number of venture capital transactions. Hungary also fares poorly among EU countries with respect to the institutional background, the chief reason for which is the inadequate quality of public services provided by the state, the complexity of the tax regime and the low recovery rate of insolvency proceedings. In the category of human capital, the authors of the report point out the low amount of education spending, and that there are very few graduates in science and engineering (Hungary is ranked 26th in the EU). The authors assert that with respect to the business environment, there are few companies offering workplace training, and the level of innovation linkages is low, especially with respect 137 138

OECD 2013, p. 109. The Global Innovation Index is published jointly by Cornell University, INSEAD and the World Intellectual Property Organization (a UN body). The top ten countries in 2015 were Switzerland, the United Kingdom, Sweden, the Netherlands, the United States, Finland, Singapore, Ireland, Luxembourg and Denmark.

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to research collaboration between universities and companies; they furthermore claim that the number of cluster developments and joint venture strategic alliance deals are also low. The World Bank’s country report on Hungary about the business environment also lists the slowness of administrative public services among the factors making the life of businesses difficult, and mentions examples such as the hurdles faced in obtaining construction permits and registering property as well as the complexity of the tax regime. In order to create an environment conducive to R&D activities, supporting microlending should be promoted, and a venture capital fund should be established through public–private co-financing. In addition, in order to lay the basis for the basic human capital conditions for research and development, more focus should be placed on scientific and engineering domains in higher education.

14.6 Increasing the number of researchers and developers The goal is to increase the proportion of workers performing R&D activities within the employed labour force, which may be supported by the extension of the social contribution tax allowance – currently granted to researchers and developers – to graduate researchers working in a research organisation in the corporate sector.

With respect to the proportion of workers performing R&D activities (researchers, developers, support staff) within the employed labour force, Hungary lags behind the EU average. While the EU average for workers performing R&D activities is 1.83 per cent, the corresponding figure in Hungary is merely 1.45 per cent (Chart 14-6).

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Chart 14-6: Proportion of workers performing R&D activities relative to the employed labour force 3.5

Per cent

3.5 3.0

2.5

2.0

1.5

1.0

0.5

0.0

Finland Denmark Austria Sweden Norway Luxembour Greece Slovenia Netherlands France Belgium Germany Ireland Portugal UK Spain EU28 Czech Republic Lithuania Italy Estonia Hungary Malta Slovakia Latvia Croatia Poland Bulgaria Romania

3.0

Source: Eurostat, 2013 data

Within corporate R&D spending, the pharmaceutical industry plays a key role: in 2012, one quarter of the R&D spending was in this industry, amounting to more than HUF 55 billion. R&D spending per researcher was also the highest here. Most researchers were employed in scientific and engineering fields, as well as in the information and communication industries (Table 14-2). In accordance with the current regulation, the researchers and developers holding a PhD degree, employed in research organisations in the corporate sector and with gross earnings of up to HUF 500,000 are entitled to a 27 per cent social contribution tax allowance and a 1.5 per cent vocational training contribution allowance, and those with gross earnings of up to HUF 200,000 are entitled to a 14.5 per cent social contribution tax allowance.

â&#x20AC;&#x201D; 663 â&#x20AC;&#x201D;

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Table 14-2: Corporate R&D spending by industries in 2012 Entrepreneurial R&D expenditure (Million forints)

Researchers, developers headcount

R&D expenditure per researcher (Million forints)

Scientific and technical activities

59 849

3 810

Manufacture of chemicals and pharmaceutical products

59 007

1 430

Wholesale and retail trade; repair of motor vehicles and motorcycles

38 061

1 731

Information, Communication

28 272

2 827

Manufacture of motor vehicles

24 472

1 269

Manufacture of machinery and equipment

15 678

830

Manufacture of computer, electronic and optical products

14 790

1 452

Other manufacturing

8 846

506

Manufacture of basic metals

5 428

281

Agriculture

5 189

214

Food and tobacco production

4 819

258

Rubber, plastics, precious metal products production

3 247

162

Construction

2 174

126

Electricity, gas supply, waste management

1 716

130

Human health activities

330

Education

118

Source: HCSO

In order to increase the number of workers engaged in research and development activities, the tax allowance should be extended to graduate researchers working in the corporate sector. Such allowances provide additional incentives for international companies exhibiting great productivity to relocate a part of their production or developments to Hungary.

â&#x20AC;&#x201D; 664 â&#x20AC;&#x201D;

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14.7 Increasing the innovation management capacities of the SME sector The goal is to raise the proportion of companies successful in innovation within the SME sector by increasing innovation management capacities. Based on the English example, the creation of non-profit consulting centres may prove an effective instrument.

Data from Hungary and the EU show that the innovation success rate of Hungarian small and medium-sized enterprises lags considerably behind the EU average (Table 14-3). Table 14-3: Percentage of companies successful in innovation EU28

Hungary

Successfully innovating companies in percentage of companies with innovation as main activity

Hungary Companies with innovation as main activity

10–49 alkalmazott

45%

28%

11 894

50–249 alkalmazott

61%

43%

3 380

250-nél több alkalmazott

76%

67%

2 674

Source: Eurostat, CIS survey, 2012 data

In order to establish sustainable competitiveness, fostering the SME sector’s innovation management capacity, i.e. supporting the process that spans from the inception of the innovative idea to the point where the product reaches the market profitably is key. This could be ensured by the state through the creation of non-profit consulting centres that can provide free consultation in vital issues such as sources of finance, tax issues, marketing, the exploration of export markets and networking. An example for this is the GrowthAccelerator programme established with British public funding and partly financed from EU funds. This programme provides advice to SMEs with high growth potential in financial, business development, management and innovation issues, organises trainings and provides networking opportunities for the managers of the companies. — 665 —

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14.8 Competing guarantee organisation for facilitating lending to SMEs The goal is to mitigate the lending risks of the SME sector and to support the development ideas of the sector through the expansion of institutional guarantees. The realised developments can boost the economy’s competitiveness and the expansion of employment even in the short term.

The economy is driven by small and medium-sized enterprises. If they can operate smoothly and implement developments, we can expect progress in the revitalisation of the economy and the expansion of employment. The Funding for Growth Scheme (FGS) of the Magyar Nemzeti Bank showed that lending can be expanded considerably if the refinancing costs are low and the interest rates are manageable for small enterprises. The FGS’s success underscores that SMEs want to grow, for which they need external funds. This may be facilitated if micro and small enterprises are represented in the distribution of credit extended by the commercial bank system in line with their market weight and more importantly economic weight, i.e. we need to do everything we can so that micro and small enterprises can realise their development ideas as soon and under as favourable conditions as possible. The developments can boost the economy’s competitiveness and the expansion of employment even in the short term, which has an even greater multiplier effect from the perspective of the country’s potential performance. Earlier studies by the central bank also demonstrated that the realisation of development ideas, i.e. the funding of micro and small enterprises is hindered by the lack of collateral and companies’ poor creditworthiness. This is mainly due to historical reasons, but we do have instruments for addressing the problems, since institutional guarantees would significantly mitigate lending risks too.

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14. Corporate competitiveness

The main task of the (majority) state and bank-owned guarantee organisations is to assume a portion of the lending risks and to support lending to micro and small enterprises. The institutional system for funding has not exploited all of the opportunities that are offered by the guarantees for refundable grants. This would minimise the risks faced by commercial banks, since the vast majority of risks – of course in full compliance with bank regulations – would be borne in part by the refundable EU grants instead of the banks. Banks’ risks would drop without economic interests being undermined. This method would not only guarantee banks’ funds, but also the loans of microlenders focusing on micro enterprises, which the banking system is currently unable or hardly able to manage. For the above-mentioned reasons, guarantees should play a special role in refundable grants. The geographical and professional distance between the current guarantee organisations located in the capital and locally active companies may hinder the widespread use of these financial instruments, which would be necessary for a successful, broad, geographically balanced allocation. In order to preserve own funds, the guarantee fund could acquire guarantees from the international market, primarily from the EIB, to mitigate its own risks. In contrast to the procedures of the currently functioning institutions, this solution would by and large conform to the framework of the new cycle of European Union grants, and it would principally focus on micro and small enterprises and the strengthening of their role.

14.9 Towards a more active domestic industrial policy, adapting new technologies The goal is to establish the institutional and regulatory system supporting the innovation process, as well as to direct the focus of support towards large enterprises and small and medium-sized enterprises based on domestic resources, labour force, expertise and sources of innovation and finance (capital).

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The main drivers of economic growth are knowledge-intensive, innovation-based activities. Accordingly, the macroeconomic environment of industrialised production has undergone several changes in the past decade, which was mostly influenced by the spread of information and communication devices and technologies, as well as the widespread use of the online domain’s organising force and computing capacities. These factors together created an economic environment in the global economy that was dominated by ever stronger competition, and therefore, the companies in the industrial sector and national economies all have to offer high performance under these changing conditions, amidst increasingly intense competition. Technological developments caused the following fundamental changes in the industrial sector: • The labour force employed by the industrial sector is falling, but increasingly high-level and specialised practical skills are needed. • With respect to the direction of business-to-business relations, the increasing cooperation along value chains is dominant, while with respect to the type of relations, irrespective of size, the establishment of coordinated networks is the most typical. • More sophisticated and more intensive communication with consumers is a general trend shaping the economy, and thus it affects companies operating in the industrial sector as well; also, test phases have become typical, and with these ongoing feedback reception an iterative and constant product development process can be achieved, and parallel with this the creation of unique, customized product series become much easier. • The need and opportunities for the compilation, rapid transmission and widespread availability of real-time information make it possible to detect previously invisible processes and phenomena, which, in addition to the above, i.e. providing new information about consumption habits and capacities, enables interventions that target optimisation and resource efficiency. — 668 —

14. Corporate competitiveness

• There were also shifts in the time demand of industrial production’s processes that primarily aim to meet the needs of demand as fully as possible, which can be achieved at ever lower costs thanks to the technological changes. Therefore, in the life cycle of products, the time from planning to reaching the market shortens considerably. One of the most determinant elements of the success of growth processes and the efficient utilisation of resources is that the countrylevel framework (institutional and regulatory system) should provide ever better opportunities for innovation processes, for economic actors to react in a flexible manner, and for all persons and economic entities to use their knowledge capital in the appropriate markets and also in international processes. When the importance of the performance of companies and the economy was recognised, between 2012 and 2014 several professional concepts and strategies were developed in Hungary to support the government’s efforts, focusing specifically on the issue of strategic breakthrough opportunities entailing economic growth. In connection with this, several strategic documents and development concepts139 were drawn up under the auspices of the Ministry for National Economy, which were utilised in this chapter. The European Union’s directives and aims outlining the strategic framework of growth do not identify key industries that could be considered as clear breakthrough points, but offer broad aspects to support more detailed policy directions at national level, such as 139

Big Reform Book – The Hungarian way of growth and employment leading to sustainable development, Hungarian Growth Plan, New Széchenyi Plan, National Development 2030 – National Development and Regional Development Concept, various specialised, sectoral strategies from the industry. In addition, the Ministry for National Economy prepared strategies for 12 industries (electronics, telecommunications industry, pharmaceutical industry and medical instrument manufacturing, basic metal and metalworking industry, vehicle industry, mining, construction and construction materials industry, textile industry, defence and security industry, chemical industry), which conformed to the aims of the New Széchenyi Plan (NSP).

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strengthening competitiveness, improving entrepreneurship and skills, research and development and innovation, the industrial application of digital technologies, the intelligent specialisation of regions or the opening up of the EU’s companies towards international markets. Of course, these are in line with the current global trends, but they do not provide concrete guidance based on domestic features and strengths, and they do not chart paths for sectoral development with respect to the community-level utilisation of funds, although the increasing importance of industrial policy is recognizable, for example, the 2014 communication by the Commission titled “For a European Industrial Renaissance140”. In Hungary, industrial production is still an integral element of economic output, and its contribution to GDP is steadily increasing. (In October 2015, the volume of industrial production exceeded the level observed in the same period of the previous year by 10.1 per cent.) Therefore, from the perspective of the country, it is vital to have an active industrial policy based on domestic strengths and in line with the economic and technological framework that developed in recent decades. Based on this, a strategic basis and vision can emerge for the implementation of private sector developments and development policy interventions. By pursuing such an industrial policy, the sectors and activities generating high value added, i.e. competitive sectors, and the opportunities in vocational training and higher education providing the basis for these, can be supported in a more targeted fashion. From a policy perspective, industrial and business development has to focus on developments being based to the greatest possible extent on domestic resources, labour force, expertise and sources of innovation and finance (capital), and on the concentrated support and development of small and medium-sized enterprises. Import substitution plays a central role within the framework of this policy. 140

Communication from the Commisson to the European Parliament, the Council, The European Economic and Social Committee and the committee of the regions For a European Industrial Renaissance. http://www.ipex.eu/IPEXL-WEB/dossier/ document/COM20140014.do

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Based on foreign examples, choosing Hungary’s own “national champions”141 may also be a successful instrument. This would mean supporting domestic companies – while also taking into account the competition regulations of the European Union – that are not only interested in financial gains (profits), but also in corporate social responsibility. In addition, key sectors of strategic importance with development potential need to be selected, i.e. sectors in which Hungary has substantial growth prospects not only in domestic terms but also internationally. Based on the strategies and concepts determined by the government, these areas include electronics, the automotive industry, tourism (for example health tourism), the food industry, logistics, information and communication technology, the pharmaceutical industry, biotechnology, medical instrument manufacturing and the creative industry (design). The instruments of an active industrial policy are summarised below: • focused industrial strategy: the development of a conscious industrial policy concept and a package of proposals supporting the government’s aims with the involvement of the chosen domestic sectoral and corporate actors; • the creation of value chains as well as a professional and business platform based on Hungarian knowledge (business-to-business cooperation, strengthening of networking): supporting and fostering the establishment of industrial agglomerations (clusters based on a new industrial culture) in key industries, which may represent 141

For this purpose, the government determines directions or introduces “incentives” that favour these entities. When the appropriate guarantees are in place, this method as a government policy approach can be an effective instrument for making the economic potential of (public or private) sector actors more predictable over the short or medium term, thereby ensuring that the economic goals and expectations of the government are met at the major sector levels. This is because this forges a strong partnership between the government and the companies, which guarantees the efficiency of central (state) planning. This method is employed in Japan and South Korea.

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a major juncture of the know-how (knowledge) linked to the sector and the relationship between the market participants (producers, consumers, suppliers), as well as creating strong links between the market, higher education and research institutes; • forming a tighter bond between the domestic SME and startup worlds, and combining the strength of Hungarian-owned multinational firms: national champions cannot substitute for the domestic role, weight and significance of the Hungarian micro, small and medium-sized enterprise (SME) sector, and therefore special attention needs to be paid to supporting and helping the latter, since they remain the engines of the economy. Coupled with this, creative teams and communities need to be created and supported that, at a certain point in their development, are able to enhance another company’s professional performance or efficiency through an acquisition or merger activity; • supporting sector-specific start-ups and innovative developments that can achieve considerable improvement with respect to companies’ efficiency through the expansion of the industrial application of new technologies, domestic patents and procedures; • corporate mentoring programme: in addition to focusing on the current top performing corporate actors in the chosen sectors, a strong emphasis needs to be placed on finding and supporting the emerging companies with significant economic potential that are able to complement or, if necessary, replace the leaders in the sectors in order to preserve and ensure the sectors’ and the country’s competitiveness and economic stability; • cooperation between the sectors and education: the designation of the key sectors may offer guidance with regard to the education of future experts within the framework of the dual training; • creating and promote a business-friendly and knowledge-based economic environment; • expanding the industrial application of new technologies, domestic patents and procedures; • supporting creative teams (e.g. start-up enterprises and their communities); — 672 —

14. Corporate competitiveness

14.10 Regional and local economic development The goal is to strengthen the competitiveness of the various regions in the country and to accelerate the convergence of less developed regions. This can be facilitated by a regional approach in economic policy and development policy, the strengthening of regional programmes to increase the weight of counties and large cities in economic development, the development of local economic development policies for jump-starting growth in inactive or rural regions and for loosening the monocentric economic spatial structure of the country.

Factoring in regional economic idiosyncrasies and spatiality is particularly important in the case of Hungary, as it is characterised by huge regional differences with respect to economic and social factors despite its small size of territory. The analysis of GDP, employment and other parameters at the regional level reveals that the Hungarian growth trajectory is not uniform; instead, 3–4 region types characterised by significantly different development paths can be identified. Not strictly economic factors such as urbanisation, agglomeration effects and geographic location also help to explain the economic differences between the various region types. Budapest and its vicinity is integrated into the global economy, and before the crisis, i.e. until 2007 it showed dynamic growth, generating a substantial share (60 per cent) of Hungarian GDP growth. However, during and after the crisis its growth halted, and it has increasingly lagged behind the capitals of the Visegrád countries. According to per capita data, it falls behind in the domestic field as well. After 2009, its labour productivity also dropped. FDI-driven manufacturing regions Komárom-Esztergom, Fejér, Vas and recently also Bács-Kiskun) have become integrated into the European economy through the facilities of multinational manufacturing corporations, and since 2011 economic growth in Hungary has been largely dependent on the performance — 673 —

Part II: Competitiveness reforms

of these regions. Their economic growth is “staggered”, i.e. growth is boosted by individual investments only temporarily, decelerating again after that, which suggests that the facilities of multinational corporations have not been integrated into the economy, they function as “islands”, and the initial push impact is not followed by others, i.e. local multiplier effects are minimal. Chart 14-7: GDP per capita in Hungary’s counties (2011), and GDP per capita in the regions (PPS) as a percentage of the EU average (2013)

Northern Hungary 41 40 Western Transdanubia 65 67

GDP per capita (thousand forint)

Central Transdanubia 60 59

Southern Transdanubia 45 45

Central Hungary 101 108

Northern Great Plain 41 42

Southern Great Plain 44 45

1429.5–1773.6 1773.7–2109.5 2757.1–4068.0

GDP per capita PPS percentage of EU average in the regions

4068.1–6842.5

2004

2013

2109.6–2757.0

Source: HCSO STADAT

The other regions of the country mainly have companies that produce and provide services for the domestic market. The improvement in the competitiveness of certain firms mainly drives domestic competitors out of the market; therefore, employment does not expand locally, and economic growth is slow. These regions form a heterogeneous group, and in counties with larger university towns (Debrecen, Miskolc, Pécs, Szeged) the skills of the labour force are close to the EU average, although a substantial portion of graduates work in the public sector. — 674 —

14. Corporate competitiveness

Still, potential localisation agglomeration advantages can arise linked to universities. Most of the rural regions do not have internationally competitive economies; only a handful of their companies are competitive, and the skills of the labour force and the quality of corporate management are generally low. Although in a somewhat different structure, regional disparities were already present in the socialist era, but they increased substantially during the transition to the market economy. As a result, a significant portion of the country’s territory - the rural regions in the north-eastern and south-western parts of the country – is unable to gain a foothold in the EU’s competitive market, and only joins economic value creation to a very limited extent, which, after a certain point, restricts the macrolevel output as well. The excessively monocentric urbanisation of the country, the highly capital-centric transportation network, the lack of transversal links and the disproportionate settlement structure all hinder the economic development of rural regions. Due to the character of the Hungarian network of cities, the urbanisation clustering necessary for achieving the “critical mass” of agglomeration advantages has very limited opportunities outside the Budapest metropolitan area. The larger regional cities located near the border owing to historical reasons cannot be considered substantial agglomerations in international comparison, but they could be able to form a region of substantial economic weight together with large cities close to the other side of the border. The previous regional convergence policies (within the framework of the regional development policy) and the rural development policy were unable to effectively tackle these issues. Economic development funds reached underprivileged regions less, and in several cases their utilisation did not contribute to the strengthening of the local, regional economy. In public developments, which dominated the economic framework, — 675 —

Part II: Competitiveness reforms

the forced tendering system generated unnecessary competition among local actors, thereby hampering territorial coordination and synergies. An economic policy with an appropriate spatial “sensitivity” should not only shape the macroeconomic conditions but also find differentiated solutions tailored to the needs of the regions being on various development paths, and it also needs to build on the role of the local, regional level in strengthening economic competitiveness. The territorial efficiency of the development policy can be increased substantially if developments are coordinated spatially and placebased development programmes are implemented reflecting the local conditions, opportunities and needs.

14.10.1 Increasing the contribution of counties and large cities to economic development, and the territorial programmes

According to international empirical results, in the globalising world the regional level plays an instrumental role in economic growth. The key to the global economic success of regions and countries is increasingly their ability to attract the higher levels of the economic value chains, and how well they can “anchor” these activities and avoid their relocation, for example with an exceptional knowledge base, synergy ties or an environment fostering innovation. The majority of the conditions for forming links with value chains can be created in individual regions or metropolitan areas; therefore, in addition to the increasing importance of agglomeration advantages, this also boosts the significance of the regional level. In Hungary, the role as well as the economic and development policy competence of the counties is unclear, and smaller local governments can only provide a limited economic stimulus due to their size and the size of their settlements. Larger cities have the best potential for the local stimulation of the economy, but unfortunately there is no designated authority that would preside over the governance and economic management at the level of regions and urban regions. — 676 —

14. Corporate competitiveness

Possible measures: • Strengthening the economic development and development policy capacities at the level of counties and towns with county-level rights. • Allocating a portion of local business tax revenues to the regional level. • Deepening the integrated regional development programmes in the 2014–2020 period.

14.10.2 Local economic development policy for jump-starting growth in moderately active and rural regions

The consistently lagging regions of a rural character – mostly in the north-eastern, but increasingly also in the south-western part of the country – can only join economic value creation to a very limited extent. The economic policy aimed at international competitiveness cannot provide a solution to the problems of the typically peripheral and mostly rural regions that mainly have low-skilled labour, while managing the social problems arising in such regions places a considerable economic burden on the country. The level of utilisation of the labour force and other resources of these regions is low. These territories require a targeted territorial economic policy beyond the current rural development and regional development policies, which, in line with the model of local economic development, stimulates production for both the domestic and the local (urban) markets based on endogenous resources and taking into account the fact that these regions hold resources of strategic importance (food production, arable land, ecological resources). Possible measures: • Supporting the social economy and community farming schemes in rural regions. • Strengthening the domestic sales channels for rural regions with regard to local products (mainly food) that can compete with imports due to their high quality or easy accessibility. — 677 —

Part II: Competitiveness reforms

• Strengthening urban–rural relations through the transportation links enabling commuting, the cooperation among economic agents (supplier networks) or the functional division of labour among settlements whereby smaller settlements are linked to the urban areas through their recreational, ecological and food producing role. • Introducing regulations favouring the local economy.

14.10.3 Measures for loosening the monocentric economic spatial structure of the country

In Hungary, metropolitan agglomeration advantages can only be observed in Budapest. The disadvantages stemming from the peculiar Hungarian settlement network include the following: the labour markets in the commuting zones of urban areas in the countryside are small, which makes input substitution expensive and difficult, launching modern business services is not financially viable and the proportion of graduates working in the private sector is low. The Hungarian transportation network is central and monocentric: the construction of motorways reaching from the capital to the border, i.e. the central transportation system, fostered the concentration of the economy. Possible measures: • Developing transversal transportation links to supplement the central network. • Strengthening the provincial regional centres (Szeged, Pécs, Debrecen, • Reversing the concentration of higher education in line with the needs of the regional labour market. • Encouraging cross-border agglomeration: the integration of the Miskolc–Košice, Debrecen–Oradea, Szeged–Arad–Timișoara and the cities and economic agents concerned, encouraging clustering, — 678 —

14. Corporate competitiveness

improving accessibility as well as launching regional economic development programmes. • Relocating public bodies to provincial regions in cases where this does not entail disproportionately high extra costs. • Expanding the Budapest metropolitan region in economic and functional terms: together with the inner circle of medium-sized cities around the capital (Salgótarján, Kecskemét, Dunaújváros, Veszprém, Tatabánya) it can be bound together to form a uniform economic region unifying agglomeration advantages and providing a larger supply of facilities and labour through transportation links, governance instruments and common economic programmes. Several aims of the regional economic development fostering competitiveness were formulated in the National Development and Regional Development Concept prepared in 2012–2013.

14.10.4 Strengthening the international and regional competitiveness of Budapest

Although loosening the monocentric spatial structure of the country is an important task, it cannot undermine the competitiveness of Budapest and its region. It should rather be based on strengthening the other regions of the country. As we have pointed out, Budapest and its region, despite its indisputable central role within the country, has lagged behind the other capitals in the region since the crisis with respect to growth dynamics. Budapest is the only urban concentration of Hungary that can be considered large in international comparison, therefore preserving and strengthening its competitiveness is vital from the perspective of the whole country. In order to enhance the attractiveness and accessibility of Budapest, it seems particularly important to improve the accessibility of the Liszt Ferenc Airport that connects Budapest to the whole world and that welcomed ten million passengers in 2015 (by improving the expressway and establishing track-based transportation). — 679 —

Part II: Competitiveness reforms

14.11 Examining the possibility of further cutting regulated energy prices The goal is to improve the competitiveness of companies, to reduce their expenses and to increase the purchasing power of household income, which may be facilitated by further cuts to administered energy prices, which in turn may be enabled by the substantial drop in oil prices over the past one and a half years, and the reduction of natural gas prices.

The price of oil on the world market has declined significantly since September 2014. After an increase in 2011 and later stagnation, the commodity lost approximately 65 per cent of its value, which, due to the considerable energy import need of the country, may enable further cuts to Hungarian energy prices. Chart 14-8: Changes in the world market price of Brent crude oil since 2010 (USD) 140

USD

140

Source: U.S. Energy Information Administration

â&#x20AC;&#x201D; 680 â&#x20AC;&#x201D;

1 Dec. 2015

3 Aug. 2015

5 Apr. 2015

6 Dec. 2014

8 Aug. 2014

10 Apr. 2014

11 Dec. 2013

13 Aug. 2013

15 Apr. 2013

26 Dec. 2012

18 Aug. 2012

20 Apr. 2012

22 Dec. 2011

24 Aug. 2011

26 Apr. 2011

27 Dec. 2010

100

29 Aug. 2010

100

1 May 2010

120

1 Jan. 2010

120

14. Corporate competitiveness

Similar, albeit more moderate, developments were observed on the European market for natural gas. The subdued rise in prices halted at the end of 2013, and then after a slight increase, the price of natural gas halved by the end of 2015. This is an important aspect for Hungary too, as, depending on the type of natural gas, 75â&#x20AC;&#x201C;90 per cent of the Hungarian natural gas imports are influenced by the benchmark futures contracts on Western European trading markets. This process may heighten the possibility of further reducing regulated energy prices.

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References 1970-2020 (Labour market performance and pensions, 1970-2020). Közgazdasági Szemle, Vol. LIV, June 2007, pp. 529–559. Baksay G. – Csomós B. (2014): Az adó- és transzferrendszer 2010 és 2014 közötti változásainak elemzése between 2010 and 2014 using a microsimulation model). Köz-Gazdaság, Special issue on tax policy, Volume IX, Issue 4. Elek P. – Scharle Á. – Szabó B. – Szabó P. A. (2009): A feketefoglalkoztatás mértéke Magyarországon (The extent of informal employment in Hungary). In: Semjén, A.– Tóth, I. J.: Rejtett gazdaság. Be nem válaszai (Hidden economy. Undeclared employment and unreported income – Government measures and the economic actors’ responses). Budapest: KTI Könyvek 11. European Commission (2007): Undeclared Work in the European Union Special Eurobarometer Report No. 284. http://ec.europa.eu/public_opinion/archives/ebs/ebs_284_en.pdf Hazans, M. (2011): Informal Workers Across Europe: Evidence From 30 Countries. IZA Discussion Paper, No. 5871. Kalyva, A. – Astarita, C. – Bauger, L. – Fatica, S. – Mourre, G. – Wöhlbier, F. (2014): Tax expenditures in direct taxation in EU Member States. European Economy. Occasional Papers. 207. December 2014. Brussels. Mosberger P. (2015): Accounting versus real production responses to tax incentives: bunching evidence from Hungary. PhD dissertation. MNB (2015): Payment System Report, MNB, June 2015. German–Hungarian Chamber of Industry and Commerce (2014): Konjunktúrajelentés. Magyarország 2014 (Growth Report. Hungary 2014). Nobilis B. – Svraka A. (2014): és a magyar kisvállalati adó (Solutions for mitigating the distorting effects arising from the taxation of capital gain and the Hungarian small enterprise tax). Köz-Gazdaság, Special issue on tax policy, Volume IX, Issue 4. OECD (2007): Fundamental Reform of Corporate Income Tax – No. 16 OECD (2013): Science, Technology and Industry Scoreboard 2013, Innovation for Growth. Scharle Á. – Benczúr P. – Kátay G. – Váradi, B. (2010): (How can the efficiency of tax regime be improved?). MNB Occasional Papers 88. Budapest: Magyar Nemzeti Bank. Schneider, F. (2015): Size and Development of the Shadow Economy of 31 European and 5 other OECD Countries from 2003 to 2015: Different Developments. Serven, L. (1996): Uncertainty, Instability, and Irreversible Investment: Theory, Evidence, and Lessons for Africa World Bank Policy Research Working Paper Series 1722.

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State competitiveness As a regulator and as the largest economic agent in modern market economies, the state plays a key role in shaping competitiveness. The rules established by the state are binding for all economic agents (although it is important whether the state is able to oversee and enforce these rules). The state collects one third to one half of its income in the form of taxes, which are then redistributed through the budget in advanced economies. Additionally, the state is also the largest employer, producer and service provider with public services playing a key role in competitiveness (such as infrastructure, education, healthcare). Besides the fact that the quality of these activities strongly determines the perfomance of the entire economy, it is also important for the state to perform them efficiently. The utilised resources are by necessity drawn away from the private sector and so the smaller the input invested to attain the best results, the better. A significant portion of public sector expenditures are wage-type expenditures. Certain areas however are characterised by insufficiently effective and motivating wages; as an alternative, performance-based wages could be a better incentives. If this could boost performance, headcounts could be reduced and average wages even increased. Reviewing the institutional structure of state governance in order to reduce parallel activities could also enhance efficiency. Additionally, the standard of state services could be and should be improved in many areas. The extension of electronic public administration could be a general tool for achieving this. To identify where interventions should first be made, regular satisfaction measurements could be introduced regarding the quality of public services. According to international comparisons, administration should be accelerated and streamlined in certain areas, such as the issuance of construction permits, access to electricity and the justice system.

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15.1 Reviewing the headcount and wage expenses of public institutions The goal is to achieve a more efficient public administration, which would free resources for the private sector. The increase in efficiency may manifest itself in the reduction of the headcount, the introduction of a wage system rewarding performances more, or the rise in the average wage, which would make public service jobs more attractive. One of the tools for it would be to reform the wage scale or to introduce wage scale management, which may boost both the financial recognition and the motivation of public employees’ performance better than the average.

The size of the bureaucracy necessary for performing its functions is vital for state operation. According to international statistics, the Hungarian state spends more on itself and employs more people in the public administration than the overwhelming majority of EU Member States (Chart 15-1). This is particularly true in comparison with the Visegrád countries. International comparisons suggest that if the efficiency of the state’s functioning substantially increased, the state would be able to perform the present amount of tasks with fewer capacities. Public administration is used here in its narrow sense (in the sense of “classic bureaucracy”), which does not include the fields of healthcare and education. The fact that the public administration is larger than the average is also proved by the employment figures. Relatively to the total number of employed, the proportion of workers employed in public administration is over 9.1 per cent. There are only two countries in the European Union (France and Luxembourg) where the share of workers in public administration is larger than this and the EU average is 7 per cent. According to the most recent data, Hungary leads the Visegrád countries in this respect. With regard to the proportion of workers employed in public administration, Slovakia is close to Hungary. In Poland and in the Czech Republic, however, the corresponding figures do not even reach the EU average. It should be noted that the institutional set-up may considerably distort statistics, and it is possible that most of the public employees are employed in state-owned enterprises, as for example in the Czech Republic. — 684 —

15. State competitiveness

Chart 15-1: General government spending on general public services (2013) Per cent

8 7 6 5 4 3 2 1

Finland Sweden Cyprus Denmark Hungary Greece Belgium Croatia Luxembourg Austria France Germany EU28 Italy Malta Portugal Slovenia Estonia Slovakia Norway Bulgaria Netherlands Iceland Spain Switzerland Czech Republic Poland Latvia Romania UK Ireland

Research, R&D General public services General services Foreign economic aid Executive and legislative organs, financial and fiscal affairs, external affairs Source: Eurostat (2013)

Chart 15-2: Proportion of workers employed in public administration, defence and the compulsory social security branch 14

Per cent

12 10 8 6 4 0

Luxembourg France Hungary Slovakia Greece Belgium Malta Bulgaria Spain Cyprus Portugal Estonia Germany Croatia EU28 Austria Poland Latvia Czech Republic Sweden Slovenia Norway Lithuania Netherlands UK Italy Denmark Ireland Switzerland Romania Finland Iceland

2014

2010

Note: Hungarian data without public workers. Source: OECD, Government at a Glance (2015), HCSO (2010), HCSO (2014)

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One of the central instruments for attracting, retaining and motivating workers is through wages. In the majority of the Hungarian public administration, this is regulated by the public administration wage scale. One of the most important factors within this is age. The public wage scale should be modified so that the position and the performance of workers receives more weight. This would hinge on wages not being influenced by the perceived or actual abilities of workers, but by the value of their work. The first step towards this would be position evaluating, in particular the assessment of the relative value of a given position within the organisation, i.e. its rank within the hierarchy of positions. The other crucial pillar in determining wages would be the performance assessment. This is relatively widespread in the public sector, but the utilisation of the results has not been adequately integrated into wage-setting decisions. According to a study, more than 50 per cent of performance assessments in the public administration have no consequences, i.e. no feedback was given and employees’ wages were not adjusted (Petró and Stréhli-Klotz 2013). If the link between performance and salaries were stronger, it would significantly boost employees’ motivation and thus the quality of the state’s functioning. Giving more weight to performance assessments may make the distribution of the current wage bill fit more to performances and the role of positions, and might also improve efficiency by being more motivating, which could also entail savings. In addition to the establishment of a set of necessary instruments for incentivising state employees, providing incentives to managers is also important in order to increase the motivation and satisfaction of the employees through efficient wage management. It would further this process if in the case of a warranted downsizing of a certain magnitude, the head of the affected budgetary institution could use the wages thus saved for raising the salaries of other employees (wage bill — 686 —

15. State competitiveness

management). This would contribute to a reduction of civil servants headcount, but more professional and more appreciated financially. Currently, the Hungarian stateâ&#x20AC;&#x2122;s spending on general public services considerably exceeds the European Union average. Based on Eurostat data, the EU countries spend 4.1 per cent of GDP on average for this purpose, while the corresponding figure for Hungary is 5.5 per cent. Within this, Hungary spends especially much on supporting legislative bodies, financial and fiscal activities and foreign affairs. With 4.2 per cent relative to GDP spent on these, Hungary comes second in the European Union.

15.2 Reviewing the structure of public administration The goal is to make the functioning of the state more efficient, which may be facilitated by a review of a broad scope of ministerial background institutions and the reduction of overlaps.

The currently functioning ministerial background institutions cover an extremely wide spectrum of public governance from scientific and cultural institutions, through education and agriculture to healthcare. However, there are many overlaps that should be eliminated in the work of more than 170 background institutions controlled by the ministries. Rationalising or streamlining the system of background institutions may contribute to the reduction of state spending and the more efficient utilisation of funds would free capacities that would help improve the functioning of the institutional system. The rationalisation of the system of background institutions and the elimination of functional overlaps may be stimulated by enhancing cooperation among various ministries. The more ministries are able to share their resources and capacities among each other, the less they will consider to be necessary to create their own background

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institutions for tasks that could be performed by an organisation controlled by another ministry. Chart 15-3: Background institutions controlled by the ministries* Agriculture Ministry of Human Capacities Ministry for National Economy Ministry of Interior Prime Ministrer's Office Ministry of National Development Ministry of Defence Ministry of Foreign Affairs and Trade Ministry of Justice no. 0

50 -

tural vocational schools were not taken into account. Source: www. kormany.hu and ministry documents (by-laws)

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15.3 Regular satisfaction surveys about state services The goal is to enhance the quality of public services through regular satisfaction surveys.

In contrast to market services, the satisfaction of those using state services is difficult to measure. In fields where there are several public service providers, people can choose, i.e. “vote with their feet”. In such areas, the goal should be the publication of objective performance indicators. However in other domains, there are no real alternatives, and therefore satisfaction surveys can help to improve the level of services. The objective and subjective performance indicators may contribute to enhancing the quality of state services. The basic aim of the state’s functioning is to contribute to the success of the community and to support the citizens. Accordingly, one of the most important measurement of the state’s activities is the satisfaction of citizens forming the target group of a given service. One of the advantages is, in the absence of a market mechanism, so it provides direct feedbacks on the activities of the various public bodies, i.e. it is able to point out the areas where more needs to be done as the quality of the service lags far behind people’s expectations. Currently, this feedback is very limited. On the other hand, as the survey would involve the public, the commitment and the identification with the service used by the citizens it may become stronger. If people feel that their opinion counts and that they can expect it to be taken into consideration while improving the service, their willingness to cooperate would certainly grow just like their tolerance, i.e. they would be more patient when minor problems arise. In certain areas of state services, competition could be enhanced by employing objective indicators. In public services where people can choose from several service providers, such as in education or — 689 —

Part II: Competitiveness reforms

healthcare, this situation could spark competition. Nevertheless, this quasi-competition cannot be fully realised in areas where the state has an obligation to provide services in a specific territory. In such cases a realistic compromise needs to be reached. On the other hand, objective performance indicators are already used to rank secondary schools. A similar ranking could be created in primary and tertiary education, too (in the case of the latter, international rankings already exists). It should be assessed whether there are objective indicators in healthcare, based on which similar composite performance indicators could be created. In all cases the chosen scope of indicators and their weight should be carefully considered. External satisfaction surveys are extremely rare with respect to the services financed by the state, especially for services offered by local governments and public service providers. Less than 20 per cent of state employees reported that a satisfaction survey was conducted among the public in the past three years with regard to the activities of the area represented by the respondent. The advantage of this method is that it can be applied even in areas where there is no competition among service providers, irrespective of whether there are objective indicators or not. In the case of state services, satisfaction can also be measured online. On the internet, a central access point could be created (linked to the IT systems of government agencies through the Client Gateway [Ügyfélkapu]) where people could rate or review state services with short text messages (similar to films and accommodations). The reviewed service providers could only access to anonymous reviews and/or the text or numeric ratings compiled by government agencies. Here, an option should be created for both service providers and users to comment on the ratings.

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15. State competitiveness

Chart 15-4: Distribution of answers to the question whether any satisfaction surveys were conducted among the public in the past three years with regard to the activities of the area represented by the respondent 70

Per cent

Public administration Yes

Local government No

Defence

Do not know

gazdálkodás (Public service career and human resource management). Közszolgálati Humán Tükör 2013, component study.

15.4 Encouraging law abidance The goal is to improve the efficiency of settling legal matters, which may contribute to strengthening economic agents’ law abidance. In order to foster this, the time to pass judgments should be shortened.

Within state services, one of the pivotal areas is the judicial system. It is a fundamental expectation of citizens with respect to the judicial system that courts in different areas of the country pass their judgments with a unified application of the law, within a reasonable time. One of the conditions for establishing a predictable and timely judicial system is an efficient, operational central administration that can respond to social and economic changes rapidly. — 691 —

Part II: Competitiveness reforms

In 2013, the AWEF Global Competitiveness Index ranked Hungary 18th in the efficiency of settling legal matters. Although Hungary ranks higher than several Central and Eastern European countries, one of the country’s regional peers the Czech Republic and two Baltic States, Estonia and Lithuania are ranked higher.

Index (1–7, best)

6 5 4 3 2

Finland United Kingdom Netherlands Germany Luxembourg Sweden Denmark Ireland Austria Malta Estonia France Belgium Cyprus Lithuania Spain Czech Republic Hungary Romania Portugal Latvia Poland Bulgaria Greece Slovenia Croatia Slovak Republic Italy

Source: WEF Global Competitiveness Index (2014-2015)

The results above also indicate that improving the efficiency of the judicial system is an important element of enhancing state services. This can include the acceleration of adjudication and the improvement of the administration in connection with the judicial system.

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15. State competitiveness

matters through e-governance The goal is to reduce the administrative burden for the private sector, the key means of which, according to international experiences, is e-governance. Currently, the electronic administration of public matters in Hungary lags far behind the EU average.

One of the instruments for enhancing the efficiency of administrative services is e-governance, i.e. the expansion of the online administration of public matters. The penetration of e-governance is low in Hungary compared to the OECD countries. Although almost 50 per cent of the population gathers information about certain matters related to public administration from official websites, less than 25 per cent get in touch with public administrators or send them forms or questions online. Chart 15-6: Managing public administration matters over the internet (percentage of the 16–74 age group) 90

Per cent

80 70 60 50 40 30 20

Iceland Denmark Netherlands Finland Norway Sweden Ireland France Switzerland Belgium Luxembourg UK Estonia Austria Portugal Spain Greece Hungary Slovenia Canada Slovak Republic Germany Poland Czech Republic Italy

Sending filled forms (last 12 months) Obtaining information (last 12 months) Source: OECD (2014)

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Part II: Competitiveness reforms

On one hand, the further spread of internet-based public administration would ease the life of their citizens, thereby enhancing the satisfaction and trust of the population with respect to state services and on the other hand, it would be the source of considerable savings for the state. The freed-up capacities could be used for improving efficiency in other areas and could also contribute to cut down state expenditures and the headcount in bureaucracy.

15.6 Accelerating the issuance of construction permits142 The goal is to boost investments and to establish a quick lier and more efficient administration in the construction sector – which is crucial from the perspective of both housing and economic growth – especially to reduce the necessary procedures for obtaining construction permit.

Reducing bureaucratic procedures is the key for both the business environment and the satisfaction of the population. Until improving, one of the most strenghten areas within this has been the issuance of construction permits. The number of necessary procedures for obtaining a construction permit for businesses was 23 in Hungary in 2014, which was the second highest figure in Europe. This acts as a distinct competitive disadvantage with regard to new investments as well. However, since 1st January 2016, an important change had been made, so that no construction permit has to be obtained for the authorisation of dwellings with a useful floor area not larger than 300 square metres. Only a simple notification has to be submitted, which significantly shortens the administrative process (e.g. in connection with public utilities) and cuts down administrative costs as well. 142

In this area the amendment to Act LXXVIII of 1997 on the Formation and Protection of the Built Environment in late 2015 was a great progress, as it abolished the construction permit procedure with respect to new residential buildings with up to 300 square metres of useful floor area.

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15. State competitiveness

Chart 15-7: Number of procedures necessary for obtaining construction permits 30

Procedures (number)

25 20 15 10

Czech Republic Hungary Croatia Poland Greece Bulgaria Finland Malta Portugal Romania Netherlands Latvia Estonia Lithuania Switzerland Luxembourg Austria Slovenia Ireland Norway Belgium Slovakia Italy UK Germany France Cyprus Denmark Sweden Spain

Source: Doing Business Index (2014)

15.7 Improving public utility services The goal is to accelerate the occupation of new buildings in the case of greenfield investments and especially to facilitate access to electricity.

In the case of new investments, especially greenfield real estate investment projects, the rapid construction of the appropriate infrastructure is vital. From this perspective, Hungary is at a severe competitive disadvantage because it takes the longest time to connect to the electric grid, according to a recent report (Doing Business Index 2014). While in other countriesâ&#x20AC;&#x2122; authorities of the continent are able to provide electricity to consumers in 103 days on average, Hungarian consumers need to wait 252 days for this. Accelerating this process is

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necessary and inevitable in the improvement of the stateâ&#x20AC;&#x2122;s functioning, the enhancement of efficiency and the raising of the quality of state services. Chart 15-8: Days it takes to connect to the electric grid 300

Days

250 200 150 100

Hungary Cyprus Romania Ireland Poland Lithuania Malta Bulgaria Czech Republic Slovakia UK Italy Luxembourg Netherlands Estonia Latvia Belgium Spain France Croatia Norway Portugal Greece Sweden Finland Switzerland Denmark Slovenia Germany Austria

Source: Doing Business Index (2014)

The following measures can contribute to the improvement of public utility services: a) Planning should be decentralised so that consumers could choose from planners and plans in a competitive setting. Public utility providers have to set and monitor the standards for the connection plan. b) The process of obtaining permits from other public utilities and authorities should be simplified, some of the standardised processes

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could be automated and the legal framework of these relationships must be regulated by law, i.e. by determining deadlines. c) With respect to public utilities, the process could be simplified by shortening the authorisation procedure and the time it takes to sign the service contract. One of the conditions for accelerating the procedure is to simplify the relevant legislations, which do not entail costs. Moreover, the number of administrators dealing with such matters may have to be raised.

The goal is to improve the efficiency of bankruptcy proceedings, which would enhance the financial stability of the private sector, especially for SMEs.

One of the fundamental elements of the stability and predictability of the legal system is the efficient implementation of various bankruptcy proceedings. This is important because these proceedings ensure that lenders and suppliers receive their money or a portion of it at least within the given financial limits and options. Accordingly, the appropriate regulation and implementation of bankruptcy proceedings coordinated by the state is an important element for the enforceability of contracts. The recovery rate of bankruptcy proceedings is only lower in four countries in Europe than in Hungary (Doing Business Index 2014). While the indicator is 38 in Hungary, the continent’s average is over 60, and most of the country’s regional peers also fare better in this respect.

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100

0 Norway Finland Netherlands Belgium UK Ireland Denmark Germany Austria Sweden Spain Portugal Cyprus Czech Republic Italy Poland Slovakia Slovenia Latvia Lithuania France Switzerland Luxembourg Malta Estonia Hungary Greece Bulgaria Croatia Romania

Part II: Competitiveness reforms

Chart 15-9: Recovery rate of bankruptcy proceedings

Per cent

Source: Doing Business Index (2014)

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The competitiveness of human resources The quality and quantity of human capital are key determinants of economic competitiveness and convergence. Human capital stock is one of the determining factors of long-term growth potential: countries with higher human capital stock are able to achieve higher economic growth. The qualitative features of human capital can be improved by increasing the performance of the educational system and the healthcare system. Education affects economic growth via several channels: it increases the productivity of the labour force and the innovation performance of the economy. An improvement in the populationâ&#x20AC;&#x2122;s health condition also contributes to economic performance, as health condition influences labour market activity and contributes to the accumulation of physical capital. Finally, as a result of higher life expectancy, investment in education may also be larger as the longer lifetime increases the return on investment (MNB 2015). This chapter deals with measures that can be taken to improve the quality of human capital in the areas of education and healthcare, and examines the opportunities for improving quantitative conditions. Quantitative labour market conditions are determined to a great extent by demographic processes. In Hungary, population ageing and the decline in population may continue in the coming decades as well, in line with the European trends. Managing these challenges requires an active social policy that supports having children. Increasing childcare benefits and further expanding the family tax allowance could provide significant financial support to families active on the labour market. Increasing the capacity of nursery schools could also allow families to reconcile work and family. Amongst other things, having children could also be compensated in the pension system if the number of children is taken into account when setting the sum of the initial pension.

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As a percentage of GDP, spending on healthcare is rising in all advanced economies, but a major part of this does not come from budgetary sources. Although the proportion of private spending is relatively high in Hungary by international standards, the institutional framework for this remains underdeveloped. In order to achieve a health care system with higher quality, the potential extension of self-care and private insurance may be proposed. The test results in education suggest that measures are needed in several areas of the educational system in Hungary, including a general increase in funding. In order to improve the knowledge of the graduates of the public education system, structural reforms and the adoption of best practices employed by successful reformer countries of education may be needed. Based on the experience of successfully converging countries, the number of persons with a university or college degree should be further increased, especially in the field of technical and natural sciences, and the amount of R&D spending in higher education should also be increased.

16.1 Measures affecting demographic developments The goal is to improve the demographic outlook. The birth rate and the fertility rate may be increased by raising the maximum amount and upper limit of the childcare benefit (gyed), further expanding the family tax base allowance as well as increasing the number of places in nursery and kindergartens.

In Hungary, population decline and the ageing of the population have been observed since the early 1980s (Chart 16-1). The population of Hungary decreased by 360,000 people between 1990 and 2010. Due to the gradual increase in life expectancy, the number of deaths per annum dropped, but the number of births contracted by more in the past two decades. Ageing is mainly caused by the lower birth rate than in previous decades and partly by the gradual rise in life expectancy. The fact that the birth rate is lower than in previous decades results in smaller generations of young people than old ones, and it also reduces the future number of women in childbearing age. â&#x20AC;&#x201D; 700 â&#x20AC;&#x201D;

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Chart 16-1: Distribution of the Hungarian population by age groups (1960–2060) 12

Million person

Per cent

2060

2055

2050

2045

2040

2035

2030

2025

2020

2015

2010

2005

10 2000

2 1995

1990

1985

1980

1975

1970

1965

1960

Population ages 65 and older Population ages 15–64 Population ages 0–14 Ratio of population ages 65 and older (right-hand scale) Note: Data between 1960 and 2010 come from the database of Eurostat, values between 2011 and 2060 show the results of the population projection of HCSO HDRI (2015). Source: Eurostat, HCSO HDRI (2015)

According to the available population forecasts, population decline will continue in the coming decades, and ageing may accelerate. Some projections suggest that the population numbers may be between 6.7 and 9.2 million in 2060 (MNB 2015). Within this, the working age population may decline substantially, while the proportion of people aged over 65 may rise from 18 per cent in 2015 to 33 per cent in 2060 (HCSO HDRI 2015). In parallel, the old-age dependency ratio may more than double in Hungary from 26 per cent in 2015 to 61 per cent in 2060 (Chart 16-2). This means that while in 2015 in Hungary there are 26 old people for every 100 people of working age, in 2060, 100 people of working age will have to cover the costs of caring for 61 old people. The total dependency ratio may rise less than this, since the drop in the number of children may partly offset the rise in the proportion of the elderly. By 2060, the total dependency ratio may be as high as 85 per cent. This means that the number of those younger — 701 —

Part II: Competitiveness reforms

and older than the working age will be close to the number of the working age population, i.e. the former may be 85 per cent of the latter. The youth dependency ratio can only rise slightly, from 21 per cent in 2015 to 24 per cent in 2060, as according to the population forecast, the working age population may decline more than the number of young people. Overall, based on the current projections, the burden on the economically active may considerably increase in the coming decades due to ageing. Chart 16-2: Expected developements of dependency ratios in Hungary (2015â&#x20AC;&#x201C;2060) 90

Per cent

Total dependency ratio Young dependency ratio

2060

2055

2050

2045

2040

2035

2030

2025

2020

2015

Old-age dependency ratio

Source: KSH NKI (2015) baseline scenario

Since population ageing is primarily caused by the low birth rate, further increasing the number of births and reversing the unfavourable demographic trends over a long horizon is a crucial challenge for social policy. In addition, due to the peculiarities of the Hungarian population pyramid, fostering a further increase in the birth rate may be an important aim in the short run. The Hungarian

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population pyramid includes two extremely large generations: the first are the so-called Ratkó children born in the first half of the 1950s, and the second are the Ratkó grandchildren born in the second half of the 1970s, who will leave childbearing age in a couple of years. As a result, the number of women in childbearing age will drop dramatically, which may also impose a limit on increasing population numbers in the future. In Hungary, the total fertility rate is extremely low in a European comparison. The total fertility rate in 1990 was 1.87, by the turn of the millennium it decreased to 1.32, and it has fluctuated between 1.23 and 1.35 since then. The fertility rate has shown an upward trend in recent years, and according to preliminary data, it may have reached 1.41 in 2014. In spite of this, it still falls short of the 2.1 figure necessary for long-term reproduction and ensuring constant population numbers. In order to increase the birth rate and the fertility rate, the willingness to have children needs to be further encouraged. The possible measures that may address the demographic developments include the following. 1. Increasing the upper limit of the childcare benefit (gyed). The gyed is a maternity benefit linked to an insurance relationship (earlier employment), i.e. it is not provided on a universal basis. Currently, the gyed amounts to 70 per cent of the labour income taken into account, but it is capped at 70 per cent of double the amount of the minimum wage. This means that in 2015 the net income of a mother with a child is at most HUF 108,780 after personal income tax and pension contribution; therefore, the previous income is considerably reduced in the case of those who earned more. The substantial income loss experienced at the beginning of the time spent at home with the child may be one of the impediments to having children. In view of this, it may be warranted to allow the amount of the gyed exceed 70 per cent of labour income on the one hand, and to increase the gyed cap from 70 per cent of double the amount of the minimum wage (HUF 147,000) on the other hand.

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Part II: Competitiveness reforms

2. Further increasing the family tax base allowance in the case of families with 2 children. The family tax allowance of those with two children was HUF 20,000 in 2015, and will gradually rise between 2016 and 2019, possibly reaching HUF 40,000 by 2019. Further raising this amount may encourage having a second child. 3. Increasing the one-off state subsidy after the birth of a child (one-off maternity subsidy). Currently the amount of the one-off maternity subsidy equals 225 per cent of the minimum old-age pension (HUF 28,500), i.e. HUF 64,125. 4. Expanding the places in nurseries and kindergartens. Womenâ&#x20AC;&#x2122;s return to the labour market is aided considerably by nurseries and kindergartens. According to the data by the HCSO, between 2010 and 2014 the number of nurseries in Hungary increased by 10 per cent, from 668 to 736, and the number of available places grew even more dynamically, by 19 per cent (HCSO 2015a). Despite this, the average number of children enrolled has exceeded the number of available places for several years (HCSO 2015a). This suggests that the number of available places should be expanded. 13 per cent of children younger than 3 go to nursery, which is considerably lower than the 30 per cent OECD average (HCSO 2012). The number of children in kindergarten is on a downward trend due to demographic developments, but increasing the number of available places might be warranted by the 2014 introduction of compulsory kindergarten attendance from the age of 3, and the lack of places in certain regions (e.g. in the capital). The expansion of available places in nurseries and kindergartens is also necessitated by the increasing labour market participation by women (for example on account of the gyed). 5. Establishing a family-friendly workplace environment. Part-time employment should be fostered so that both parents can return to the labour market even during the time of childcare. With the development of distance learning and targeted programmes, the further education and training of parents staying at home during childcare can be supported. â&#x20AC;&#x201D; 704 â&#x20AC;&#x201D;

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6. Improving day-care services. Enhancing day-care services boosts the employment opportunities of parents with small children. This may be facilitated by family day-care centres or the establishment of a workplace childcare system (in the public sector), and the introduction of allowances (corporate tax or tax base allowances) encouraging the creation of such a system in the private sector. In addition, in the long run, the settlement environment fostering healthy free time activities (with opportunities for public use) is also important. Decreasing regional differences in public services affecting children and education would serve vital social policy objectives, which would require enhanced wages for teachers and targeted development programmes in underprivileged regions).

16.2 Providing additional funds to the healthcare system by letting in private funding The goal is to the enhance the quality of publicly financed healthcare provision, which must be more efficient, and the funds available to the healthcare system need to be expanded. Taking into account the international examples and the domestic opportunities, the primary method for this could be the active involvement of private funding in the healthcare sector.

In international comparison, the Hungarian healthcare system is underfunded. Both in a broader international and in a narrower regional context, the per capita funds available to the Hungarian healthcare sector are low (Chart 16-3). With respect to healthcare expenditure financed from the budget, Hungary spends less than half of the level observed in the OECD countries, and only three quarters of the regional average. In addition, the proportion of healthcare budget expenditure also lags behind in international comparison.

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In Hungary, healthcare spending amounted to 7.4 per cent of GDP in 2013, of which 4.8 per cent was financed from the budget. By contrast, the OECD countries spent 9 per cent of GDP on healthcare in 2013, with related budget expenditures amounting to 6.5 per cent of GDP. Partly due to low healthcare spending, life expectancy in Hungary is among the lowest in the European Union countries: at 75 years in 2013, it was 5 years less than the EU average. Chart 16-3: International comparison of per capita health care expenditures based on data 2013 6,000

Per capita USD, PPP

5,000

4,819

Per capita USD, PPP

5,000

4,553

4,000

3,453

3,000

6,000

3,000

2,511 2,040

2,000

4,000

2,010

1,719

2,023

2,000

1,530

1,000

Budget spending

OECD

CEE average

Poland

Hungary

Czech Republic

Slovakia

Slovenia

Austria

Germany

1,000

Private spending

Note: The group of CEE countries includes the data of Slovenia, Slovakia, Czech Republic and Poland. Source: OECD (2015a)

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The underfunded nature of the Hungarian healthcare system can also be seen from the fact that, in addition to the insufficient contribution payments, substantial subsidies are needed from the central budget (amounting to HUF 560 billion in 2014) to bring the balance of the Health Insurance Fund close to zero. Since, in an international comparison, the total tax burden (tax wedge) on the domestic labour force can still be considered high, despite the targeted and universal reduction of the income tax burden, the revenues of the Health Insurance Fund cannot be increased by raising the income tax or the contribution rate. Therefore, additional financing can only be provided to the healthcare sector by letting in private funds, which must be coupled with the more efficient distribution of the available assets and funds. These additional funds would facilitate wage increases for workers in the sector, which is necessary for several reasons. On the one hand, the age pyramid of doctors also reflects ageing (Chart 16-4), and on the other hand, a further wage increase may help halt the emigration of doctors, since that would provide them with additional income in Hungary. Thanks to the sectoral wage rises since 2010, the salaries of doctors have risen significantly in recent years. Based on OECD data, Hungarian medical specialists earned 1.6 times the national economy average in 2010, and almost double the average in 2013. Nevertheless, in international comparison the salaries of doctors working in Hungary and Western European countries still diverge considerably (Chart 165). Compared to regional countries, the average salaries for doctors in Hungary exceed those in Poland, but lag behind those in the Czech Republic, Estonia and Slovenia.

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Chart 16-4: Distribution of Hungarian physicians by age (2012) 9,000

Persons

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

1,000 0

0 Younger than 35 years

35–44 years old

45–54 years old

55–64 years old

Older than 65 years

Source: OECD

Chart 16-5: Wages of physicians in international comparison as a ratio of average wage in the national economy (2013)

Average value Note: * Data for year 2012. Source: OECD

— 708 —

Luxembourg

Ireland

Germany

Finland

Denmark

Italy

1 United Kingdom

Spain

Greece

Slovenia

Czech Republic

Estonia

Hungary, 2013

Hungary, 2010

Poland*

16. The competitiveness of human resources

This proposal may enable the exploitation of unutilised capacities, the provision of wage supplements to healthcare workers (which is necessary for retaining skilled workers in the healthcare sector and Hungary), and may encourage better performance, as in the distribution of resources, institutions representing higher quality and performing better can obtain orders from private insurers. Box 16-1: The health insurance system in Germany

The basic principle of the German health insurance system is that it is compulsory for everyone living in Germany. The system is dual: it consists of compulsory state insurance and private insurance. Germans can opt for private insurance, but otherwise they are included in the public system. Similar to the Hungarian system, the public system operates on a risk-sharing and solidarity basis, while the private system is based on the traditional insurance principle. The features of the two types are the following: • Those earning less than EUR 50,000–53,000 per annum (this figure is indexed annually) are included in the compulsory state health insurance system fund. The fund provides a wide range of services, membership cannot be terminated and the fund cannot differentiate between the members based on risk factors. • For high earners, students and public servants, it may be worth choosing the private insurance due to the services provided and the potentially fairly low costs (about 11 per cent of the population are members). The privately insured can benefit from the insurance differently, depending on which group they belong to. High earners do not pay contributions as a percentage of their earnings, but based on their age and health condition, i.e. risk profile. Due to low risk, students pay low fees, and after entering the labour market, their membership fees remain low on account of having been insured previously. In the case of public servants, the state can assume part of the costs, and the rest is covered by a private insurance contract. Source: Germany Health Insurance System (2015)

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Part II: Competitiveness reforms

16.3 Strengthening preventive healthcare The goal is to gradually approximate life expectancy to the European Union average, which may be facilitated by strengthening preventive healthcare. Possible methods to achieve this include increasing the number of regular screening tests, encouraging sports in the workplace and schools, and further raising the public health product tax.

The health condition of the Hungarian population is unfavourable in international comparison and also lags behind the level warranted by the country’s economic development (Chart 16-6). In 2013, life expectancy in Hungary was 79 years in the case of women and 72 years in the case of men. These figures steadily rose in recent decades in Hungary, but are still among the lowest in the European Union. Compared to the average for the 28 EU Member States, the Hungarian figure is lower by 6 years in the case of men, and by 4 years in the case of women (Chart 16-7), and in Poland, which is at about the same level of development, life expectancy is longer by 2 years on average. In an EU context, only Latvia, Lithuania, Romania and Bulgaria lag behind Hungary with respect to life expectancy. The fact that life expectancy is low in international comparison is linked to a couple of major disease groups, the frequency of which could be reduced by strengthening preventive efforts. In Hungary, the most frequent causes of death are linked to cardiovascular diseases and cancer. In 2012, most men died due to diseases of the circulatory system, and the mortality rate per 100,000 people was double the EU Member States’ average (Table 16-1). The Hungarian rate is also higher than the rates observed in the other Visegrád countries. Cancer is the second most frequent cause of death for the total male population, and among those under 65 (i.e. early deaths) this is the most common cause of death. In the Hungarian population, the male mortality rate is substantially higher than the female figure. The mortality rate of women also exceeds the average of the EU countries and the rate of the other Visegrád countries. The number of deaths due to cardiovascular — 710 —

16. The competitiveness of human resources

Chart 16-6: Preston curve on the data of OECD countries (2012) 84

ICL ESP ITA FRA

83 Life expectancy at birth, 2012

KOR

SLV

CHI

ISR

JAP

SWE FIN NLAUT

UK DEU IRL BEL

CHE

NOR LUX

AUS

DEN

CZE

78 POL

77 76

HUN

EST SVK

TUR

MEX

73 0

20 000

40 000 60 000 Per capita GDP, 2012 (US$)

80 000

100 000

Source: OECD

Chart 16-7: Life expectancy at birth in the countries of the European Union (2013) Men

Women Spain France Italy Cyprus Finland Portugal Malta Greece Luxembourg Sweden Austria Slovenia EU28 Netherlands Germany Belgium Ireland United Kingdom Denmark Estonia Czech Republic Poland Croatia Slovakia Lithuania Hungary Latvia Romania Bulgaria

90 85 Years

90 Years

Note: The left panel shows the life expectancy of men, the right panel shows that of women. Source: Eurostat

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Part II: Competitiveness reforms

diseases was double the EU average in 2012. In the case of women under 65, cancer is the leading cause of death. Table 16-1: Standardised mortality rates in Hungary and the Visegrád countries, males (2012) Total population

Total

Of which: diseases of the cardiovascular system

Of which: malignant neoplasms

Of which: diseases of the respiratory system

EU28

1281

462

358

117

Czech Republic

1656

834

399

105

Poland

1767

814

423

116

Hungary

1940

944

505

121

Slovakia

1862

837

461

139

Under age 65

Total

Of which: diseases of the cardiovascular system

Of which: malignant neoplasms

Of which: diseases of the respiratory system

EU28

297

Czech Republic

359

107

108

Poland

506

151

127

Hungary

561

172

190

Slovakia

467

133

134

Note: Deaths per 100 thousands inhabitants. Source: Eurostat

The proportion of spending on prevention in the Hungarian health insurance system is low. As attested by international comparisons, the weight of pharmaceutical subsidies and hospital care is high within the current expenditures, while only a small portion of expenditures is allocated to disease prevention and specialised care outside hospitals. Supporting prevention is of primary importance, since unhealthy eating habits and the lack of exercise are the main factors behind the increase in the proportion of diabetes, obesity, osteoporosis and cardiovascular diseases that are extremely frequent in Hungary. The amount of long-

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16. The competitiveness of human resources

term healthcare spending on chronic diseases can be lowered by strengthening the role of prevention, which can also boost the number of healthy life years and productive years. The measures that could be potentially introduced for strengthening the role of prevention in Hungary include: • The strengthening of the general practitioner system, coupled with which compulsory and regular (annual or, above a certain age, semiannual) screening tests must be introduced as well. Conducting and controlling these tests would fall within the purview of general practitioners. This could also be complemented with the creation of a direct link between healthcare provision and screening tests, which would mean, in practice, that patients would risk losing the pharmaceutical subsidies related to the given disease if they miss the compulsory screenings without justification. • Promoting sports at the workplace (this could include all possible methods by employers encouraging workers to do regular exercise, even during working hours). In addition, it is important to instil the love of sports in students, which was supported by the 2012 introduction of everyday physical education in primary and secondary schools. This measure has been gradually expanded in a progressive system, and has applied to all classes from the 2015/2016 academic year. • Reviewing the VAT content of sports equipment. • Expanding the scope and/or raising the rate of the public health product tax (PHPT).

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16.4 Linking childbearing and pensions The goal is to make the pension system fair and sustainable, and this may be facilitated by the recognition of childbearing in the pension system.

The common characteristic of Hungarian and European societies is the ageing of the population, which is caused by low birth rates and the gradual increase in life expectancy. The decline in the number of workers paying contributions can make financing the pay-as-you-go pension system highly difficult within a relatively short timeframe. In the pay-as-you-go system, the costs of the retirement provision of the old are primarily covered by the current contributions of the employed. The sustainability of the pension system is supported to a large degree by a rise in the birth rate. According to a report by the European Commission, the Hungarian pension system may be sustainable until 2030, as under the present rules pension expenditures may even slightly decrease until then (EC 2012). However, in the 2040s, with the retirement of the RatkĂł grandchildren, an especially large generation, the toll exacted by the ageing of the population on the pension system may mount. The labour force may only expand by 2040 due to the current increase in the birth rate, and therefore negative demographic developments need to be addressed as soon as possible. The current Hungarian pension system does not promote childbearing. Pay-as-you-go systems link three generations: the economically active pay the pensions of the old, and at the same time raise the next generation of contribution payers, who in turn will finance their pension. As the amount of pensions depends partly on the resources used for raising the next generation of contribution payers, the current system is inconsistent. In Hungary, the parents (mothers) that had more children are precisely those that can expect the lowest pensions compared to their peers in similar professions, despite having provided the most labour with the highest qualifications and the most human capital to society. This is because they did not earn wages during the time spent at home with their children, and thus their pension is set â&#x20AC;&#x201D; 714 â&#x20AC;&#x201D;

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at a level lower than for those who did not bear children and therefore did not drop out of the labour market. The recognition of childbearing in the pension system may basically serve two purposes. It would contribute to fairness, i.e. the subsequent recognition of raising children, and looking ahead, it would also foster childbearing. • The recognition of raising children is warranted by the fact that the associated costs are mostly borne by families, although it produces benefits for society. In addition to its direct costs, child-rearing can reduce the parents’ initial pension, since the years spent raising a child decrease working time and career income. • Demographic developments are so unfavourable in Hungary and other European Union countries as well, that active economic policy interventions may be necessary to reverse the negative trends. One of the incentives for childbearing may be to reward it through the pension system. The pension system must take into account the personal efforts to raise a child and the number of children raised. In addition, taking into consideration the educational attainment (and potential contribution payments) of the children raised may also be warranted, as education entails considerable costs for the parents, while more skilled workers pay more personal income tax and social security contributions to the budget due to their higher earnings. The proposal may provide a positive incentive for childbearing, education and legal employment, too. The fiscal impact depends crucially on the amount of the pension increase parents with children get when their initial pensions are set, and on how many children are born. In an optimal scenario, the amount of the subsidy may be set in such a manner that does not increase the budget deficit substantially over the long term. This is because children

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will boost the revenues of the budget as contribution payers, and they typically start paying before their parents retire. The proposal requires cautious implementation. Childbearing can only be recognised in the pension system if the social security system has a complex, up-to-date database containing, in many cases, personal data as well. There are several situations that are hard to take into account, such as infertility, child mortality, the disease of a child, divorce, remarriage, adoption and emigration. However, the experiences from the family tax allowance show that similar issues have already been successfully regulated in Hungary.

16.5 Strengthening the role of self-provision The goal is to gradually increase the role of partial self-provision in healthcare and the pension system, and to boost pension savings. This can be facilitated by supporting the development of voluntary pension funds and health funds and the protection of consumers opting for pension insurance.

The economically active population is not motivated enough by the expectations about the future to focus on savings and prudence. According to OECD data (2015), households’ savings amount to HUF 2.1 million per person, while in Western Europe the same figure is 23.9 million, and in Central and Eastern Europe it is 3 million. Based on the calculations of bankmonitor.hu, the aggregate savings of the Hungarian population is 2.7 times the country’s total annual wage bill (in Southern and Western Europe this factor is twice as high). However, more than 80 per cent of the Hungarian population lives in an owneroccupied home, which is unparalleled in Europe. According to the OECD (2013), 86 per cent of Hungarian pensioners’ income stems from the state pension system, which is significantly higher than the OECD average of 59 per cent (Chart 4-8). Merely — 716 —

16. The competitiveness of human resources

2 per cent of the income of Hungarian pensioners stems from pension savings, for example from pension fund annuities, while this proportion is much higher in Western Europe: for example in the Netherlands, England, Denmark and Norway it is over 30 per cent. With respect to the income of Hungarian pensioners, income from the state pension system is the highest in the OECD, while income from employment is one of the lowest. Labour income amounts to only 12 per cent of the income sources among those above 65, while in other developed countries this proportion is much higher. In Hungary, pensioners are unable or, possibly because of their state of health, are not willing to work. Meanwhile, in European countries, the proportion of income from work exceeds 30 per cent in both Estonia and Slovenia. Chart 16-8: Sources of incomes of the age of over 65 in OECD countries, late 2000s Per cent

HUN LUX BEL AUT FIN IRL CZE POL CHE SVK FRA PRT ITA ESP DEU GRC EST SLO SWE OECD NOR DNK GBR ISL NZL TUR JPN NLD AUS CAN USA ISR MEX KOR CHL

Transfers

50 Work

Source: OECD (2013)

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80 Capital

100

Part II: Competitiveness reforms

In several other European countries, retirement entails a sharp drop in income compared to average earnings and earlier income. In a European comparison, Hungary ranks third with respect to the net replacement ratio, which shows the proportion of the initial pension relative to earlier net earnings. In Hungary, this proportion is 90 per cent for both men and women, i.e. initial pensions amount to 90 per cent of previous earnings (Chart 16-9). This comparison uses the average income of the individual countries in each case, i.e. it does not reflect the absolute value of pensions. Over the long term, however, the current replacement ratio may decline in Hungary due to the decreasing number of contribution payers, which may make ensuring the fiscal sustainability of the pension system more difficult. Chart 16-9: Net replacement rate in OECD countries in 2014, males Per cent

Netherlands Austria Hungary Portugal Spain Luxembourg Slovak Republic Italy EU28 France Denmark Czech Republic Sweden Finland OECD - Average Belgium Norway Estonia Australia Slovenia Greece Poland Germany Switzerland Korea New Zealand Canada Ireland Japan United Kingdom

100 90 80 70 60 50 40 30 20 10 0

Source: OECD (2015b)

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For the above reasons, supporting the development of voluntary pension funds and health funds and protecting consumers opting for pension insurance is important. This is facilitated by the MNB’s proposals from May 2014 in relation to pension insurance schemes subsidised with tax incentives. The proposals require the transparency of pension insurance products, especially with respect to costs. Based on the proposals, the MNB capped the total cost indicator, which cannot exceed 4.25 per cent in the case of 10-year maturities, 3.95 per cent in the case of 15-year maturities and 3.5 per cent in the case of 20-year maturities. This ensures that the return on investments is not eroded by excessive costs. In addition, people’s willingness to save for the future should be increased (by raising awareness and introducing financial incentives), especially among those without children (or with only one child), since they have more opportunities for saving.

16.6 Increasing public and private funds spent on education The goal is to improve the performance of the education system, which may be facilitated by boosting the public and private funds available to educational institutions.

According to the available data, budgetary expenditures on education relative to GDP are lower in Hungary than the OECD average. Based on OECD data, these expenditures amounted to 4.4 per cent of GDP in 2011 in Hungary which lagged behind the 5.3 per cent average observed in OECD countries (Chart 16-10). Hungary spent 9.5 per cent of budgetary expenditures on education in 2011, which was one of the lowest values among OECD countries.

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Chart 16-10: Public spending on education in 2011 (as a percentage of GDP and as a percentage of budgetary expenditures) Per cent

Per cent

8 7 6 5 4 3 2 1 0

24 21 18 15 12 9 6 3 0

GDP-proportionate public expenditure (left-hand scale) Public spending on education as a percentage of total budget expenditures (right-hand scale) Source: OECD (2015c)

According to the available data, budgetary expenditures on education showed a downward trend in Hungary due to the crisis, declining from 5.5 per cent in 2005 by 1 percentage point until 2011, while the average in the EU Member State’s increased by 0.3 percentage points. The fiscal adjustments on account of the economic crisis necessitated cuts to spending on education in several countries including Hungary. The adjustments affected the Hungarian primary and secondary education the most: spending in these areas dropped by more than 20 per cent in real terms between 2005 and 2011, while budgetary expenditures on higher education expanded by 12 per cent. The decrease in public education spending may have also been warranted by demographic developments in the country: school-age population diminished from 2.3 million people by 8 per cent, i.e. 180,000 people between 2005 and 2011.143 143

Source: HCSO (2015b), school-age population includes those aged 3–22.

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16. The competitiveness of human resources

The quality of education is influenced by the efficiency and the level of spending on education. There is a positive correlation between spending on education and the success of the education system: in countries where a greater portion of the gross national income is spent on primary and secondary education, students, on average, perform better in PISA tests (Chart 16-11). Nevertheless spending falls well short of the OECD average, Hungary achieved only 10 points less, which may be attributed to the relative efficiency of spending on public education. This means that by increasing the current level of spending, the quality of education can be further enhanced. Chart 16-11: Average PISA test scores and per capita spending on primary and secondary education 600

JPN KOR

EST POL

500

LTV

CZE

HUN RUS SVK

TRK

FIN CAN DEU AUS NL BEL FRA UK IRL

SLV PRT ESP OECD ITA ICL ISR

DNK USA

CHE AUT

LUX

NOR

SWE

450 MEX

Per capita spending on primary and secondary education, 2011 (equivalent USD, PPP) Source: OECD

— 721 —

20,000

18,000

16,000

14,000

12,000

10,000

8,000

350

BRA ARG

6,000

IND

COL

CHI

4,000

400

2,000

Average PISA test scores, 2012

550

Part II: Competitiveness reforms

Finally, it should be noted that based on international trends, private funds make up an increasing share of education spending, complementing budgetary expenditures. Private funds include households’ spending (e.g. tuition fees) and corporate expenses as well. In the case of higher education spending, private expenditures increased more than twofold in real terms between 2000 and 2009 and the proportion of private funds in higher education spending rose from 23 per cent in 2000 to 30 per cent in 2009.144 The expansion of private funds did not substitute for budgetary spending, as they only complemented the latter in the education system. In the whole education system, higher education is typically the area with the largest share of private funds. According to the latest available data, private spending on educational institutions in Hungary (in the whole education system) amounted to 0.5 per cent of GDP in 2006, which represented an approximately 9 per cent share in total education spending, a slightly lower proportion than the 12 per cent in EU countries.145 According to budgetary data, in 2015 Hungary spent HUF 1,610 billion, i.e. 4.8 per cent of GDP on education, and spending on education may increase in the coming years by 0.1 per cent of GDP, as the process of teachers’ wage increases lasts until 2017, and reclassifications will be finished until 2019. Based on the above, budget expenditures on education may increasingly approximate the level of spending characteristic of OECD countries. In addition, it should be examined how the proportion of private funds in the education system, especially in higher education could be increased (e.g. within the framework of cooperation with companies). In order to keep the most qualified teachers in their profession, competitive wages in line with the qualifications of individual teachers should be offered at all levels of the education system.

144 145

OECD 2012. Eurostat 2015.

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16. The competitiveness of human resources

Chart 16-12: Distribution of total budgetary expenditures on education by levels of education (2011) Per cent

Per cent

10 9 8 7 6 5 4 3 2 1 0

Primary and secondary education Tertiary education Pre-primary education Other expenditures OECD average – primary and secondary education Note: The graph shows direct public expenditures on education plus public subsidies to households related to education. Source: OECD (2014)

16.7 Improving the quality of primary and secondary education The goal is to improve the quality of primary and secondary education as well as the acquisition of basic skills. In line with the needs of the labour market, this may be supported by strengthening the role of competence and skill-based curricula, and perhaps also by 9-year primary education.

The role of secondary education is very important, since this represents the highest qualification for most workers before they enter the labour market, and it also lays down the foundation for entering higher education. One of the indicators of the knowledge acquired in primary — 723 —

Part II: Competitiveness reforms

and secondary education is the result achieved in PISA tests. The test assesses the abilities of 15-year-old students in mathematics, reading and sciences. According to the results of the most recent PISA study, conducted in 2012, the performance of Hungarian students lagged behind the average of the OECD countries in all three areas.146 In an international comparison, the largest divergence was observed in mathematics: the Hungarian figure for 2012 was 17 points lower than the OECD average. In the other areas, the difference was less striking: Hungarian students achieved 6 points less in reading and 7 points less in sciences than the OECD average in 2012.147 Over a longer horizon, Hungarian scores exhibit a declining trend: the average scores in mathematics fell by 13 points compared to 2003 (Chart 16-13). Among the Visegrád countries, Hungary’s test result was the worst in the recent period, while in Poland average scores in mathematics have increased by almost 30 points since 2003, despite starting out from the same level (Chart 16-14). Average scores hide proportions of the best and worst-performing students: During the last survey, the share of the top performers was 10 per cent in Hungary while 13 per cent in the OECD countries. In an international comparison, the proportion of students performing the worst in mathematics was exceptionally high, amounting to 28 per cent in 2012. In Hungary, more than 20 per cent of the divergence in students’ performance could be attributed to their social status, which suggests that it is more difficult for students from less privileged families to achieve higher scores.

The most recent PISA study was conducted in 2015, but the results of this test are still not available. 147 OECD 2014. 146

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Chart 16-13: Results of PISA test in mathematics 560

540

520

500

480

460

440

420

400

380

Mexico Turkey Greece Hungary Sweden United States Slovak Republic Spain Italy Portugal Norway Luxembourg Latvia Iceland France Czech Republic New Zealand Denmark Ireland Australia Austria Germany Belgium Poland Canada Finland Netherlands Switzerland Japan Korea

560

2003

2012

Source: OECD

Chart 16-14: PISA test results in Visegrád countries between 2003 and 2012, mathematics 530

530

520

510

500

490

480

470

460

450

2003 Hungary

2006 Slovakia

2009 Czech Republic

Source: OECD

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2012 Poland

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The results of the PISA test point out the importance of improving the performance of primary and secondary education. One of the possible methods for this, more in line with the needs of the labour market, is strengthening the competence and skill-based curricula. According to current experience, the quality and success of secondary education is partly hindered by the fact that there is no time in primary education for laying down the foundations of basic skills, which considerably hampers studentsâ&#x20AC;&#x2122; progress in later stages. Longer primary education could be realised in several ways. One of the possible approaches would be the introduction of 9-year primary education.

16.8 Improving language skills in secondary education The goal is to improve the level of language knowledge, which may be facilitated by the expansion of language education in secondary education.

Hungarian statistics lag far behind with respect to language learning and language skills. 80 per cent of the students in secondary education learn English, although the same figure is close to 100 per cent in most EU countries. Presumably a portion of students who only learn one foreign language in secondary school chooses a language other than English (e.g. German), which may explain why the ratio is less than 100 per cent. Nevertheless, the share of those learning German is also lower than the figure characteristic of Central and Eastern European countries (Chart 16-15). The number of foreign languages spoken in Hungary is low: more than 60 per cent of the population does not speak any foreign languages, and merely one quarter of the population speaks one foreign language (Chart 16-16). According to the data from the 2011 census, the proportion of those speaking English shows a slightly improving trend: at the time of the 2001 survey 9 per cent of the population spoke English, and by 2011 this rose to 14 per cent, but within the whole population the share of those speaking any foreign languages is still low. â&#x20AC;&#x201D; 726 â&#x20AC;&#x201D;

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Chart 16-15: Share of students learning English and German language as a foreign language in the secondary school (2012) 100

Per cent

100 90

Portugal Hungary Cyprus Bulgaria Denmark Lithuania Poland Greece EU28 Germany Belgium Italy Estonia Spain Luxembourg Slovenia Latvia Slovakia Croatia Austria Finland France Romania Czech Republic Malta Netherlands Sweden Ireland United Kingdom

English

German

Source: Eurostat

Due to the above, the role of learning language should be strengthened, especially in secondary education. If possible, the number of classes dedicated to language teaching should be increased, and each student should have the opportunity to acquire a foreign language at a high level in secondary school. The enhancement of language skills would further improve the quality of labour supply as well. In order to achieve this, the possibility of raising the number of classes in primary and secondary schools should be considered. In line with the needs of the labour market, providing the opportunity for each student to learn English at secondary school has to become a priority. In addition to expanding language teaching in public education, the language knowledge of the population may be improved by showing foreign language films in the television and cinemas with subtitles instead of dubbing (something similar has been introduced in Croatia, for example). â&#x20AC;&#x201D; 727 â&#x20AC;&#x201D;

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Chart 16-16: Distribution of number of languages spoken (2011) 100

Per cent

100 90

3 or more

Note: Self-reported data. Source: Eurostat

16.9 Further increasing the proportion of graduates The goal is to make the skills of the Hungarian labour force meet current expectations and to make it able to adapt to future needs. In order to achieve this, the proportion of graduates in Hungary should be expanded, which, in the context of shrinking age groups, can be attained by maintaining the current quotas in higher education.

The proportion of graduates in Hungary falls short of the European Union average and the rates typical in advanced economies (Chart 16-17). In Hungary, the share of graduates in the 25–34 age group has doubled, rising from 15 per cent in 2000 to 31 per cent in 2013. This figure, however, is 10 percentage points lower than the average in OECD countries. In OECD countries, more than 40 per cent of — 728 —

16. The competitiveness of human resources

25–34-years-olds hold a degree, but in certain countries such as Japan or Korea, the share of graduates amounts to 60–70 per cent. Chart 16-17: Share of tertiary graduates among population ages 25-34 in 2000 and in 2013 80

Per cent

80 70

Turkey Italy Austria Mexico Czech Republic Portugal Slovakia Germany Hungary Greece Slovenia Iceland Finland New Zealand OECD average Spain Denmark Poland Belgium Netherlands Switzerland Estonia France United States Sweden Australia Norway Luxembourg United Kingdom Ireland Canada Japan Korea

2000

2013

Source: OECD

In Hungary, the proportion of graduates in the 25–34 age group is higher than the average for the total working-age population (23.4 per cent), and is double the share observed in the 55–64 age group (16.9 per cent) (Chart 16-18). In the recent past, the increase in the proportion of graduates was caused by the higher qualifications of younger generations entering the labour market. For the above-mentioned reasons, further increasing the average qualification level and the proportion of graduates in younger generations is important, and it also contributes to raising the share of those holding a degree within the total population.

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Part II: Competitiveness reforms

Chart 16-18: Share of tertiary graduates in certain age groups (2014) 45

Per cent

0 25–34 years old

35–44 years old Hungary

45–54 years old EU28

55–64 years old

25–64 years old

OECD countries*

Note: * Data for year 2012. Source: Eurostat, OECD

The share of graduates in the population is one of the central qualitative features of the Hungarian labour force. By maintaining the current quotas in higher education, the proportion can be raised to 45 per cent by 2030, which would enable the country to catch up with the OECD average. This would further improve the quality of the Hungarian labour force and the competitiveness of Hungary, which would contribute to economic growth. In the recent past, in countries where the share of highly skilled workers increased more rapidly, per capita GDP growth was also higher. A more highly skilled labour force is more productive and contributes to technological innovation, since it develops and learns to use new technologies quicker. Better qualified workers generally have better labour market opportunities: they are characterised by higher participation and employment rates, higher average incomes and better health conditions compared to less skilled groups. According to Eurostat data, life expectancy varies considerably across groups with different educational attainment: in the case of 30-year-old men in Hungary, those holding a degree can expect to live longer by 12 years on average than those with only primary educational — 730 —

16. The competitiveness of human resources

attainment. Overall, raising the proportion of graduates would further improve labour market indicators in Hungary. By maintaining the current quotas in higher education over the medium term, the share of graduates in the 25–34 age group can be increased to 45 per cent by 2030. This is substantially influenced by the fact that due to demographic processes, the number of students applying to and entering tertiary education exhibits a declining trend. The number of students applying to higher education in 2015 was 105,616, the number of those admitted amounted to 72,200, of whom 55,800 received a state scholarship. Looking ahead, the population forecast by the HCSO’s Demographic Research Institute (HCSO HDRI 2015) projects that the number of persons entering the 25–34 age group,, i.e. those currently aged 10–19, could drop dramatically, and over 10 years a 9 per cent contraction is expected in the number of those entering tertiary education.

16.10 Increasing the share of engineering and science graduates The goal is to better align the structure of higher education with the needs of the labour market, i.e. to further increase the share of engineering and science graduates. This may be facilitated by expanding the proportion of places related to these fields within higher education quotas.

Currently in Hungary there are less than 10 engineering graduates per 1,000 people in the 20–29 age group (Chart 4-19). This proportion is low in both EU and regional comparison. In certain countries, the share of engineering graduates significantly increased in the past decade: in the Czech Republic it tripled, and in Romania it quadrupled between 2001 and 2011. In September 2015, 72,000 students enrolled to higher education institutions, and within those the proportion of students enrolling to engineering and science courses amounted to 16 per cent (approximately 11,500 students). Based on this, the proportion of those entering — 731 —

Part II: Competitiveness reforms

engineering and scientific fields is lower than 10 per cent of those enrolling to higher education. Chart 16-19: Tertiary graduates in science and technology per 1 000 inhabitants aged 20-29 years 25

Persons

25 20

2001

2011

Source: Eurostat

International comparisons attest that the proportion of engineering and science places within higher education quotas should be increased, as due to technological progress, the labour demand for engineering and science graduates may continue to rise in the coming period. This does not require an additional expansion of quotas from the current levels, since it can be achieved by reshaping the internal structure. However, it must be taken into consideration, that increasing the numbers requires substantial investments: new buildings need to be built and expensive instruments and equipment necessary for education must be purchased.

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16.11 Increasing R&D spending in the higher education sector The goal is to raise the contribution of the higher education sector to the innovation performance of the Hungarian economy. In order to achieve this, R&D spending in the higher education sector may have to be increased, which may be facilitated by the common centres of excellence established between universities and companies.

With respect to the distribution of its utilisation, R&D spending in the higher education sector amounts to merely 0.2 per cent of GDP, while the EU average is more than double this figure, at close to 0.5 per cent of GDP. Compared to the top performing countries, Hungary lags even further behind, for example Sweden or Denmark spend almost one per cent of GDP on R&D in higher education (Chart 4-20). The establishment of centres of excellence with the cooperation of companies, universities and research centres may be key in expanding R&D spending in higher education. Chart 16-20: R&D expenditures by sectors (2013) 3.5

Percentage of GDP

3.5 3.0

2.5

2.0

1.5

1.0

0.5

0.0

0.0 Sweden Finland Denmark Germany Austria Slovenia Belgium France EU28 Netherlands Czech Republic Estonia Norway United Kingdom Ireland Hungary Portugal Italy Spain Luxembourg Lithuania Poland Malta Slovakia Croatia Greece Bulgaria Latvia Cyprus Romania

3.0

Tertiary education

Corporate sector

Source: Eurostat

â&#x20AC;&#x201D; 733 â&#x20AC;&#x201D;

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One crucial precondition for efficient research and development is the existence of innovation ties among companies, research centres and higher education institutions. Higher education institutions benefit from these, since they can test their research results in practice as well, and they can obtain funding for their further research projects, while companies can access the highly skilled human capital specialised in specific fields as well as the results of basic research. There are numerous examples for this cooperation in other countries too. It is generally true that in addition to state subsidies, project promoters need to acquire financing from the market as well. Box 16-2: International examples – Cooperation of universities and companies in research

The United Kingdom’s Department for Development launched a programme called Catapult in 2010, within the framework of which Catapult centres were established that specialised in special research fields, where the best researchers and engineers from companies and universities work together. The projects are financed jointly by the corporate and the public sector. Their top priority is to involve companies from the SME sector with high growth potential. In 2014, University Enterprise Zones were set up in four university towns as a pilot, which are intended to foster the cooperation between companies and universities in various innovation projects. The projects include robotics, molecular biology, big data analysis, energy and the modernisation of certain production processes. Universities must obtain funding amounting to double the state subsidies. In Canada, Centres of Excellence for Commercialisation and Research help the common research and development projects of academia, research centres and companies, as well as the market sale of the developed innovation products. In addition to state funding, corporate funding has to be obtained as well, which may even take the form of FDI or venture capital. In Sweden, the Swedish Foundation for Strategic Research has been operating for 20 years as an independent foundation, providing funding to scientific, engineering and medical research projects for several

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years from public money. Their priorities include supporting practical research projects that can be utilised by companies, assisting internationally acclaimed research in attracting foreign capital, with a special focus on the cooperation between universities and companies, as well as fostering networking.

16.12 Mental health package The goal is to improve the Hungarian population’s mental health. From a strictly economic perspective, this can contribute to the increase in the labour force’s productivity and the decrease in the social costs associated with diseases, thereby boosting competitiveness, economic efficiency and the willingness for childbearing.

One of the paramount factors in competitiveness and economic efficiency is mental health. According to the projections by the WHO, by 2020 depression will be ranked second on the list of health-adjusted life years. Hungary does not fare well with respect to the occurrence of depression, since chronic depression affected 4.9 per cent of the population in 2008, with only Spain and Belgium reporting higher figures. Depression represents the highest share within the disease burden caused by mental disorders, amounting to 20 per cent in the European region of the WHO overall, and to 26 per cent in the European Union. Depression in itself accounts for 15 per cent of the days spent with a disability. Another severe problem of the ageing population is dementia: the top-level conference of the WHO called on all the governments of the world and all the member states of the WHO to develop a strategy against dementia in their countries.148

148

First WHO Ministerial Conference on Global Action Against Dementia, Geneva, 16-17 March 2015, http://www.who.int/mediacentre/news/releases/2015/action-on-dementia/en

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With respect to families’ mental health, the OECD’s report, which compared the subjective well-being of children aged 11–15 in individual countries, is especially insightful. The report showed that the subjective well-being of the Hungarian youth was the worst after Turkey. According to the results by Hungarostudy, family support (from spouses, parents, children, partners) is a major protective factor against mental disorders. The overwhelming majority of the Hungarian population, i.e. 86.5 per cent of Hungarians feel that they can count on their families in a difficult situation. 13.5 per cent feel that they cannot fully count on their families or that they cannot count on them at all. All of the quality of life indicators under review were found to be better in the case of people with family support (Kopp–Skrabski, 2006). Based on the above, the possible measures that may be considered are the following: • Developing a prevention concept • Including elements boosting mental health in education (e.g. communication, relationship skills, self-awareness, stress management) • Establishing and implementing a national network engaged in mental health issues – Based on good practices – multi-level intervention, EAAD (European Alliance Against Depression) – Building on local needs and opportunities – Implementing and maintaining interventions geared towards local needs (e.g. unemployment, depopulation, ageing, integration) • Launching a sanitation programme, consciously educating the population about sanitation and consistently imposing fines for related offenses, since a clean and orderly environment is essential for mental health • Creating and strengthening cost-effective instruments for intervention – Bolstering the system of over-the-phone mental first-aid services – Establishing a network of voluntary assistance activities • Applying the appropriate screening tools (not only in healthcare) — 736 —

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References European Commission (2012): The 2012 Ageing Report. Economic and Budgetary Projections for the 27 EU Member States (2010–2060). Eurostat (2015): Tables by theme, Population and social conditions, Education and training, Education, Indicators on education finance, Private expenditure on education. http://ec.europa.eu/eurostat/data/database Germany Health Insurance System (2015): German Health Care System – an Overview, Compulsory Health Insurance in Germany, Health Insurance for Students, Private Health Insurance in Germany. http://www.germanyhis.com/ Accessed: 11 September 2015 Kopp M. – Skrabski Á. (2006): Magyar lelkiállapot az ezredforduló után (Hungarian state of mind after the turn of the millennium). Hungarian Central Statistical Office (2012): Kisgyermekek napközbeni ellátása, (Day-care of small children, November 2012). http://www.ksh.hu/docs/hun/xftp/idoszaki/pdf/kisgyermnapkozbeni.pdf Hungarian Central Statistical Office (2015a): day-care centres [2000–]). https://www.ksh.hu/docs/hun/xstadat/xstadat_eves/i_fsg005a.html Hungarian Central Statistical Office (2015b): Az oktatásra ható népesedési folyamatok (2004–2015) (Demographic developments affecting education [2004–2015]). http://www.ksh.hu/thm/2/indi2_2_1.html Hungarian Demographic Research Institute of the Hungarian Central Statistical Office (2015): Magyar Nemzeti Bank (2015): Growth Report 2015. Demográfiai portré, 2015 (Demographic portray, 2015). OECD (2012): Is increasing private expenditure, especially in tertiary education, associated with less public funding and less equitable access? OECD Education Indicators in Focus, 2012/08 (October). http://www.oecd.org/education/skills-beyond-school/EDIFE8.pdf OECD (2013): Pensions at a Glance 2013: OECD and G20 Indicators, OECD Publishing. http://dx.doi.org/10.1787/pension_glance-2013-en OECD (2014): Education at a Glance: OECD Indicators, OECD Publishing. OECD (2015a): OECD Health Statistics 2015, WHO Global Health Expenditure Database. https://data.oecd.org/eduresource/public-spending-on-education.htm OECD (2015b): Net pension replacement rates (indicator). https://data.oecd.org/pension/net-pension-replacement-rates.htm OECD (2015c): Public spending on education (indicator). https://data.oecd.org/eduresource/public-spending-on-education.htm

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The role of European Union funding in enhancing competitiveness and growth To strengthen domestic competitiveness the development policy based on European Union funding is one of the most important resources. During the 2014–2020 seven years period the EU cohesion policy gives a budget of 25 billion EUR for Hungary 149, of which a greater proportion than ever, 60 per cent, is available for economic development purposes. The Hungarian Government has already agreed with the European Commission on the operational programmes representing the sources of EUfunded developments between 2014–2020. At the same time, the method of implementing the programmes is pivotal in terms of the success of development policy in terms of bolstering competitiveness and growth over the long run. Intervention with public funds into market relationships requires additional circumspection, as a development policy which operates on different ways than market logic may have side effects, such as a crowding-out effect. Development policy should offer subsidies that foster innovation among market players, thereby boosting their competitiveness, or support these efforts, avoiding the reinforcement of specialisation to obtain development funds and the dependence on subsidies. On balance, Hungary’s absorption of EU funds has so far been positive in terms of economic development, but its efficiency can be improved. Among development policy objectives, we must make a distinction between short-term and more durable, structural impacts that improve competitiveness. Short-term demand boosting considerations may often replace structural transformations, and public investments may push aside investments with slower return, as the former may already improve the fiscal balance in the 149

In the context of the Partnership Agreement concluded between the Hungarian Government and the European Commission, funds will be dedicated to Hungary’s operational programmes from the European Regional Development Fund, the European Social Fund, the Cohesion Fund, the European Agricultural and Rural Development Fund, the European Maritime and Fisheries Fund, without Hungarian co-financing.

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short run. A conscious choice of value is therefore necessary, coupled with a conscious combination of long-term and short-term motives. Key tasks related to the Hungarian implementation system of EU programmes are to accelerate implementation, to reduce the corporate cost of access to EU funds (administration, charges, uncertainty) and to effectively enforce competitiveness considerations at the project level as well. In addition, the funds should be more strongly focused on key areas of growth (investments that increase the value added, specific market segments, possibly specific sectors and geographic areas). The success of these efforts depends particularly on rules of procedure and the professional expertise available in the responsible programme management bodies. Stronger inclusion of the banking sector, which possesses the professional know-how on funding and which is naturally linked to the corporate segment, could prove beneficial in terms of support for the corporate sector. Development funds could be better channelled to companies if all opportunities, or at least information on EU funds would be made available through a one-stop shop system accessible via commercial banks. For this reason, it would be beneficial to create uniform corporate bank products in which refundable EU funds, nonrefundable grants and market funds are available easily in a compact manner. The rules of procedure for programme implementation should be rapid and flexible enough to ensure that the financial products based on EU development funds are competitive in technical terms as well (this holds particularly true for refundable financial instruments), along with market funding. The absorption, planning and implementation of economic development funds should be managed and organised as integrated as possible within the institutional system of implementation. At the same time, within the programme implementing institutions considerable emphasis must be placed on the economic development skills and professional competencies of personnel within programme-implementing institutions to ensure that competitiveness objectives (increasing value added, boosting export capacity, positive employment effect) are addressed in the case of every single relevant project. Beyond the operational programmes installed at the Member State level, â&#x20AC;&#x201D; 739 â&#x20AC;&#x201D;

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the so-called directly managed European Union funds may also increase the opportunities to receive more EU funding for numerous competitiveness-related efforts, if the absorption capacity of domestic organisations could be improved.

17.1 Competitiveness and growth aspects of development policy and their impacts The European Union created the structural and cohesion funds to assist the convergence of regions with less developed economies (although recently the development of the whole EU along a common strategy has gained in importance). In recent years in Hungary, EU funds have played a central role in financing the economy. Since its 2004 accession, Hungary has received transfers worth about EUR 40 billion from the EU, half of which flowed to the government sector, and half to companies (Chart 17-1). In the private sector, agriculture was treated as a priority, since half the funds received by companies were agricultural grants (when land-based grants are taken into account as well). The drawdown of funds accelerated in the past three years as the 2007-2013 budget cycle drew to a close, and therefore in this period the grants that flowed into the country amounted to 5–7 per cent of GDP (Chart 17-2). The grants were important for both the government and the private sector. The funds granted to the government budget represented approximately 8–10 per cent of public sector spending in 2014–2015. On the expenditure side of the state budget in the recent years, the grants received from the European Union served as a significant complementary resource of the domestic public investments. As the utilisation of funds steadily increased, grants from the European Union covered an increasingly large share of public investment expenditures. By 2014, about half of the public investments were financed from EU funds. In parallel with the continuous expansion of capital transfers, public investments gained momentum, i.e. a large portion of the funds financed additional investments. — 740 —

17. The role of European Union funding in enhancing competitiveness and growth

Chart 17-1: EU transfers between 2004–2014 4.0

Billion EUR

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 EU transfers to government

EU transfers to non-government

Source: MNB, Ministry for National Economy

Chart 17-2: Composition of government sector investment expenditures 2,000

Billion HUF

2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 EU capital transfer to government Government investment expenditures

Source: MNB, Ministry for National Economy

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The capital transfers towards the state were important to the private sector from many aspects. Companies, as the contractors in investments, were faced with higher investment demand, which basically served as an economic stimulus without expanding the budget deficit. In addition, the grants partly financed large infrastructure investments that increased the efficiency of companies.

17.1.1 Development policy intervention

The basic motivation of development policy is to intervene in processes with public funds to achieve social aims, increasingly with the intention of boosting growth and competitiveness. In the past decade, Hungarian development policy received quite substantial additional funding from the cohesion and structural funds of the European Union, although in connection with this payment obligations and restrictions regarding the utilisation of funds also emerged. Hungary is among the EU Member States where the proportion of EU grants within public investments was the highest between 2010 and 2012 (EC 2014b). Despite the additionality requirements of the EU, this situation provided an opportunity to somewhat ease the burden on Hungary’s state budget to some extent (and indirectly also for increasing tax revenues), however, in a certain sense it may also entailed dependence, since the goals and conditions of the European Commission substantially influenced Hungarian public investments through the utilization of these development funds. These EU-level development policy rules and conditions will be much stricter in the new 2014–2020 seven-year period, and the room for manoeuvre of individual Member States with respect to the utilisation of cohesion policy funds will be more constrained. Of course, there may be other considerations behind development policy actions than growth and competitiveness. These are principally social policy and national strategy efforts, which may also have competitiveness aspects or growth impact over the long term.

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17. The role of European Union funding in enhancing competitiveness and growth

In the traditional Keynesian approach, the production of economic agents can be boosted by increasing government spending. One of the features of development policy interventions is that they have both short-term and long-term economic impacts. Above all they directly increase aggregate demand in the economy, and interventions employing the basic logic of short-term, direct crisis management also seek to achieve this, i.e. to stimulate demand (through state orders and direct supports for employment). Longer-term effects, however, cannot be expected from the demand stimulus approach (BalĂĄs et al. 2015). Such effects arise from encouraging structural transformations strengthening competitiveness. The logic behind development policy interventions is complex: it goes beyond directly stimulating demand, and targets social, economic and environmental structures and the further enhancement of their interrelationships, attempting to influence supply conditions, often at the micro level. Such development policy interventions outside of the scope of crisis management may cover capital adequacy, products, the infrastructure conditions as well as the availability of resources and human capital in economic activities, the organisational framework and interrelationship of economic agents as well as the markets. The leeway for the economic interventions of development policies under free market conditions is limited, and effects distorting the market should be avoided. A telling example for this is the sophisticated EU regulation of corporate grants. In this context, from a policy perspective, economic development interventions seek to offset, negative market processes (market failures) and to strengthen positive ones using public money. For example, when supporting small and medium-sized enterprises (SMEs), development policy endeavours to counterbalance the lack of market funding from credit institutions. This group of businesses is characterised by higher risk, as such firms typically cannot obtain funding or only at higher prices, and lending them generates Addressing these financing issues of SMEs is a priority in development policy because they has strategic importance that is also highlighted in the â&#x20AC;&#x201D; 743 â&#x20AC;&#x201D;

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development policy of the EU. This is partly because the SME sector plays an exceptionally crucial role in employment both in Hungary and in the EU, and the proportion of domestic ownership is very high among them. Considering that the economy cannot be fully explored and it changes dynamically, development policy is a public policy with risky interventions, in which success is not guaranteed. This is especially true because it intervenes from a policy perspective in those areas where taking on high and long-term risks are not expected from the business actors, i.e. companies and credit institutions. Long-term effects or social policy objectives (such as the positive externalities stemming from research, development and innovation activities – Romer 2011) typically cannot dominate the decisions among the wide range of market participants. In development policy the preference of long-term effects are not only true for direct economic development interventions but for other structural investments as well (that indirectly, over the long term also exert an economic impact). The public sector and individual policies can often only afford to take a longerterm view at the expense of the additional funds of the development policy. Therefore it is important to see that in a development strategy based on external funds, such as the Cohesion Policy in the case of Hungary, more risky and longer-term goals should be targeted, since these jeopardise the utilisation of limited, domestic resources much less. Although many assessments analyse the economic effects of development policy, the success of interventions is difficult to measure, in the case of the Hungarian programmes as well (Agenda–Expanzió 2010; Antal–Pomázi 2011; State Audit Office, 2015; Balás et al. 2015;

PPH–Tárki 2010; KPMG 2010, 2013a, 2013b, 2013c; NDA 2013; Varga 2007; Zubek 2014; etc.). One of the challenges is the complexity of the topics, since modelling reality is difficult in itself, as there are countless links between the social, economic and environmental structures, and — 744 —

17. The role of European Union funding in enhancing competitiveness and growth

the results of the developments need to be distinguished from the existing processes. Moreover, the impacts will occur with considerable delay. This is not only true for interventions originally targeting longer-term effects (e.g. youth education), but also for infrastructure developments with relatively faster delivery (e.g. transportation), because their effects in generating economic ties take many years to establish. The assessment of the impact of direct economic development interventions is also burdened by time constraints. The market expansion of companies can only be measured in two or three years, and the performance indicators of research and development interventions can only be interpreted after many years (Balás et al. 2015). According to a Mexican study, the effect of the support provided to SMEs only emerged after four or five years in the performance indicators of the companies (Lopez-Acevedo and Tinajero-Bravo 2013). The GMR-Hungary model attempts to create a preliminary economic representation (Varga 2007) of the cohesion policy interventions in Hungary between 2007 and 2013 at lower regional levels (counties). According to the findings of the researchers, development funds only exert an impact beyond 2016 when effects strengthening productivity and innovation are also present. Therefore, the durable effect is largely dependent on the development programmes’ implementation method, i.e. whether the institutional system provides truly good incentives for developers to select their projects and whether the system finds these innovation and productivity led projects with a high probability. Based on the above, those development projects can be considered good from a growth perspective which foster innovation and thus increase the competitiveness among economic actors or support these efforts. By contrast, EU funds may also entail negative effects, if they strengthen counterproductive mechanisms, rent-seeking and the excessive focus on efforts targeting the acquisition of development funds. In such a scenario, the above-mentioned innovation effects do not emerge, and in fact, a considerable dependence on grants can arise, and a large portion of economic and social actors will focus on securing development funds instead of boosting innovation and competitiveness. — 745 —

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Examining the utilisation of the EU’s Cohesion and Structural Funds from a general theoretical and logical perspective, they can be expected to exert a significant positive effect on economic growth, but the assessment of their employment impact leaves more room for doubt (Borkó–Oszlay 2007). When cohesion policy funds are utilised in such a magnitude as in the case of Hungary in the 2007–2013 period, in addition to the considerable and positive growth effects, negative impact elements can also arise (e.g. crowding-out effect) (Balás et al. 2015), and therefore the establishment and targeting of development instruments requires special attention. In the utilisation of EU grants in development, over the programming period should be as balanced as possible. Due to the above-mentioned demand effect, the uneven disbursement of development funds may lead to substantial fluctuations in investments and growth, which entails macrostability risks. The demand generated by the developments in each sector, and how the sectors can meet that demand from domestic capacities, also need to be taken into account. When there are substantial unutilised capacities, developments boost the utilisation of domestic capacities, but the sudden surge in demand entails a spike in imports. On the other hand, as the expected project demand is unpredictable for economic agents, it may also encourage the establishment of superfluous capacities. It is worth to monitor the volume of the newly generated capacities and further development demand should be increased in parallel with this rate. The impact of imports, however, is not necessarily negative, as these may play a crucial role in technological change and in increasing the efficiency of the economy, which is targeted by development policy as well.

17.1.2. General considerations for improving companies’ competitiveness

The assessments carried out in this field indicate that the competitiveness-enhancing effect of development grants awarded to the corporate sector does not prevail automatically, it requires enhanced circumspection. — 746 —

17. The role of European Union funding in enhancing competitiveness and growth

The recently developed CGE model of the Hétfa Research Institute examines the impact of the funds utilised up to 2015 and shows positive aggregate effects at the level of companies as well (Balás et al. 2015). This is particularly true for income over all horizons. Increasing employment may entail a drop in labour productivity (when the number of employees grows more rapidly than production), but over the longer term, due to the dominance of demand effects, positive labour productivity effects can be presumed. The picture is vastly different in the various sectors: above all construction diverges the most from the others, being extremely exposed to demand effects (with its unfavourable productivity and positive return on equity indicators). According to the model, the strongest economic growth in the examined period was caused by the focused economic development grants dedicated specifically to enterprises, and by the research, development and innovation subsidy schemes (Balás et al. 2015). The share of these fields in the impacts far exceeded their share of funding (see the “economic development” category in Chart 17-3). Chart 17-3: Relative size150

151

categories A 24.80 2.20 32.30

B 0.34

17.10 6.00 7.60 5.30 4.70

Economic development Education Employment

0.74

0.47 0.35

Health Public administration Transportation

0.27

0.26

0.08

Energy efficiency Other

Source: Balás et al. 2015, the results of the simulation calculations based on the CGE model

150 151

Funds disbursed to individual categories as a percentage of total grants. The proportion of the relative effects for each category relative to each other.

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According to the assessments of the 2007-2013 programming period’s enterprise support schemes carried out by the institutional system of the development policy (Agenda–Expanzió–KTI 2010; Budapest Institute 2013; NDA 2013), the impact of grants on sales, export revenues or the expansion of profits cannot be observed yet. Nevertheless, the schemes had a positive effect on the volume of investments and assets as well as the number of workers employed. The effects are especially complex with respect to investments and entrepreneurial culture. Overall, the targeted values of investment indicators were realised (State Audit Office 2015). According to some evaluations of the technological developments, the investments also generated additional investments (Agenda–Expanzió–KTI 2010). Nevertheless, the evaluations and the experiences of the institutions suggest that, linked to developments and investments, an entrepreneurial culture has also emerged which is in line with the development policy, but only specialises in securing EU funds and does not point towards macro-level growth and competitiveness. These unfavourable phenomena may be strengthened by the uneven and unpredictable disbursement of funds. According to certain evaluations, development policy can only have a limited impact on corporate culture and environment, and the efficiency of fund utilisation could be increased by improving management and corporate skills (KPMG 2013a). The results of the targeted research and development and innovation measures are hard to demonstrate over the short term. The examination of monitoring indicators shows that the input indicators exhibit growth exceeding the targeted values (R&D&I expenditure and headcount), while the value of output indicators (e.g. patents) falls short of the expected figures, i.e. the utilisation of grants is inefficient (KPMG 2013b). The financial instruments of the period (see refundable corporate support instruments) partly offset the deficiencies of the marketbased financial system, and provided funds to companies that would — 748 —

17. The role of European Union funding in enhancing competitiveness and growth

otherwise have not received any. It is also promising that parallel with this, the opportunities for banks and companies for establishing relations have broadened, and the scope of information available about companies has expanded (KPMG 2013c). This enables further access to credit or results cheaper loans. It can happen due to the fact that beneficiaries are more likely to obtain funding after developments delivered with non-refundable or financial instrument-type grants, and they have more opportunities for doing so (positive track record

The more development policy funds directly targeting SMEs to foster the earlier realisation of planned investments, the more efficient they are. With respect to non-refundable EU funds targeting the technological development of SMEs, several studies reported that a large portion of the investments thus implemented would have been undertaken by companies on any other ways (Agenda 2010; Béres 2008). This substitution effect is not problematic if funds bring forward companies’ highest-ranked investments. Therefore, based on economic logic, it is reasonable to suppose that the EU became a co-financier of the most efficient projects, and helped the earliest possible realisation of the second-best projects by bringing forward the best ones. In this sense, non-refundable grants substitute for the credit market or they compete with it. However, as a large share of companies use loans for the own contribution necessary for the projects, non-refundable funds may also contribute to the improvement of the credit market for SMEs. Securing funds from the EU makes SMEs more creditworthy in the eyes of banks, and loans reduce the lack of information regarding the credit history of SMEs, which further strengthens the supply geared towards the SMEs that have obtained grants. Therefore, the investments that should be supported are viable in their own right, and they guarantee the continued operation of the activities affected by the development.

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One of the experiences of the cycle that started in 2007 was that the costs of utilising the EU funds were too high for economic actors due to the mechanisms of fund allocation. The institutional system spent about 4 per cent of the funds on its own operating activities, and a huge share of this amount maintained jobs in the public sector. The administration necessary for drawing down funds entailed further costs for the applicants, although they could have used this money for productive investments instead. Accordingly, in several cases the application costs exceeded even the reasonable return expected from the investments. Raising the necessary own funds posed another difficulty for the applicants (Balás et al. 2015).

17.2 Competitiveness and growth plans of the Hungarian development policy in Hungary Preparation for the 2014–2020 period occurred in a new planning context compared to the previous two cycles. From the domestic side, the approaches that emerged were more robust than the previous ones, focused mainly on economic growth, based on the interventions into the real economy, strengthened the national economy and eased the vulnerabilities of the economy resulted from its openness in order to maintain stability. The messages of the economic development intentions were summarised in the National Development and Regional Development Concept (OFTK) which was outlined in the first phase of the planning then adopted by the Parliament in 2014 (Salamin et al. 2014). In addition, it was recorded in an early planning phase that 60 per cent of the funds had to be spent on economic development (Gov. 2012). In line with the EU’s planning procedure, the Hungarian concepts had to be discussed with the European Commission, which led to compromises. As a result of the cohesion policy reform, for the 2014–2020 period the Commission exercised tighter control over the cohesion policy planning of the Member States than previously, demanding direct — 750 —

17. The role of European Union funding in enhancing competitiveness and growth

consent to the EU’s aims laid down in the Europe 2020 Strategy (Péti et al. 2014a). The basic motivations of the EU and Hungary were largely overlapping, highlighting consistent efforts of the Hungarian and the EU’s research and development, employment and energy projects and the preparation for climate change (Péti et al. 2014). However, the position on the desired avenues of development in Hungary drafted by the European Commission (the so-called Position Paper – EC 2012) diverged somewhat from the Hungarian ideas. In social convergence, Hungary concentrated on job creation, while the EU focused on the traditional inclusion actions. The Hungarian focus regarding economic development and business development did not really emerge in the plans of the Commission, which however did contain the paths for transportation and environmental infrastructure development that traditionally make up a large share of improvements (Péti et al. 2014). The development concepts laid down in the Partnership Agreement between Hungary and the European Commission reflecting their compromises maintained the level of direct economic development allocation at 60 per cent, which was higher than before. The budget of the operational programmes with a primary agenda of economic development increased substantially, rising more than fivefold (Péti et al. 2014). This increase was not only influenced by the considerable expansion of the framework of the economic development operational programme (in the 2007–2013 Economic Development Operational Programme – EDOP, in the 2014–2020 Economic Development and Innovation Operational Programme – EDIOP), but also the fact that the primary mission of the regional operational programmes (the 2007–2013 Regional Operational Programme – ROP, the 2014–2020 Territorial and Settlement Development Operational Programme – TOP and the Competitive Central Hungary Operational Programme – CCHOP) became the economic development. In addition to the operational programmes primarily focusing on economic development, other operational programmes also contained significant economic development allocations (Partnership Agreement 2014).

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Beyond business support, other developments also contribute to the concentration of direct economic development funds. Their common motivation is to use the grants to invest in economic entities, foster the improvement of the infrastructure conditions on the market or in the economy, and stimulate the relations between economic actors (Péti et al. 2014). In line with this logic, the developments in energy and information and communication technology must be implemented with an economic development approach, and economic development must be taken into account in the improvement of public transportation, urban development or the development of e-governance as well. Compared to the previous development period, the direct allocation of economic development funds increased substantially in the different fields overall, albeit to a lesser extent than the framework of the operational programmes with a primary focus on economic development (see the change broken down by the EU’s so-called thematic objectives in Chart 17-4). Examining the thematic objectives of the EU conceived in the spirit of the Europe 2020 strategy in light of the economic development efforts, it is not surprising that the allocation of the thematic objectives clearly linked to direct economic development increased in most of the cases in the plans for 2014–2020 compared to the plans for 2007–2013 (Chart 17-5): grants for information and communication technologies (ICT)152, energy projects, research and development and innovation as well as employment. One exception is the thematic objective of business development that can also be categorised as direct economic development, but its general allocation will decrease in the 2014–2020 period. This does not mean, however, that the total amount spent on business support will not grow (even according to conservative estimates, it will expand by EUR 100 million to EUR 3,800 million), but in contrast to the previous cycle, a substantial portion of business grants will be available in targeted themes, i.e. thematic objectives (such as funds for research and development and innovation, energy projects, information and communication technologies and the expansion of employment; Péti et al. 2014). 152

The increase in ICT would be even greater, but a major part of the developments in this area can be found under the 11th thematic objective (public administration development).

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17. The role of European Union funding in enhancing competitiveness and growth

Chart 17-4: Share of economic development resources according to certain thematic objectives in the programming period of 2007–2013 and 2014–2020153 100 90 80 70 60 50 40 30 20 10 0

Per cent

2007–13

2014–20

100 90 80 70 60 50 40 30 20 10 0

Non-economic development allocations Economic development allocations under other Tos TO8 (Employment) TO4 (Energy) TO3 (SMEs) TO2 (ICT) TO1 (RDI) Note: The other thematic objectives shown in the chart and their economic development content are the following: TC2 [information and communication technologies]; TC3 [SME competitiveness]; partly TC6 [environment development, including: urban economic structures, tourism]; partly TC7 [transportation development, including: sustainable urban transportation]; tangentially TC9 [social convergence, including: community economic development, microloans]; partly TC10 [education, including: vocational training, human resource development in research and development]; partly TC11 [public administration development, including: e-governance]; (The chart shows the funds of the Structural Funds [ERDF and ESF] and the Cohesion Fund.) on the basis of the categorisation based on the direct economic development contribution of the development contents stipulated in the Partnership Agreement and the operational exchange rates) on the basis of the categorisation of the development content – established in the programming documents of the period – based on the 11 thematic objectives and the direct economic development, and in certain cases on estimates. Source: Hungarian Partnership Agreement and Operational Programmes, Estimated data (Péti et al. 2014)

153

In 2007–2013, less than 40 per cent of the available funds allocated to the country served economic development purposes (although such utilisation eventually amounted to considerably less), while in 2014–2020 almost 60 per cent of the available funds are used for this purpose.

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according to the planned estimated allocation to the thematic objectives in the 2007–2013 and 2014–2020 programming period 25

Percentage of the total financial frame within the mentioned period

6 – Environment protection

11 - Public administration development

10 – Education

9 – Social Inclusion

8 – Employment

7 – Transport

5 – Climate change

4 – Energetics

3 – SME

2 – ICT

1 – R+D+I

Thematic objectives 2007–2013

2014–2020

Note: The tabulation contains the EU Structural Funds (ERDF and ESF) and the Cohesion Funds (Total amount in the 2014-2020 period, based on 2013 exchange rate, with national coPartnerhip Agreement and in the operational programmes (allocations for the 3. thematic objective make up only a part of the total resources which are available for the SME-s, these the 2007-2013 are based on the period program documents which contents were categorized by the 11 thematic objectives, and other estimations. Source: Hungarian Partnership Agreement and Operational Programmes, Estimated data (Péti et al. 2014)

The development policy concept package is unique because financial instruments, which have a greater absorption risk but serve long-term economic benefits due to the reinvestments receive greater weight — 754 —

17. The role of European Union funding in enhancing competitiveness and growth

contrary to the share of the non-refundable grants, i.e. these refundable resources have trebled, amounting to more than HUF 800 billion (Péti et al. 2014). The development package that emerged in the OFTK and the Partnership Agreement also reflects comprehensive national strategy and social strategy objectives beyond economic development. Such efforts are the preparation for climate change, territorial decentralisation and community building, geographical mobility, the demographic change (which is not promoted at the EU level by the way), the strengthening of national ties between the countries with a Hungarian population and the home country, and the stimulation of the cooperation in the Carpathian Basin (Péti et al. 2014), which may serve competitiveness purposes over the medium and longer term. The institutional framework responsible for the implementation of the development policy was also included in the focus of the planning preparation for the 2014–2020 period, as previously experienced, it is one of the key factors of fund utilisation’s success (Gov. 2012). Within the framework of overhauling the institutional system, the coordination of the development policy and the various targeted policies, as well as the establishment of firmer central coordination of development policy commenced (Péti et al. 2014a).

17.3 Other preparatory tasks for the development cycle to support competitiveness and growth The goal is to focus EU funds on economic activities, sectors, entrepreneurial groups and regions with high potential economic growth, as well as on employment and the boosting of value added. This can be facilitated by an efficient and coordinated institutional system with rapid procedures and high-quality capacities enhancing the competitiveness dimension, by fostering the development of unified bank products from EU funds designed for companies, and by strengthening the one-stop-shop system with respect to the access to funding opportunities.

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The reform of the development policy system with respect to the 2014â&#x20AC;&#x201C; 2020 period was clearly launched in Hungary with the government decisions in 2012 and later. The efforts include several new, previously uncharted development paths and implementation solutions. Several principles have been laid down, but certain activities more or less are developing continuously during the whole development cycle due to their nature, such as the structure of the individual procedures and schemes, project generation and the preparation of the beneficiaries. In these tasks, the competitiveness dimension can also be further strengthened. In addition to the general economic development dimension described in Chapter 17.1, two aims should be pointed out with respect to EU grants: their disbursement must be accelerated and their utilisation must be more efficient. To this end, the funds should be more emphatically targeted towards the areas of growth (prioritising investments, market segments and possibly specific sectors and geographic areas that increase the value added). The gradual inclusion of the banking sector, which is naturally linked to the corporate segment and which possesses professional know-how and experience in the field of corporate finances and project funding, could prove beneficial in terms of supporting the corporate sector. Development funds may be brought closer to companies by giving firms access to EU funding opportunities in commercial banks, i.e. in a sort of one-stop-shop system. If a portion of the EU funds was dedicated to create uniform bank products for businesses, it would represent value added, because that would provide easy access to refundable and non-refundable grants and market funds at the same place. Utilisation of economic development funds in the various operational programmes should be as coordinated as possible.

That the EU developments contribute less to growth and competitiveness than their potential is also due to the fact that investments have always flowed into the sectors that were considered optimal based on long-term â&#x20AC;&#x201D; 756 â&#x20AC;&#x201D;

17. The role of European Union funding in enhancing competitiveness and growth

economic development considerations, and they were utilised efficiently in every case (e.g. the private sector’s investments were relegated to the background, the developments increased imports, they did not encourage additional investments and their disbursement was delayed). The efficiency of fund utilisation could be increased by stronger fund concentration. The efforts to achieve this can be seen in the 2014–2020 plans, but it should be further strengthened during the implementation. The country should consciously prepare for the necessary changes, and the EU funds should be spent on financing projects of economic entities where the increase in value added, export capacity or employment, is clearly perceptible. Sharper focus on sectors of growth

There was no marked sector focus in the Cohesion Policy of the EU in the past period (despite the fact that in certain sectors community-level cooperation has been strong from the outset, and it is still strong in the case of agriculture and fisheries). The Cohesion Policy was basically sector-neutral, for example in Hungary only tourism stands out from the developments. By contrast, a marked orientation towards certain industries can be observed in the development policy of East Asian countries exhibiting rapid growth (Ábel et al. 2016). At the EU level, the crisis brought about a slow change in this respect, which can be seen in the developing community industry policy (see for example the Commission’s communication favouring productive industries titled “For a European Industrial Renaissance” (EC 2014a). Among the current Hungarian economic development concepts, the sectoral focus, which also appears in the OFTK, is an important element, and this leeway should be used duly (at the programme level, this manifests itself in the focus on productive industries). Of course, sectoral targeting entails risks, but those should be assumed at the expense of the EU grants representing additional external funds, and such risks can be significantly mitigated by regularly reviewing the focus. — 757 —

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The focus among the SME players in the individual sectors can cover service centres (SSCs: multinational corporation’s facilities for global cost-cutting and optimisation, primarily in the fields of HR, financial services and IT back office activities), electronics (manufacturing of consumer electronics, telecommunications equipment and electronic medical equipment), the vehicle industry, tourism or logistics. From this perspective, it is an important achievement that in the operational programmes tourism already enjoys relatively great weight (except for accommodation development, which is not preferred by the Commission regulation in the 2014–2020 period), just like the support for the food industry, a major portion of manufacturing, as well as companies with an information and communication or research and development and innovation orientation (Péti et al. 2014), and from the demand side the development of companies in the energy industry and construction. Target group-focus based on the domestic entrepreneurial environment

The application of unique target group focus on domestic entrepreneurial groups may also be useful. Small and medium-sized enterprises, which are mostly domestic-owned and are major employers, represent an important group from the perspective of national strategy, but there may be more groups in this sector that should be preferred and supported in addition to the innovation-oriented (start-ups) and equal opportunity-oriented (e.g. women’s businesses) target groups preferred at the EU level. It is important to develop grants tailored to the needs of the currently (unfortunately) small group of medium-sized enterprises, as well as to support the development of small enterprises into medium-sized ones. This effort can be joined by domestic-owned large enterprises as well, but according to EU rules and the plans for the 2014–2020 period, large enterprises can only be supported in the case of R&D&I, value chainbased solutions and energy projects. Identifying and stimulating the category of family-owned enterprises that typically have an anticyclical impact should also be considered. In order to mitigate the crowding— 758 —

17. The role of European Union funding in enhancing competitiveness and growth

out effects and increase additional value creation, the conditions for supporting the developments of companies that otherwise, under market conditions, could not obtain financing should be determined. This means greater risk, which should be taken into account and controlled. This approach may run counter to the one of absorbing funds as rapidly as possible, but that in itself cannot be considered a competitiveness objective. Strengthening the territorial focus

The decentralised economic development efforts (Territorial and Settlement Development Operational Programme) in counties and large cities that are implemented in the new cycle of the development policy presumably contribute to the creation of local and regional economic systems. As was pointed out in Chapter 7, the regional dimension has a greater weight in growth and competitiveness, which may foster or in certain cases hinder macro-level growth, and managing the different features of the regions is important from a competitiveness perspective. Domestic economic development concepts should be tailored to the countryâ&#x20AC;&#x2122;s distinct internal economic systems where unique resources are available, and therefore the economy and employment exhibit traditional sectoral patterns and regional features. The development of these regions should focus on taking advantage of their characteristics. One classic example for this is the Balaton region that is based on tourism, but the National Development and Territorial Development Concept mentions other regions as well where the growth that could be achieved due to their special territorial features could have national significance (e.g. in urban growth zones). Moreover, in the Partnership Agreement these special territorial developments are not even expected to be managed solely by the counties or large cities individually, their development requires territorially integrated sectoral interventions and fund coordination as well (e.g. to establish automotive industry centres). Nevertheless, in order to ensure success, content changing

â&#x20AC;&#x201D; 759 â&#x20AC;&#x201D;

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competencies and implementation responsibilities should be given to the territorial levels (primarily to counties and towns with county rights) in the delivery procedures, at least on a trial basis. Regionallevel programmes can be pivotal in coordinating the developments on a territorial basis. Until 2012 an unprecedented territorial unit, the region, was designated to manage regional developments, and in parallel with that, regional self-organisation capacities declined as the rights and funds of the counties diminished. This increases the vulnerability of the country, as the central state apparatus must respond to external and internal shocks, while the information on the possible unique local and regional solutions and obstacles may get lost in aggregation. Although the Territorial and Settlement Development Operational Programme envisages a key role for counties in the 2014–2020 period in the integrated regional programmes, the counties need to be prepared for participating in the implementation of the TOP with the appropriate own contributions, self-organisation capacities and the ability to promote their own interest. The situation of the Central Hungary region poses several challenges. In 2013, the region’s GDP per capita was 108 per cent154 of the EU average (at purchasing power parity). Based on this, following an earlier transitional phase, this region is now among the most developed regions which are not entitled to the grants of the first target area (convergence). Therefore, in this cycle the region is entitled only to HUF 287.6 billion, half of which is made up of domestic funds, compared to the HUF 625 billion in the previous period. The lack of funds cannot be offset by the theoretical opportunities offered by the EU regulations, according to which in the case of certain interventions with national relevance, the developments implemented in the central region can be partly financed from the operational programmes of the convergence regions. Meanwhile, the development system of the region with a large 154

Source: Eurostat

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17. The role of European Union funding in enhancing competitiveness and growth

share of the country’s competitiveness potential (e.g. two-thirds of the R&D capacities, almost 40 per cent of GDP) is not fully developed, which may entail competitiveness risks in the absence of an alternative development funding system. (The reorganisation of the position of Budapest and County Pest in regional statistics, i.e. their separation, may offer a solution for County Pest in the seven-year funding cycle after 2020.) The introduction of the focus on convergence would improve the employment effect of the EU’s economic development funds. Providing special support to the Special Enterprise Zones in the most underdeveloped regions is warranted. Labour-intensive industries should also be truly preferred. These aspects already appear in the programmes, but they should be treated consistently in the system of calls for proposals.

17.3.2 Increasing the competencies and the procedures of the development policies institutional system with respect to competitiveness

The fault of the institutional system was the delay in allocating and disbursing the funds in the first half of the previous programming period. This was due, inter alia, to the rules of procedure and the lack of preparedness on the part of the beneficiaries. The scheduling of fund disbursement should be changed also because the EU’s requirements have shifted in the meantime, since the new rules sanction deviations from the schedule in terms of fund disbursement, the success rate and the results (Péti et al. 2014). The schedule should also be more predictable because this would improve the usefulness of the developments. When access to the funds is not predictable for economic actors (or, of course, for public bodies), and when the framework of conditions is not known well in advance, this creates a hotbed for ad hoc, rent-seeking developments that only concentrate on formal requirements, and that should be realised without EU grants because they are not in line with the goals of the funds. — 761 —

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These risks can be presumably mitigated by developing funding plans providing guidance several years in forward. This should be attempted despite the fact that in the present European and global geopolitical environment, projections about the factors influencing development policy involve considerable uncertainties even over the shortest horizon, which further expands the scope of the risks that are otherwise acceptable for development policy. For most of the previous period, the rules of procedure passed on a large portion of the costs of obtaining funds to the beneficiaries (e.g. application documentation, certificates, guarantees). Somewhat deviating from its spirit, development policy assumed relatively few risks and required strong guarantees from applicants and beneficiaries in Hungary. Therefore, an important element in the transformation of the implementing institutional system should be to imbue these institutions with a sense of service provision and support towards beneficiaries instead of letting them act as authorities. In this respect, developing electronic application systems and easing the requirements for proposal submission represents substantial progress. The beneficiaries must be prepared thoroughly so that the best possible projects are realised that are truly in line with the domestic development policy goals. Project generation, as the institutional background of the active development policy interventions supported by the public sector, should also be strengthened. These measures should cover an appropriate territory in the country. Accordingly, the earlier professional analysis and planning competencies of the regional development agencies should be represented in the county-level development centres. The professional competencies of the institutional system responsible for the development policiesâ&#x20AC;&#x2122; implementation are crucial factors in the usefulness of the developments. It is problematic if the programme managing apparatus (programme managers) cannot appropriately implement the strategy of the seven-year programme or the professional values and messages of the operational programmes in the individual support projects. Creating institutional guarantees for â&#x20AC;&#x201D; 762 â&#x20AC;&#x201D;

17. The role of European Union funding in enhancing competitiveness and growth

this and increasing professional competencies within the institutional system is a daunting task. The motivation system that is developed in connection with this should reward both the speed of fund absorption and the professional value added. Furthermore, systems of professional requirements should be developed for the individual development areas, interpreting and detailing the original plans’ and policies’ mission. Projects that are realised with the integration of a subsector and the sector and that provide better responses to the real challenges and opportunities also generate greater professional value added. The implementation of integrated projects and programmes should be enabled in the institutional system, and supporting the combination of different priorities or the different programmes of the various policies should be encouraged.

17.3.3 Institutional coordination of the utilisation of EU funds for direct economic development

Transformation of the institutional system was a central element in Hungary’s preparation for the 2014–2020 period. Earlier development policy diverged from the policies responsible for the developments, while the central coordination of certain programmes was not strong enough. In many cases, such a situation leads to inefficient, underutilised developments which are under-coordinated at the regional or sectoral level, and the sector concepts cannot be implemented. With the government’s decision in 2012 to relocate the coordinating authorities and participating organisations of the operational programmes to the relevant ministries, it was possible to mitigate these risks. The efficiency of the newly formed, more segmented structure can be ensured by the strong central coordination. However, economic development could be coordinated in an even stronger and more conscious manner. Most of the direct economic — 763 —

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development funds can be found in three operational programmes, but a large proportion is also presented in the various priorities of the other operational programmes. Direct economic development should also be implemented in areas that are far removed from business support (e.g. public administration development, urban development, public transportation). It is also peculiar that in contrast to former practices, the main mission of regional development is now economic development, and that the funds for general business grants (i.e. not intended for ICT, R&D&I or energy projects) have declined. These phenomena may necessitate a uniform, coordinated approach when implementing economic development measures. The institutional system for development policy taking part in economic development should be prepared for the implementation of the economic development requirement framework designed for the various areas. In line with these intentions, the institutional rules of procedure influencing the work of the coordinating authorities could be harmonised. It is especially important to develop targeted mechanisms for coordinating business support and the business infrastructure in terms of time, conditions and forms. This can include all the priorities of the EDIOP, and the job creation and human resource development priorities of the TOP. The development of unified systems operating on a one-stop-shop basis, acting as intermediaries in the disbursement of funds and tailored to the needs of the individual groups of potential beneficiaries may not only be useful in general, but also specifically in the case of economic development grants (the general principle of the one-stopshop approach is also present in the Partnership Agreement). It would be welcome, for example, if beneficiaries could combine the various business grants, perhaps even across operational programmes. Generally, the rules of procedure of programme implementation should be rapid and flexible enough to ensure that EU development funds are competitive with market funding, even in technical terms. â&#x20AC;&#x201D; 764 â&#x20AC;&#x201D;

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In addition to the performance values with respect to fund absorption, the recognition of value added creation should also be represented horizontally, both among the orientation instruments of the various development areas’ potential beneficiaries (e.g. preferences in choosing the projects) and in the incentives of the implementing institutions (e.g. in performance motivating instruments).

17.3.4 EU funds and banking products fostering competitiveness and growth

The surge in the volume of financial instruments available to companies is one of the most important novelties of the 2014–2020 period. During implementation, the role of the credit institution should also be considered. The cooperation with or the inclusion of the banking system may have mutual benefits, as the substantial fund disbursement would boost the turnover of the credit institution sector, and the financing experience of commercial banks could be channelled in to the appropriate extent. Banks’ engagement could also create a healthy competition in lending, facilitating the implementation of the desired rapid spending, possibly even lowering the operating costs (banks could undertake to do it at cost price), or increasing the quality of the services (e.g. several contact points for businesses can be established, and this spatial proximity may entail further positive effects). Based on international institutional experiences, opening up opportunities for the agents in the domestic credit institution sector for the management of non-refundable funds should also be considered. The development policy basis for this in Hungary is the success and rapid drawdown of the combined products in the previous programming period (refundable and non-refundable grants). The refundable and non-refundable business development instruments can be basically regarded as financial products facilitating finance. At the beginning of earlier development cycles, economic development funds were disbursed by the implementing institutional system, but the various business grants could also be considered uniform bank — 765 —

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products, and credit institutions could be included in their management, if only on a trial basis. This is all the more timely because, according to the plans, in addition to the financial instruments (refundable grants) of the 2014–2020 period, the combined corporate products of refundable and non-refundable grants will also expand considerably (Péti et al. 2014). If business grants (both non-refundable and loan-type grants) were handled in an integrated manner in a unified, one-stop-shop system a banks, it would accelerate and simplify the utilisation of funds for final beneficiaries. The financial instruments of EU grants would typically consist of loans, capital investments, guarantee and venture capital instruments. Later on it should be also considered that the credit market currently offers favourable conditions for corporate customers, and in the case of lending and investing venture capital, the reusable funds from the financial instruments of the 2007–2013 period can be disbursed again. Thus, raising the proportion of guarantee instruments within the EU’s financial products should be considered. These can appear as independent products or in combination with a loan, i.e. as “hybrid products”.

17.4 Increasing the utilisation of direct-access EU funds in Hungary The goal is to increase the participation of Hungarian actors in obtaining, absorbing and utilising the funds directly controlled by the European Commission and the European Investment Bank (EIB).

Of the grants provided by the European Union, 80 per cent are managed and controlled by Member State’s authorities. The remaining 20 per cent is managed and controlled by authorities linked to various international organisations and the European Commission’s Directorates-Generals as well as its agencies in charge of implementation. For most of the latter — 766 —

17. The role of European Union funding in enhancing competitiveness and growth

funds, the organisations of the Member States compete with each other to a certain extent. The EU level call for proposals support projects and organisations of which contribute significantly to the implementation of the objectives defined by the EU, and developments of which are keys from the perspective of the community’s long-term growth. The EU level institutions in charge of disbursing these funds (European Commission, European Investment Bank, European Investment Fund) provide several financial instruments and, to a lesser extent, nonrefundable grants directly to the beneficiaries by drawing on both the multiannual budget of the EU and their own institutional funds. The most important target areas of these development funds are innovation, the improvement of the competitiveness of small and medium-sized enterprises, and various infrastructure developments. In addition to the Cohesion Policy funds dedicated for Member States, the European Commission controls 9 major programmes based on direct access (including the package of the European Territorial Cooperation Programmes), which amount to almost 14 per cent (EUR 142.46 billion) of the European Union’s multiannual financial framework for the 2014– 2020 programming period. Within the framework of these programmes, the disbursement of grants depends technically on the amount of funds: it occurs either directly or indirectly through financial intermediaries. In the 2007–2013 programming period, Hungary drew down 1.1 per cent of the total funds of the nine major programmes offered by Brussels, which is more than the average in view of the country’s GDP contribution, but is below the average relative to population size. However, among the Visegrád countries, the country clinched the top spot in per capita terms. Nonetheless, in absolute terms, Poland drew down more funds than Hungary (Table 17-1, 17-2).

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Table 17-1: Obtained amount of the mainstream diretly managed funds outside the national cohesion policy frameworks in Hungary in the 2007–2013 period Share of the Total Programme Obtained amount Budget per capita Budget 2007-2013 obtained in Hungary of the total (million EUR) programme budget programme budget (EUR/capita*) in Hungary (%) in Hungary (million EUR) Seventh Research 49765.69 247.09 0.5 24.71 framework programme (incl. compl.of sixth Research FP) Competitiveness 2672.64 27.3 1.02 2.73 and innovation framework programme (CIP) Life+ 1415.49 20.84 1.47 2.08 Culture 347 6.96 2.01 0.7 2007-2014 Media 2007-2013 785.73 5.8 0.74 0.58 Life Long 8636.41 99.45 1.15 9.95 Learning 2007-2013 Youth in action 1066.11 23.57 2.21 2.36 Public health and 519.79 9.73 1.87 0.97 consumer protection programme European 7980.92 370.48 4.64 37.06 territorial cooperation objective Total 73189.79 811.23 1.11 81.14 Programme 2007-2013

Source: EU COM (2016); HCSO (2015)

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17. The role of European Union funding in enhancing competitiveness and growth

Table 17-2: The mainstream nine diretly managed funds outside the national cohesion policy frameworks in Visegrád countries in the 2007–2013 period Czech Republik

Poland

Slovakia

Hungary

607.88

1320.25

262.74

811.23

Obtained ratio of the programme budgets (percentage)

0.83

1.8

0.36

1.11

Per capita amount of the total programme budget obtained from the 9 mainstream direct funds (EUR per capita)

57.68

34.74

48.46

82.37

Available amounts from the 9 mainstream direct funds outside the cohesion policy framework (million EUR)

Note: The nine programmes noted in table 17-1. Source : MNB based on EUROSTAT (2015); HCSO (2015); EU COM (2016)

If Hungarian organisations become more successful in the utilisation of the direct EU funds, which are not delegated to Member States, additional funds could be used in the country’s efforts to foster competitiveness (Table 17-3). This has special significance in the Central Hungary region, since the amount of funds available to this region from the operational programmes delegated to the Member States in this development period has fallen substantially.

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Table 17-3: Available amounts outside the member states cohesion policy framework between 2014 and 2020 Programme

External Organization, Executive Agency

Forrásnagyság 2014-2020 (milliárd EUR)

1. Horizon 2020

Innovation and Networks Executive Agency (INEA)

2. Connecting Europe Facility, CEF

Directorate-General for Research and Innovation, Innovation and Networks Executive Agency (By the measures of smart, green and integrated transport; secure, clean and efficient energy)

33.25

3. Competitiveness of Enterprises and Small and Medium-sized Enterprises, COSME

European Investment Fund

2.25

4. LIFE programme

European Investment Fund

3.4**

5. Creative Europe Programme

Education, Audiovisual, and Culture Executive Agency

1.54

6. Employment and Social Innovation programme, EaSI

European Investment Fund

0.92

7. Erasmus+ Programme

European Investment Fund

14.7

8. Third health programme

Consumer, Health, Agriculture and Food Executive Agency

0.45

9. European Territorial Cooperation

Different authorities by each programme within the member states

8.95*

Source: EC (2015); *egtc.kormany.hu; **EC (2014)

The Horizon2020 (H2020) programme, which controls the most funds (almost EUR 80 billion), targets the financing of the implementation of the EU’s innovation policy. In many cases, the calls are for nonrefundable grants, with an aid intensity of 70 or even 100 per cent. The new element of the programme is that a total of EUR 513 million will be available specifically to small and medium-sized enterprises (SME instrument). Thus, companies now have an opportunity to obtain substantial funds, and therefore improving the Hungarian participation rate is an important objective of the domestic innovation policy as well. This means increasing the number of successful Hungarian applicants, mobilising new actors, expanding the proportion of obtained funds — 770 —

17. The role of European Union funding in enhancing competitiveness and growth

and boosting the number of Hungarian institutions in international projects. In the 7th Framework Programme for Research (2007–2013) that was the forerunner to the H2020, Hungarian applicants were able to obtain central EU research and development funds worth almost EUR 250 million. These grants between 2007 and 2013 amounted to 0.5 per cent of total funds, which is close to Hungary’s contribution to the EU’s GDP (0.7 per cent). In the next period, the country could strive to reach or even exceed the level of the GDP contribution, for which Hungarian applicants would have to obtain EUR 300 million from the central development funds offered by Brussels in the former case and EUR 350 million in the latter. In international comparison, Hungary’s performance was average among the EU Member States both in terms of the amount of funds obtained and in terms of the number of successful applicants (the country ranked 16th among the 28 Member States), while with respect to the success rate of the applicants (20 per cent), the country fared even better, ranking 14–15th (NIO 2013). The institutional system of the domestic innovation policy has already taken several preparatory steps to increase Hungarian participation. The domestic operational programmes contain backup funds for facilitating the drawdown of H2020 funds and the participation in international programmes. These calls are typically put out within the framework of the EDIOP, the HRDOP155 and the CCHOP. The National Research, Development and Innovation Office has set up National Contact Points in connection with the H2020, with the purpose of providing information and advice on proposals. More efficient, cross-border cooperation (between public institutions, companies or NGOs) and a higher level of integration also have an important growth potential for Hungary, which is based on the high proportion of territories located near the border and the central geopolitical position of the country. With the spread of globally organised processes, the role in economic, infrastructure and social 155

Human Resource Development Operational Programme

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networks (HUB) also represents a competitiveness factor, and therefore the more intensive participation in the European Territorial Cooperation Programmes (ETC), which control funds of close to EUR 9 billion, in addition to the participation in the H2020 programme, may also have a positive effect on competitiveness. The goal of the European Territorial Cooperation (ETC) is to foster common cross-border actions, investments and policy discussions among the national, regional and local actors of the various Member States through providing the appropriate funds. In the case of cross-border cooperation programmes and transnational programmes, the development of the programmes falls within the purview of the countries concerned, but they require consent from the European Commission. The comprehensive aim of the ETC is to foster the harmonious economic, social and regional development of the European Union as a unified area, with implementation of the following three types of cooperation programmes: • cross-border cooperation programmes, that, in most cases, are realised in regions near the border with the participation of two Member States (74.1 per cent of the ETC funds) (Chart 17-6), Chart 17-6: Cross-border cooperation programmes and their designated areas in which Hungary participates

HU-RO-SK-UA HU-SK AT-HU SLO-HU

HU-RO HU-CRO HU-SER

Source: European Commission

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17. The role of European Union funding in enhancing competitiveness and growth

• transnational programmes covering several countries (programme regions), e.g. the Danube Programme lasting until 2020 with the participation of Hungary or the Central European Programme (20.4 per cent of the ETC funds), • interregional programmes in which the cooperation can manifest itself in the thematic alliance of regions located far from each other, for example the exchange of experiences between authorities or institutions, cooperation in urban development or other regional research (5.6 per cent of ETC funds). Hungary’s share of the funds managed by the European Investment Bank Group, which are partly controlled by the European Commission (COSME156, InnoVFin157), is also only average. Between 2010 and 2014, a total of EUR 6,141 million in EIB funds flowed into Hungary. In 2014, the country used EIB funds amounting to EUR 756 million. The funds linked to the signed contracts fell continuously between 2010 and 2013, but there was a slight, 6 per cent increase between 2013 and 2014 (Chart 17-7).

Competitiveness of Enterprises and Small and Medium-sized Enterprises: the initiative controlled directly by the European Commission offers funds of EUR 2.25 billion to companies between 2014 and 2020, and the programme’s implementation is overseen by the European Investment Fund. 157 The goal of the InnoVFin programme introduced by the European Investment Bank Group (EIB, EIF) is to provide unique financial instruments to higher-risk projects that support innovation. The products of this programme serve as instruments directly linked to the implementation of the H2020 programme, and its funds amount to more than EUR 24 billion, with which it aims to support the research and development and innovation activities of the EU’s Member States. 156

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Chart 17-7: Territorial distribution of the funding contracts signed by the EIB in 2014 (left panel) and in 2010-2014 (right panel) Spain

Spain

France

Germany

United Kingdom

Poland

Netherlands

Portugal

Greece

Sweden

Czech Republic

Hungary

Ireland

Finland

Hungary

Ireland

Romania

Croatia

Denmark

Estonia

Cyprus

Latvia

Luxembourg

Latvia

Million EUR 0

2,000 4,000 6,000 8,000 10,000 12,000

Million EUR 0

10,000 20,000 30,000 40,000 50,000

Source: EIB (2014)

A significant portion of the projects supported by the EIB is implemented as public investments, serving transportation development and other infrastructure development purposes. Beneficiaries include entities from the public sector, local governments and the private sector as well (Chart 17-8). One of the major advantages of the EIB’s products is that they can be combined with each other and also with the European Commission’s support initiatives, and the organisation exploits these synergies by providing advice to applicants. The EIB uses several instruments to support SMEs: it lends (loans, guarantees, capital grants), links the funding opportunities offered by the EIB and the European Commission together (fosters higher-risk initiatives supporting innovation), and provides advice with respect to the implementation

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17. The role of European Union funding in enhancing competitiveness and growth

of projects, primarily in connection with JASPERS158 and PPP (EPEC)159 projects. Chart 17-8: European Investment Bank credits provided to Hungary in sectoral breakdown (2010–2014) Total: 6141 million EUR 624 1 693 1212

724

652 1236

Energy (10%) Transport, telecommunications (20%) Water, sewerage, solid waste, urban development (11%) Industry, services, agriculture (20%) Education, health (12%) Small and medium-scale projects (27%) Source: EIB (2015a)

As these programmes manage international funds, and with the exception of the European Territorial Cooperation Programmes, they are implemented outside the sphere of responsibility of the Member States, and the absorption of Hungarian organisations can be primarily boosted by supporting potential beneficiaries. Incentives should definitely focus on presenting the opportunities for direct EU funding to potential domestic beneficiaries, since compared to the Technical assistance instrument that facilitates the project preparation process of mainly large infrastructure developments with budgets of more than EUR 50 million. 159 European PPP Expertise Centre. 158

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operational programmes implemented by Hungarian institutions, these programmes are much less widely known. In addition to popularising the opportunities and providing information on the programmes, giving assistance in preparing projects, finding international partners and establishing cooperation should also be treated as priorities. This can occur within the framework of technical assistance or by giving advice. The engagement of domestic actors in international programmes is often hampered by the pre-financing of project preparation and the related risks. Therefore, a fund for the preparation of projects that would finance the preparation of domestic actors’ applications for various direct EU grants would be an effective incentive. A system should be established that would enable companies and other potential target groups to gain information through participating organisations or financial institutions about funding opportunities, such as market-based projects, operational programmes implemented in Hungary, non-refundable and refundable grants as well as the potential direct funds from “Brussels”. The establishment of state-level coordinating guidelines and operational solutions with respect to the utilisation of the funds from the various institutions may be warranted. This would enable the operational-level coordination of the sectoral, regional and temporal access to funds available in country-level programmes. The Hungarian Development Centre (HDC), established by the Hungarian Government in December 2014 to facilitate access to funds managed directly by Brussels, could play an instrumental role in this. In the case of the European Territorial Cooperation Programmes, applicants’ co-financing is expected to be provided by state funds in this programming period as well.

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17. The role of European Union funding in enhancing competitiveness and growth

References Ábel I. – Csutiné Baranyai J.– Komlóssy L. – Lehmann K. – Madarász A. – Szalai Z. – Vadkerti Á. – Végh N. (2016): Sikeres nemzetközi tapasztalatok (Successful international experiences). In: Versenyképesség és növekedés 1.: Út a fenntartható gazdasági felzárkózáshoz – MNB-tanulmánykötet (Competitiveness and Growth 1: The way to successful economic convergence – MNB Studies). Magyar Nemzeti Bank. Agenda Consulting – Expanzió Humán Tanácsadó – KTI (2010): A Kis- és Középvállalkozások technológiai fejlesztési beruházás támogatásának értékelése (Assessing the investment grants to small and medium-sized enterprises for technology and development). Antal-Pomázi K. (2011): medium-sized enterprises. The impact of various funding schemes on companies’ growth). MTDP–2011/9. Downloaded from: http://econ.core.hu/file/download/mtdp/MTDP1109.pdf) SAO (2015): community grants awarded to Hungary in the 2007–2013 budget cycle). Balás G. – Kiss G. – Piross A. (2015): Az EU-források gazdaságfejlesztési és növekedési hatásai (The economic development and growth impact of EU funds). 30 November 2015, HÉTFA RESEARCH INSTITUE, research report www.hetfa.hu Béres A. (2008): támogatásoknak a vállalkozások beruházásaira és növekedésére gyakorolt hatásainak elemzése (GVOP 2.1.1) (The analysis of the impact on SMEs’ investments and growth of the technology development grants awarded to them within the framework of the National Development Plan [GVOP 2.1.1]). Borkó T. – Oszlay A. (2007): Az Európai Unió költségvetési forrásainak várható makrogazdasági és fiskális hatásai 2007–2013-ban (The expected macroeconomic and fiscal impact of the European Union’s budget funds in 2007–2013). In: ICEG Workbook 21 November 2007. Budapest Institute (2013): A kkv-k komplex technológiafejlesztését célzó beavatkozások hatásvizsgálata (Impact assessment of the interventions aimed at the complex technology development of SMEs). Kkv-k versenyképessége – a korábbi tapasztalatok és értékelési eredmények áttekintése (SMEs’ competitiveness – Overview of earlier experiences and assessment results). HÉTFA. Commissioned by the National Development Agency. EC (2012): European Commission: Position of the Commission Services on the development of Partnership Agreement and programmes in Hungary for the period 2014–2020.

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Part II: Competitiveness reforms EC (2014a): European Commission: For a European Industrial Renaissance [COM(2014) 0014]. Communication from the Commission to the European Parliament, the Council, the European Economic and Social committee and the Committee of the Regions http://www.ipex.eu/IPEXLWEB/dossier/document/COM20140014.do EC (2014b): European Commission: Investment for jobs and growth Promoting development and good governance in EU regions and cities – Sixth Report on Economic, Social and Territorial Cohesion. EC (2014c): European Commission: The programmes of the 2014–2020 multiannual financial framework. http://ec.europa.eu/budget/mff/programmes/index_en.cfm EC (2015a): European Commission: Beginners Guide to EU Funding. https://ec.europa.eu/budget/funding/file/9/download_en?token=rjaWWLOV EC (2015b): European Commission: Member States Factsheets. http://ec.europa.eu/agriculture/statistics/factsheets/pdf/eu_en.pdf EC (2016): European Commission: EU expenditure and revenue 2007–2013. http://ec.europa.eu/ budget/figures/2007-2013/index_en.cfm egtc.kormany.hu http://egtc.kormany.hu/european-territorial-cooperation-2014-2020 Gov. (2012): 1600/2012. (17 December) Government decree on the current tasks in connection with the plans and the institutional system to be established for utilising European Union development funds between 2014–2020. Guillaume, P. (EIB), (2014): EIB’S Loans for SMEs and/or MidCaps Multiple Beneficiary Intermediated Investment Bank Group Support for SMEs https://eu-access-to-finance-day.teamwork.fr/docs/ luxembourg/presentations/Marc-D_HOOGE.pdf A turizmusfejlesztés területi kohézió szempontú értékelése (Assessment of tourism development from a regional cohesion perspective). 27 March 2013. Downloaded from: http://palyazat.gov.hu/a_turizmusfejlesztes_teruleti_kohezio_szempontu_ ertekelese Hétfa – Revita (2013c): A foglalkoztatást célzó programok értékelése (Assessment of the programmes aimed at employment). 25 March 2013. Downloaded from: http://palyazat.gov.hu/foglalkoztathatosag_ javitasat_szolgalo_intezkedesek_ertekelese A kohéziós politika hatása a visegrádi országok employment in Visegrád countries). Downloaded from: http://palyazat.gov.hu/hefop_ertekelesek KPMG Advisory (2010): A GVOP 3.3. intézkedés értékelése – értékelési jelentés (Assessing the GVOP 3.3 measure – Assessment report). Downloaded from: http://palyazat.gov.hu/gvop_ertekelesek KPMG Tanácsadó Kft. (2013a): Értékelés a komplex vállalati technológiafejlesztés kis- és development schemes available to small and medium-sized enterprises).

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17. The role of European Union funding in enhancing competitiveness and growth KPMG Tanácsadó Kft. (2013b): A GVOP 3.3. intézkedés értékelése. Értékelési jelentés (Assessing the GVOP 3.3 measure. Assessment report). KPMG Tanácsadó Kft. (2013c): (Assessing the financial instruments of the Economic Development Operational Programme). Lopez-Acevedo, G. – Tinajero-Bravo, M. (2013): Evaluating Different Types of Enterprise Support Programs Using Panel Firm Data: Evidence From The Mexican Manufacturing Sector. In: Economia Journal of the Latin American and Caribbean Economic Association, August. NDA (National Development Agency) (2013): Értékelési évkönyv 2013 (Assessment Yearbook 2013). Péti M. – Mészáros B. – Kohán Z. – Szabó B. (2014): Magyarország Partnerségi Megállapodása Agreement 2014–2020 – Another step in the renewal of regional and economic development). Falu Város Régió 2014/2, pp. 12–22. Péti M. – Kohán Z. – Csizmár O. – Hoffmann Cs. (2014): financed by the European Union). In: FALU VÁROS RÉGIÓ 20:(1) pp. 25–28. Romer, D. (2011): Advanced Macroeconomics. Fourth Edition, McGraw – Hill. Partnership Agreement: Hungary’s Partnership Agreement for the 2014–2020 development period (September 2014). https://www.palyazat.gov.hu/szechenyi_2020 Salamin G. – Kígyóssy G. – Tipold F. – Salamin G. – Szabó B. – Borbély M. – Tafferner B. – Péti M. (2014): A fejlesztéspolitika és területfejlesztés új koncepciójáról, Az Országos Fejlesztési és (On the new concept for development policy and regional development – The experiences from the National Development and Regional Development Concept and from the implementation of the 2005 National Regional Development Concept). Falu Város Régió 2014/1, pp. 7–24. Stiglitz, J. E. – Weiss, A. (1981): Credit Rationing in Markets with Imperfect Information. The American Economic Review, Volume 71, Issue 3 (June 1981). Seibert, T. (EIB), (2014): Responding to Europe’s Challenges – Supporting Growth and Investment in Hungary. Varga A. (2007): GMR-Hungary: A complex macro-regional model for the analyses of development policy impacts on the Hungarian economy – Final report. Zubek, I. (2014): impact of the developments implemented within the framework of the cohesion policy). Fejlesztéspolitika Tematikus Füzetek. October 2014. Downloaded from: http://palyazat.gov.hu/a_kohezios_ politika_kereteben_megvalositott_fejlesztesek_koltsegvetesi_hatasa European Territorial Cooperation 2014–2020 http://egtc.kormany.hu/europai-teruleti-egyuttmukodes-2014-2020

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Part II: Competitiveness reforms The EIB in Hungary http://www.eib.org/projects/regions/european-union/hungary/index.htm?lang=-hu The European Investment Bank http://europa.eu/about-eu/institutions-bodies/eib/index_hu.htm EIB Financial intermediaries in Hungary http://www.eib.europa.eu/attachments/lending/inter_hu.pdf EIB in Hungary http://www.eib.org/projects/regions/european-union/hungary/index.htm EIB, InnovFin: EU Finance for Innovators – Questions and Answers http://www.eib.org/attachments/innovfin_faq_en.pdf EIB (2014): Statistical Report http://www.eib.org/attachments/general/reports/st2014en.pdf EIB (2015a): http://www.eib.org/projects/regions/european-union/hungary/hungary_sectors_5years_hu.jpg EIB (2015b): http://www.eib.org/products/blending/innovfin/innovfin_en.jpg Applying for a loan at the European Investment Bank http://exim.hu/wp-content/uploads/2014/11/EIB-anyag.pdf Eurostat (2015): Eurostat News Release – First population estimates. http://ec.europa.eu/eurostat/documents/2995521/6903510/3-10072015-AP-EN.pdf/d2bfb01f-6ac5-47758a7e-7b104c1146d0 Loans (MBIL) Warsaw http://www.eib.org/attachments/general/events/20141106_innovfin_warsaw_piat_en.pdf National Innovation Office (NIO) (2013): a 7. keretprogramból (New opportunities – Excellent foundations. Hungarian success stories from the 7th framework programme). http://nkfih.gov.hu/magyar/kiadvanyok/uj-lehetosegek-kivalo.

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Special topics This chapter covers the key areas, not addressed in the previous topics, related to the stock market and the incentivisation of savings. Their common feature is that they are both able to foster the economy’s competitiveness from the funding side. The state of the Hungarian capital market – and in particular the stock market enabling the efficient distribution of funds – and its role and perception within the European Union and at international scale has a significant impact on the economy’s competitiveness. The stock market plays an important role in multiple respects. Presence on the stock market represents an important alternative for corporations to access funding, enhances companies’ valuation and fosters more efficient corporate operation and transparency, while contributing to liquidity and thereby enhancing investor confidence. On the investor side, it offers a market for placing savings and may contribute to developing households’ financial literacy. A smoothly-functioning stock market can be an economic catalyst for the national economy and a tool for economic development, and the economy’s position and prospects can be gauged through the market index. In the past decade, the Hungarian capital market – and specifically the Budapest Stock Exchange (BSE) – found itself at a competitive disadvantage within the region due to scarce supply and falling turnover, and is therefore unable to effectively fulfil the abovementioned role. Expanding the BSE’s activity and capitalisation with the participation of the BSE with a transformed ownership structure is essential for improving competitiveness in the context of a new capital market development strategy offering new instruments on both the supply and demand side. The introduction of the shares of large public corporations to the stock exchange forms part of the supply-side toolset, as well as multifaceted support for the stock market introduction of private sector SMEs. The demand-side toolset includes reinforcing the BSE’s brand and the related marketing activities, as well as enhancing the financial literacy of small investors, fostering personal pension savings and creating a regulatory incentive system that promotes stock market investments. — 781 —

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An adequate level of investments based on domestic funds is a key factor for long-term economic growth. Long-term liabilities are particularly favourable for market players (public finance, corporations) in need of funding. Cutting back healthcare contribution on interest incomes aiming to incentivise savings should be considered, as well as the reduction of the personal income tax obligation of long-term government securities intending to lengthen the maturities of savings.

18.1 Expanding stock exchange activity and capitalisation The goal is to expand the activity and capitalisation of the Budapest Stock Exchange in order to increase the weight of capital market financing and financial intermediation. On the supply side, this could be facilitated by floating the shares of certain large state-owned enterprises on the stock exchange and by supporting IPOs of domestic private enterprises. On the demand side, activity could be stimulated with the help of regulatory and cost-side incentives and by improving the financial awareness of small investors as well as their propensity for self-provision.

In the past decade, the Hungarian capital market has accumulated a substantial disadvantage in development compared to its regional peers, and currently it basically does not fulfil its classic economic function of efficiently distributing capital and funding companies. Hungary’s disadvantage manifested itself in the reduction in the number of highly capitalised companies on the Budapest Stock Exchange (cf. the withdrawal of EGIS), and in the continuous decline in stock exchange turnover in recent years. Due to the sluggish turnover and supply, the stock exchange does not represent a substantial attraction that would channel in domestic households’ savings to the capital market: as a result, in recent years risk-taking retail investors turned to foreign equity markets and FX markets through direct and indirect channels. Moreover, the subdued activity has also impacted companies’ interest in the stock exchange, as the stock exchange does not have enough appeal to encourage large enterprises to list their shares. — 782 —

18. Special topics

The domestic fund management sector registered considerable capital inflows, and between June 2013 and September 2015 the total assets managed surged from HUF 6,947 billion to HUF 8,554 billion, and within that assets managed in investment funds increased from HUF 4,167 billion to HUF 5,691 billion. According to data for 30 September 2015, the majority of assets in public investment funds was in bank deposits (33.9 per cent) and government securities (28.9 per cent), while shares issued by real economy actors represented a very minor proportion within the portfolio (4.3 per cent). Chart 18-1: Average daily turnover of the Budapest Stock Exchange 25

Billion HUF

2008

2009

2010

2011

2012

2013

2014

2015

Daily average turnover of BSE Source: BSE

The goal can be achieved by changing the ownership structure of the BSE, which already occurred in December 2015 when the MNB acquired a majority interest in the BSE. The MNB, not being a profitoriented owner, can develop and implement a new business strategy of capital market development, the elements of which contain measures substantially strengthening both the demand and the supply side of stock exchange products. â&#x20AC;&#x201D; 783 â&#x20AC;&#x201D;

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The supply-side measures include floating the shares of large stateowned enterprises on the stock exchange and supporting the IPOs of domestic private enterprises. The stock exchange listing of large state-owned enterprises will have a dual positive effect, as in the context of the state’s pledge to be capital market-friendly, capitalisation and turnover will both increase as new shares emerge. Out of the state-owned enterprises, the large public service providers and financial corporations seem to have the most potential. As the state is the owner of these companies, it can contribute significantly to stimulating the supply side of the domestic capital market, as it would introduce companies to the stock exchange that are large enough to attract the attention of both foreign and domestic institutional investors. The investors that can contribute considerably to liquidity growth do not acquire interest in companies below a certain size, since a larger transaction can influence the price of the shares of smaller firms much more unpredictably. Therefore, an enterprise with higher capitalisation can expect more attention and thus also liquidity, so the stock exchange privatisation of large state-owned enterprises may significantly increase the interest of investors in BSE. After the appropriate preparations, the state would be able to support the development of the capital market by selling a certain proportion of the shares of the large state-owned enterprises, while still retaining its control over the companies. By promoting domestic privately owned large enterprises’ new issuance on the stock exchange, market capitalisation and indirectly the stock exchange turnover can be further boosted (see the previous paragraph on stock exchange liquidity). Domestic privately owned large enterprises can be encouraged to list on the stock exchange on the one hand via tax allowances, and on the other hand via the stock exchange’s active engagement in the form of consultancy activities furthering the IPO and the application of targeted communication tools. For domestic privately owned large enterprises, the factors that may be attractive and exploited to their advantage against their competitors are the — 784 —

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growing trust of clients due to stock exchange transparency, raising funds without indebtedness and the high marketing value of being a listed company. Stock exchange listing of small and medium-sized enterprises. The new strategy should also focus specifically on small and medium-sized enterprises which form the backbone of the domestic economy, calling for the establishment of a new SME segment that takes into consideration the special needs of smaller firms and that could perfectly complement issuances by large enterprises. The emergence of SMEs is not expected to raise the capitalisation of the companies listed on the stock exchange or the turnover of the stock exchange over the short term, but later on successful SMEs can grow big and become the next generation of large enterprises which is currently missing. The success of jumpstarting the SME segment can be facilitated by the Capital Programme for Growth launched in cooperation with the state. Within the framework of the programme, in addition to preferential initial listing and listing maintenance fees, potential issuers could be supported by special advice provided by the stock exchange helping the preparation for the listing, the reimbursement of the costs accrued in connection with the listing through tenders, listing guarantees or a potential bond issuance capital guarantee. When formulating the rules for the SME segment, it is important to make stock exchange trading companies interested in the listing of companies and supporting the liquid market. From a regulatory perspective, it is a relief that from 2017 MiFID II allows the simplified listing of SMEs even on regulated markets, not only through the current MTF (Multilateral Trading Facility) solution. The emergence of SMEs on the stock exchange may also be supported by making stock exchange presence a precondition for taking part in central bank programmes and state subsidy schemes. Both the economic development programmes of the state and the enhanced FGS of the central bank offer the possibility for making the acquisition of funds by companies conditional on listing on the low-cost SME segment of the stock exchange. â&#x20AC;&#x201D; 785 â&#x20AC;&#x201D;

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For the capital market financing (“crowdfunding”) of start-ups that are in the pre-SME stage or the venture capital funds financing them, a platform separate from the organised equity market for large enterprises could be the solution (the “Alternative” market operating in France and Sweden, the Polish “New Connect”, the Czech “Start” and the Romanian “AeRo” can serve as examples). In addition to brand building and marketing tools, the demand side can be stimulated by regulatory and cost-side incentives on the one hand, and by improving the financial awareness of small investors as well as their propensity for self-provision on the other hand. With respect to the regulatory environment, the interventions should principally employ positive motivating instruments. Both direct and indirect demand from institutional investors can be expanded by providing options for exchange gain tax allowances or tax refunds on quoted shares and the investment products containing them in large proportions. Nevertheless, it is important to consciously integrate these into the currently existing allowances (e.g. healthcare contribution allowance on the income from a controlled capital market transaction, the allowances on long-term investment accounts and forms of voluntary savings), and a level playing field must also be maintained. Elimination of the personal income tax payment requirement of listed companies on the dividend paid for shares traded on the BSE may also be considered. In contrast to dividend paid out from businesses, the healthcare contribution has not been levied on dividends from traded securities. A further incentive would be to make the stock exchange dividend exempt from personal income tax, similar to the interest income from a long-term investment account. Increasing financial literacy and financial awareness may also promote the flow of households’ savings to the capital market. By channelling retail investments to the stock exchange, risk-taking savers can be encouraged to finance domestic companies instead of investing in foreign shares or speculative transactions involving FX: due to the — 786 —

18. Special topics

different risk appetites, this would not represent a competition for households’ government securities demand.

18.2 Encouraging the expansion of households’ savings The goal is to promote households’ savings, whereby the funds necessary for economic development investments would expand, without increasing external debt. This could be facilitated by reducing the tax burden on interest income realised on savings, and by cutting the personal income tax obligation on retail government securities with maturities of over one year in an effort to lengthen maturities of savings.

The basic preconditions of long-term sustainable growth include the expansion of the capital stock, and an adequately high investment rate sustainable over the long term. Investments could be financed from external or internal funds, but financing from external debt entails greater vulnerability. Nonetheless, investments can only be financed from domestic funds if domestic savings increase. Long-term liabilities are particularly favourable for economic agents in need of funding (the general government, corporations). The volume of government securities held by households has grown substantially in recent years, due to a conscious change of strategy with respect to debt management. However, currently most of the government securities held by households have short maturities, which is less favourable from a debt management perspective. Today, in Hungary a 15 per cent income tax and a 6 per cent healthcare contribution is levied on interest income, but the interest income from retail government securities is exempt from the latter. The following proposals may be considered that could encourage savings and give a targeted boost to the demand for retail government securities with longer maturities. — 787 —

Part II: Competitiveness reforms

1. In order to promote households’ savings, the reduction and possible elimination of the healthcare contribution levied on interest income may be considered. 2. Reduction of the personal income tax obligation levied on government securities with maturities longer than one year would have a favourable impact on demand for longer-term government securities. Of course, the Hungarian tax regime already supports long-term savings, as in the case of long-term investments no tax liability arises after 5 years, and between 3 and 5 years the personal income tax rate is 10 per cent (there is no tax allowance for deposits shorter than 3 years). Nevertheless, strengthening the tax-type financial incentive in the case of government securities should be considered. Chart 18-2: Seasonally adjusted net savings of households* 7

Per cent

Liabilities

Net financial position

2015Q3

2015Q1

2014Q3

2014Q1

2013Q3

2013Q1

2012Q3

2012Q1

2011Q3

2011Q1

2010Q3

2010Q1

–3 2009Q3

–3 2009Q1

–2 2008Q3

–1

2008Q1

–1 –2

Claims

Note: *Data adjusted for estimated effects of the settlement and the broker cases, and earlier for the early repayment scheme. Source: MNB

— 788 —

18. Special topics

Chart 18-3: Households’ cumulative net government securities purchases by type 3,500

Billion HUF

3,500

3,000

2,500

2,000

1,500

1,000

1,000 500

500

Stock of government securities owned by households

— 789 —

Oct. 2015

July 2015

Apr. 2015

Jan. 2015

Oct. 2014

July 2014

Apr. 2014

Jan. 2014

Oct. 2013

July 2013

Apr. 2013

Jan. 2013

Oct. 2012

July 2012

Apr. 2012

Jan. 2012

Part II: Competitiveness reforms

References Dancs K. (2011): interrelationship between regional development and tourism in Zakarpattia Oblast [presentation]). Hardi T. – Imre G. (2014): határtérség társadalmi-gazdasági folyamatainak tükrében – Határok és határtérséfek konferencia, (The features of the Hungarian capital investments in Zakarpattia Oblast in the light of the socio-economic developments of the Hungarian–Ukrainian border region – Borders and border regions conference, Nyíregyháza [presentation]). Imre G. (2014): investments entered a new phase in Zakarpattia Oblast?). Tér és Társadalom, Vol. 28, Issue 3, pp. 110–125. Strategic Plan for the Economic Development of Zakarpattia Oblast (2013). Péti M. (2015): haza egységes turisztikai terében (The economic positions of Hungarians in Zakarpattia Oblast and the development opportunities of the territory within the unified tourism region of the Carpathian Home). Berehovo, 16 October 2015. Portfolio.hu (2015a): labour shortage). http://www.portfolio.hu/gazdasag/munkaugy/sulyos_munkaerohiannyal_kuzd_magyarorszag.220735.html

— 790 —

The banking system scheme A smoothly functioning financial intermediary sector is essential to improve the economy’s competitiveness, and hence for driving growth and convergence. As a result, a competitive banking sector is also crucial, as banks supply the credit necessary for investments and operation of the economy. In the past three years, many steps have been taken towards a smoothly functioning banking sector. Foreign currency denominated household loans, by far the biggest source of vulnerability for the banking sector and the entire economy, were converted into forints with the active participation of the central bank. Furthermore, MNB introduced numerous measures aimed at achieving sound and safe banking sector, applying its macroprudential mandate conferred upon it in 2013. Caps have been put on excessive indebtedness based on the lessons learned from the crisis. As another lesson from the crisis, namely the risks of currency and maturity mismatch in bank balance sheets have also been addressed. Finally, changes to the international regulatory environment have also been adopted in Hungary: the introduction of stringent new capital and liquidity rules contribute to more prudent bank operation. At the same time, the annual growth of corporate lending continues to fall short of the necessary 5–10 per cent. While MNB prevented a sharp drop in corporate lending with the Funding for Growth Scheme, market-based lending must be revived in order to achieve the lending dynamics needed to drive sustainable growth, which is the objective of MNB’s Growth Supporting Programme launched in end-2015. The banking sector’s profitability, which falls short of the international and regional level, represents an additional challenge. A reduction of the bank levy may generate a marked improvement in the short run. In case of additional cuts of fiscal burdens, a conditioning on lending activity may be worth considering

— 791 —

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in an effort to foster the revival of market-based lending. On the cost side, there is significant room for improving profitability by increasing cost efficiency along with innovation on the one hand, and taking advantage of cost synergies through consolidation within the banking sector on the other hand. Finally, the greatest impediment to a smoothly functioning banking sector in Hungary is the high volume of non-performing loans. The reduction of NPLs could greatly improve profitability by curtailing costs and could also boost market lending. MNB has set up MARK Zrt. to assist the clean-up of the corporate portfolio. In the case of the household loans, a potential further expansion of the NET (National Asset Management Company) and the provision of targeted fiscal subsidies to large families in the context of the Home Creation Programme may be worth considering in an effort to reduce the non-performing portfolio. In addition, incentivizing restructuring to ensure a sustainable debt trajectory could prove helpful for a significant portion of customers.

19.1 Promoting corporate lending supporting growth The goal is to restore market-based corporate lending to ensure support for sustainable economic growth, which in annual terms means a 5–10 per cent expansion of corporate credit, and within that lending to SMEs. MNB has taken several steps to achieve this: of these the Funding for Growth Scheme and the Growth Supporting Programme stand out, with the latter taking hold from 2016.

After the onset of the crisis, most of the large banks that were actively involved in corporate lending considerably restricted their credit supply. In contrast to retail lending, the reduction of credit in the segment for non-financial corporations was not warranted by companies’ widespread, excessive indebtedness. The slump in corporate lending carries the risk of the recovery not entailing an adequate lending boom in the future, which, according to earlier international experiences, may have a negative impact on growth as well. Over the — 792 —

19. The banking system scheme

long term, the banking sector should be able to meet the credit demand of real economy actors on a market basis. Chart 19-1: Annual growth rate of the outstanding borrowings of the corporate and SME sector 6

Per cent

2015Q2

2015Q1

2014Q4

2014Q3

2014Q2

2014Q1

2013Q4

–20

2013Q3

–10

2013Q2

–16 2013Q1

–8 2012Q4

–12

2012Q3

–6

2012Q2

–8

2012Q1

–4

2011Q4

–4

2011Q3

–2

2011Q2

2011Q1

2010Q4

2010Q3

2010Q2

2010Q1

Real GDP growth GKI – Business sentiment indicator (right-hand scale) Corporate sector (MFI, year on year) SME sector (banking sector, year on year) Corporate sector estimated without FGS (MFI, year on year) Source: MNB

Since 2013, MNB has adopted important measures to reverse the negative trends in corporate credit, and especially SME lending. The two phases of the Funding for Growth Scheme can be considered successful in terms of halting the contraction of SME lending. The FGS fulfilled its objective, and therefore in the third, gradual phase-out phase companies’ access to financing is supported by a restricted and targeted fund until the restoration of market-based lending. In addition, the Growth Supporting Programme was introduced with precise, verifiable, and unique numerical goals. This may be able guarantee that corporate credit supporting growth, and within that SME credit, expands by — 793 —

Part II: Competitiveness reforms

5–10 per cent, even over the short term. Over the long term, however, improvement in the domestic and European business environment is essential for the restoration of market-based lending. The upswing in corporate lending should also be stimulated with fiscal instruments. In addition to cutting the Bank levy in 2016, linking the further reduction of the tax burden – from 2017 – to the pick-up in lending should also be considered. As a result of this modification, the players in the banking sector would support the actors in the real economy more due to the easing of the supply restrictions.

The goal is to achieve active but prudent retail lending, primarily in the financing of home construction. In order to achieve this, changing the conditions of the currently available home creation interest subsidy or the introduction of a loan guarantee stimulating supply should be considered. On the other hand, with the introduction and capping of the payment-to-income (PTI) ratio and the loan-to-value (LTV) ratio, MNB provided effective protection to banks and borrowers against over-indebtedness.

The excessive expansion of retail lending before the crisis (especially in the consumption segment) was followed by an also excessive downturn hampering sustainable economic growth, which has persisted ever since. This could not be offset by the newly extended – primarily housing – loans, the volume of which has expanded continuously in the past one and a half or two years. Despite the fact that banks expect a continued rise in the demand for loans (thanks, for example to the introduction of Purchase Subsidy Scheme for Families and the low interest rate environment), the dynamics of lending do not provide adequate support to the achievement of a healthy credit level or an upswing in home construction. In our view, the latter would still be necessary, since the slight positive turnaround observed in the number of home construction projects is not even sufficient to offset the depreciation of the current stock of dwellings. Moreover, spending — 794 —

19. The banking system scheme

on home construction in Hungary only amounts to one third of the euro area average (1.3 per cent) and is considerably lower than in the country’s regional peers (in the Visegrád Group countries the figure was 2.4 per cent). The current sector of the home creation interest subsidy160 is not effective due to the low interest rate environment, and this sector cannot adequately support an upswing in healthy housing loans, since the interest rate of subsidised loans is at least 6 per cent, while the current market rates are lower in many cases. Within newly extended housing loans, the proportion of loans taken out for purchasing or building a new home was exceptionally low, at just 8 per cent, in 2015, while in 2008 this figure was 24 per cent. The number of home construction projects will only return to normal in the context of healthy, sustainable retail lending. Chart 19-2: Volume of home construction to GDP in 2014 7

Per cent

7 6

Germany Belgium France Finnland Italy EU27 Austria Sweden Spain Denmark United Kingdom Estonia Netherland Czech Republic Cyprus Luxemburg Malta Lithuania Poland Visegrád countries Ireland Portugal Latvia Slovenia Slovakia Romania Bulgaria Hungary Greece

Source: Eurostat

160

The newly announced preferential loan of up to HUF 10 million with an annual interest rate capped at 3 per cent is only offered to families with 3 or more children.

— 795 —

Part II: Competitiveness reforms

The central bank has recently taken several measures to regulate prudent, sustainable lending. Together with the introduction and capping of the payment-to-income (PTI) ratio and the loan-to-value (LTV) ratio, the introduction of the debt brake regulation effective from 1 January 2015 provides effective protection to banks and borrowers against over-indebtedness. In addition, the regulation on fair banks – in which MNB played an active role – enabled the transparent and fair pricing of loan products. Within the framework of the Purchase Subsidy Scheme for Families, the preferential loan with an interest rate capped at 3 per cent and provided to families with at least three children may considerably boost mortgage lending in the affected segment. To further stimulate the demand side of retail lending, changing the conditions of the currently available home creation interest subsidy or the introduction of a loan guarantee stimulating supply could be considered. The resulting revenue loss on the fiscal side may be offset by the expanding investments, and this realignment of fiscal resources may drive economic growth.

19.3 Solid capital and liquidity situation in the banking sector over the long term The goal is to ensure that banks have the necessary long-term capital to cover their expected losses even during an unfavourable macroeconomic scenario and to adequately support sustainable growth through lending. The regulatory measures introduced in the recent period may be able to guarantee this.

One essential precondition for the stable operation of banks is an appropriate solvency and liquidity situation. Capital and liquidity not only provide a buffer in times of crisis, they are vital for uninterrupted lending. Therefore, the lack of these has a direct negative impact on the real economy, hampering growth. The capital and liquidity situation of the banking sector has improved steadily since the onset of the crisis, — 796 —

19. The banking system scheme

and it is now believed that the banking sector would be able to weather even a severe stress without any external intervention (by the state or parent banks). According to the stress test carried out by MNB, the shock-resistance of the banking sector has improved in the past half year, which was influenced to a large extent by the capital injection that followed the settlement of household loans. The declining expected losses, the reduction of the burden on the banking sector and the stable level of the income generating capacity have together improved the anticipated profitability of the banking sector in a stress situation. Chart 19-3: European capital adequacy ratios in 2014, consolidated data 45

Per cent

45 40

EE MT IE SE BG LT HR LV UK LU NL DK SI RO BE FI SK DE CZ HU AT CY FR PL IT GR ES PT

Source: ECB

Both in its supervisory and regulatory function, MNB has to worked on making the operating environment of the banking sector guide banks in a Current favourable direction over the long term. Banks need to have the necessary long-term capital to cover their expected losses even during an unfavourable macroeconomic scenario and to adequately support sustainable growth through lending. In addition, banks must have sufficient liquidity on hand to ensure that their core functions can be performed even under adverse macroeconomic conditions. â&#x20AC;&#x201D; 797 â&#x20AC;&#x201D;

Part II: Competitiveness reforms

This is guaranteed by the regulatory measures introduced in the recent period. • The Debt Cap Rule mitigates risks assumed by banks, which improves the quality of the portfolio. This cuts the anticipated lending losses on the one hand, and reduces the necessary level of capital on the other hand. • The introduction of the Liquidity Coverage Ratio (LCR) was intended to ensure that banks hold an appropriate stock of liquid instruments to absorb shocks. • The Foreign Exchange Funding Adequacy Ratio (FFAR) promotes the financing of FX instruments by the banking sector from stable funds, thereby mitigating rollover risks. • The Mortgage Funding Adequacy Ratio (MFAR) encourages banks to diversify their financing, which reduces the impact of shocks, even in a crisis. • Gradual implementation of the capital adequacy directive (CRD IV – CRR) regulation will further tighten both capital and liquidity rules in the future, which promotes banking sector stability sustainable over the long term.

The goal is to stabilise the profitability of the banking sector over the medium term at a level which is able to ensure the lasting interest of owners and is achieved via prudent lending practices and fair competition among the parties.

One essential precondition for the stable operation of banks is an appropriate solvency situation, which hinges on adequate profitability. As owners can only provide capital to loss-making banks in the short run, over the long term internal capital accumulation is also necessary. In addition to stability, profitability also plays a key role in the competition for the capital and funding required for growth. In the capital allocation of the banks that are active in the region, profitability — 798 —

19. The banking system scheme

is one of the most important factors. Over the medium term, profitability must stabilise at a level which ensures the lasting interest of the owners on the Hungarian market and is achieved as a result of appropriate competition and prudent lending practices. This can mean an annual return on equity of 10–12 per cent.161 Even adjusting for one-off items, the Hungarian banking sector is among the weaker performers in the EU, even in terms of the profitability of the banking sector adjusted for state measures and oneoff effects (Chart 19-4). Looking ahead to the coming years, the results Chart 19-4: Distribution of return on equity in the EU banking sectors 30

Per cent

–10

–20

–30

2003–2007

2008

2009

2010

2011

2012

2013

2014

–30

Hungary – non-consolidated, adjusted by the effect of the early repayment scheme, the settlement, and one- off institutional effects Hungary – consolidated Source: ECB

161

Fábián G. – Vonnák B. (eds.): Átalakulóban a magyar bankrendszer – Vitaindító (The Hungarian Banking Sector in Transition – A keynote paper for developing a consensus-based vision for the Hungarian banking sector)

— 799 —

Part II: Competitiveness reforms

will be substantially influenced by changing legislation and government measures, but from 2017 the gradual decline in the bank levy will offset the impact of the measures that cause the losses exerted on profits. Nonetheless, the domestic banking sector’s low profitability, which is below the expected yield, may represent a competitive disadvantage in the fund allocation among the countries of the region. A permanent improvement in the sector’s profitability requires the rethinking of the business strategy that was typical earlier, and that was – in many cases – built on unilateral increases in interest income from households. This is supported by MNB through the positive incentives directly employed in lending, the self-financing programme and through facilitating portfolio cleansing. Resolution of the distressed portfolio facilitates cost-effectiveness and may accelerate the consolidation of the banking sector. Due to the exploitation of synergies, consolidation can provide a further impetus for costeffectiveness. Larger average bank size allows a better utilisation of economies of scale, at least up to a certain level (however, an excessive size carries risks from a regulatory aspect as well), and significant cost savings may stem from the streamlining of management and other costs. The fiscal side can also improve profitability by supporting lending activity with positive incentives, for example by reducing the bank levy, which would enhance profitability from two sides: by increasing revenues due to the heightened activity and via lower tax expenses.

19.5 Non-performing household and corporate credit The goal is to significantly reduce the high proportion of non-performing loans within the credit portfolio extended to the private sector, which may improve the banking sector’s willingness and capacity for lending.

— 800 —

19. The banking system scheme

Since the onset of the crisis, the share of loans past due by over 90 days, i.e. non-performing loans, within the corporate and household loan portfolio of the banking sector has expanded considerably, peaking at close to 18 per cent in 2014 (Chart 19-5). The proportion of non-performing loans has not declined significantly since then. This is largely due to the slow portfolio cleaning by banks, which in the case of the corporate portfolio is mainly caused by the lack of a market for non-performing receivables, and in the case of the household portfolio by several administrative hurdles hindering the cleaning of mortgage loans. Chart 19-5: Volume and ratio of the banking sector’s loans past due by over 90 days 1,400

Billion HUF

Per cent

21 18

1,000

800

600

400

200

Mar. 2010. Sep. 2010. Mar. 2011. Sep. 2011. Jan. 2012. Mar. 2012. May 2012. July 2012. Sep. 2012. Nov. 2012. Jan. 2013. Mar. 2013. May 2013. July 2013. Sep. 2013. Nov. 2013. Jan. 2014. Mar. 2014. May 2014. July 2014. Sep. 2014. Nov. 2014. Jan. 2015. Mar. 2015. May 2015. July 2015. Sep. 2015.

1,200

Volume of corporate loans with 90+ days delinquency Volume of household loans with 90+ days delinquency Percentage of corporate loans with 90+ days delinquency (right-hand scale) Percentage of household loans with 90+ days delinquency (right-hand scale) Total percentage of loans with 90+ days delinquency (right-hand scale) Source: MNB

The high proportion of non-performing loans increases the risk of the future erosion of the capital guaranteeing banks’ lending capacity. Furthermore, in addition to the one-off effect of the depreciation reducing profits, if the non-performing loan stays on the balance sheets of banks, then banks consistently finance assets not generating — 801 —

Part II: Competitiveness reforms

interest or fee revenue, while paying high costs, which impairs their profitability until the cleansing of the portfolio. In the case of persistently low profitability, banks’ capital accumulation capacity decreases, which leads to low levels of capital (Chart 19-6). Thus, the high proportion of non-performing loans impacts the banking sector’s capacity and willingness for lending negatively in a circular fashion. Consequently, the sector’s lending activity cannot sustainably support economic growth. Chart 19-6: High ratio of non-performing loans and the lending activity of the banking sector Low profitability

High NPL ratio Additional provisioning need and the loss in interest and fee income is decreasing profitability

Loan volume decreases due to low lending activity, which ceteris paribus increases the NPL ratio

Permanently low profitability worsens the banks’ ability to accumulate capital

Banks’ capital provide its lending capacity

Decreasing lending activity

Decreasing capital level

The slow cleaning of the banking sector’s non-performing loan portfolio called for regulatory intervention. In order to accelerate the cleaning of the corporate portfolio, the central bank set up an asset management company (MARK Zrt.) in November 2014 to facilitate the resolution of commercial property loans. If the capacities of MARK Zrt. are fully utilised, the non-performing corporate loan ratio in the banking sector could fall from 14 per cent to below 9 per cent by the end of 2016. In addition, the legal environment governing the management of non-performing loans should also be modified: MNB and the EBRD have worked in close cooperation since 2014 on proposals helping — 802 —

19. The banking system scheme

the elimination of the legal and administrative barriers linked to nonperforming corporate loans. Finally, extending the expanded home creation programme to certain non-performing loans may also provide great help in addressing the remaining problem. Cleaning the balance sheets of the banking sector’s household mortgage loans past due by over 90 days, which amount to HUF 1,000 billion and affect 140,000 debtors can currently only be effectively supported by the National Asset Management Agency (NAMA). Despite the expanded funds of the NAMA and the introduction of personal bankruptcy in late 2015, in 2016 the problem of almost 100,000 non-performing mortgage debtors may remain unresolved, which may necessitate further steps. Based on the international experiences in managing the problem of non-performing mortgage loans, the mass liquidation of collateral is not a solution, while the widespread restructuring of non-performing transactions may be expedient. According to an MNB study,162 there are restructuring reserves in about 45–50 per cent of the non-performing mortgage loans. However, banks would have to progress with the restructuring at a more rapid pace, and clients should show greater willingness to cooperate with respect to finding a solution to the problem of non-performing mortgage loans. In addition to the above, several administrative barriers hinder the effective cleaning of this portfolio from the balance sheets, and their elimination would facilitate the more widespread restructuring of the transactions. From the shrinkage perspective of non-performing household loans, it should be considered the possible further expansion of NAMA, or the providing of targeted fiscal subsidies to large families under the Purchase Subsidy Scheme for Families.

162

Dancsik B. – Fábián G. – Fellner Z. – Horváth G. – Lang P. – Nagy G. – Oláh Zs. – household mortgage loan portfolio with micro-level data). MNB Occasional Papers, Special Issue, October 2015.

— 803 —

Part II: Competitiveness reforms

Overall, the considerable drop in the proportion of non-performing loans in the banking sector would entail a rise in lending activity. Therefore more active market lending by the banking sector may further foster the reduction of the proportion of non-performing loans within the portfolio.

The goal is a banking sector that functions with low operating costs and features an advanced risk management framework, which in turn allows for the application of lower margins. The cost-effectiveness of the Hungarian banking sector should be gradually approximated to the average of European countries, in a way that does not undermine quality.

The cost-effectiveness of the Hungarian banking sector has lagged far behind the European average, whether we look at the international comparison of operating costs relative to interest and fee revenues or the comparison of operating costs relative to the balance sheet total (Chart 19-7). Over the longer term, this also threatens the sustainable profitability of the sector, which is already below the expected return on equity after adjusting for one-off effects. On the one hand, this weakens the growth prospects of the sector through the poor capital accumulation capacity of the banking sector, and thus also the banking sector’s role in assisting sustainable economic growth, and on the other hand it exerts a negative impact on the sector’s competitiveness. However, radical, indiscriminate cost reduction entails long-term risks, because if banks cannot implement the necessary developments in time, the quality of their services is impaired, their security sector may become more vulnerable and they may lag behind their regional peers. Accordingly, the convergence of the Hungarian banking sector is impossible without innovation. In the financial sector, innovation should not only focus on the expansion of products and services, but also on cutting operating costs. — 804 —

19. The banking system scheme

In the short run, the successful reorganisation and cost-cutting at MKB, and the exploitation of the cost-saving opportunities offered by the integration of savings cooperatives may represent progress. In addition, it is important to free the banking sector’s balance sheet from the portfolio of non-performing loans that only generate costs, which may be facilitated by the central bank’s programmes (see 19.5) aimed at portfolio cleaning. Chart 19-7: Cost-to-income ratio in EU banking sectors 100

Per cent

100

2008

2009

2010

2011

2012

Hungary – consolidated Source: MNB

— 805 —

2013

2014

Part II: Competitiveness reforms

19.7 Competitive banking sector The goal is the fair competition in the banking sector, which may improve the economy’s competitiveness and growth potential through the more efficient allocation of funds. This hinges on the fact that the banking sector’s concentration does not increase in the future, and it is also important that banks compete in prices (interest rates and fees) and not in offering increasingly risky products and lending to increasingly risky clients.

Competition between banks fosters innovation, improves efficiency and results in interest rates reflecting the actual costs. From the perspective of fund allocation, it is efficient for the real economy if products and premiums do not arise in the sector in the context of an oligopolistic market structure, but consumers with a sense of financial awareness choose from an appropriate range of bank products in line with their risk profile. It would facilitate the healthier operation of the sector if fewer universal banks functioned at larger economies of scale, while in the specialised sub-markets the possibility for competition should be created with the elimination of the barriers to entry. Competition point of view, it can be however problematic if after the consolidation of the banking sector the share of the three largest banks raise more than 50 percent, within one bank’s share would go up significantly above 25 per cent (Chart 19-8). This would distort the market and competition as well. Such expansion should not be supported partly on account of the “too big to fail” problem, as the sectoratically important institutions increase the vulnerability arising from the sector, which may have direct and indirect implications for the budget.

— 806 —

19. The banking system scheme

Chart 19-8: Concentration of European banking sectors in 2013 Per cent V4

Per cent Club Med

0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00

Slovakia Czech Republic Hungary Poland Greece Portugal Spain Italy Estonia Lithuania Finland Netherland Malta Denmark Latvia Belgium Cyprus Sweden Slovenia Rumania Bulgaria Ireland France UK Austria Luxemburg Germany

100 90 80 70 60 50 40 30 20 10 0

Shares of the 5 largest credit institutions in total assets Herfindahl-Hirschmann Index (right-hand scale) Source: ECB

With the debt brake regulation, MNB instituted substantial measures to prevent banks from competing in risks, and increasing price competition is fostered by the law on fair banking in the household segment. In addition, over the short term MNB contributes to the competitive banking sector with a stronger, reorganised MKB. Indirectly, MNB’s FGS programme and the Growth Supporting Programme also promote enhanced competition in the SME lending segment.

— 807 —

Acknowledgements A large number of people supported and facilitated the creation of this book. The editors are grateful to György Matolcsy and Márton Nagy for their inspiring support, and Eszter Hergár for her assistance regarding the communication of the book. We would also like to thank Árpád Kovács and László Domokos that they improved the professional standard of the book through their valuable comments. We are also indebted to the authors of the studies, analyses and proposals: István Ábel, János Ádám, Dániel Babos, Dóra Bak, Gergely Baksay, Máté Bálint, Ádám Banai, Dávid Berta, Márton Bókay, Tamás Briglevics, Péter Csillik, Norbert Csizmadia, Balázs Csomós, Judit Csutiné Baranyai, Gábor Dakó, Gergely Fábián, Sára Farkas, Bence Gergely Kicsák, Balázs Kóczián, Laura Komlóssy, Péter Koroknai, László Kozma, Emese Kreiszné Hudák, Adrienne László, Kristóf Lehmann, Rita Lénárt-Odorán, Imre Lengyel, Zsolt Lovas, Annamária Madarász, Pálma Mosberger, Lívia Ónozó, István Papp, Gábor Pellényi, Márton Péti, Gábor P. Kiss, Géza Rippel, Géza Salamin, Balázs Sisak, Balázs Spéder, Ákos Szalai, Zoltán Szalai, Gergely Szeniczey, Árpád Vadkerti, Ákos Vajas, Péter Varga, Noémi Végh, Richárd Végh, Balázs Vonnák and Ádám Zágonyi. The authors would like to express their gratitude to Edit Altbäcker for her editing and coordination assistance, as well as to István Schindler for his help in preparing the charts and tables in the book. Thanks are due to Soma Szabó and Károly Pavela for their work on graphic design and page layout, as well as our proofreader Krisztina Wéber. The authors are also grateful to Gergely Wonke, Viktória Németh, Eleonóra Németh, Gábor Meizer and all their colleagues for the conscientious work that was vital for the publication of this book.

— 808 —

List of acronyms ACU AMECO APR AT BIS BKK BPM5 BSE C CA CAGR CAR CART CCHOP CEE CEF CES CGE CLUB MED COFOG Comecon COSME CP X CPF CZR EaSI

Asian Currency Unit Annual macro-economic database of the European Commission Annual percentage rate Austria Bank for International Settlements Centre for Budapest Transport Balance of Payments Manual 5th edition Budapest Stock Exchange Consumption Current account Compound annual growth rate Capital adequacy ratio Classification and regression trees Competitive Central Hungary Operational Programme Central and Eastern Europe Connecting Europe Facility Constant elasticity of substitution Computable general equilibrium Mediterranean countries: Italy, Portugal, Spain, Greece Classification of Functions of Government Council for Mutual Economic Assistance Competitiveness of Enterprises and Small and Medium-sized Enterprises Convergence programme for the year X Central Provident Fund Czech Republic Employment and Social Innovation Programme

â&#x20AC;&#x201D; 809 â&#x20AC;&#x201D;

List of acronyms

EC ECB ECOP EDB EDIOP EDOP EDP EEC EIB EMS EPB EPEC EPO ERDF ESA ESA balance ESF EST ETC EU EU15

EU28 (27) FAO FDI FECR FFAR FI

European Commission European Central Bank Economic and Competitiveness Operational Programme Economic Development Board Economic Development and Innovation Operational Programme Economic Development Operational Programme Excessive Deficit Procedure European Economic Community European Investment Bank European Monetary System Economic Planning Board European PPP Expertise Centre European Patent Office European Regional Development Fund European System of Accounts Accrual-based fiscal balance European Social Fund Estonia European Territorial Cooperation European Union Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands Portugal, Spain, Sweden, United Kingdom The 28 (27) European Union Member States Food and Agricultural Organization of the United Nations Foreign direct investment Foreign exchange coverage ratio Foreign exchange funding adequacy ratio Finland

â&#x20AC;&#x201D; 810 â&#x20AC;&#x201D;

List of acronyms

FX GDP GMR GNI Gov. Gyed H2020 HCSO HCSO HDRI HDB HDC HK HR HRDOP HU HUF HUN I ICP ICT IE IFS IMF ISCED IT JASPERS KATA KIVA KR LAT

Foreign Exchange, forex Gross domestic product Geographic macro and regional Gross national income Government Child-care allowance Horizon2020 Hungarian Central Statistical Office Hungarian Demographic Research Institute of the Hungarian Central Statistical Office Housing Development Board Hungarian Development Centre Hong Kong Human resources Human Resource Development Operational Programme Hungary Hungarian forint Hungary Investment International Comparisons Program Information and communications technology Ireland International Financial Statistics International Monetary Fund International Standard Classification of Education Information technology Joint Assistance to Support Projects in European Regions Itemised tax for small taxpayer businesses small enterprise tax Republic of Korea Latvia

â&#x20AC;&#x201D; 811 â&#x20AC;&#x201D;

List of acronyms

LIBOR LTIA LTU LTV M

London Interbank Offered Rate, interbank rate Long-term investment account Lithuania Loan-to-value ratio Import

MAS MÁV MIFID MNB MNV Zrt. MOFE MTF MVM NAV NDA NEET NET NHDP NIO NPF NPL NSP NUTS NUTS2 OECD

Monetary Authority of Singapore Magyar Államvasutak Zrt. Markets in Financial Instruments Directive Magyar Nemzeti Bank National State Holding Company Ministry of Finance and Economy Multilateral Trading Facility Hungarian Electricity Ltd. National Tax and Customs Administration National Development Agency Not in Education, Employment or Training National Asset Management Agency New Hungary Development Plan National Innovation Office National Protection Fund Non-performing loan New Széchenyi Plan Nomenclature of Territorial Units for Statistics Nomenclature of Territorial Units for Statistics Organisation for Economic Cooperation and Development National Development Policy and National Regional Development Concept People’s Action Party Programme for International Student Assessment Poland Public-private partnership

OFTK PAP PISA POL PPP

— 812 —

List of acronyms

PPP PPS PTI PWT R&D R&D(&I) ROA ROE ROP S SAO SG SME SNA SPÖ SREP SSC SVK SVN TARGEN TFP TO TOP TW UN UNCTAD USA USD V4 VAT

Purchasing Power Parity Purchasing Power Standard Payment-to-income ratio Penn World Table Research and development Research and development (and innovation) Return on assets Return on equity Regional Operational Programme Savings State Audit Office Singapore Small and medium-sized enterprises System of National Accounts Social Democratic Party of Austria Supervisory review and evaluation process Shared Service Centre Slovakia Slovenia TÁRKI Reallocation of resources among generations and career financing database Total factor productivity Thematic objective Territorial and Settlement Development Operational Programme Taiwan United Nations United Nations Conference on Trade and Development United States of America US dollar Visegrád countries Value-added tax

— 813 —

List of acronyms

WDI WEF WEO WHO WIIW X Y

World development indicators (database) World Economic Forum IMF World Economic Outlook World Health Organization Vienna Institute for International Economic Studies Export Income

— 814 —

List of charts and tables158 List of charts Chart 1: Key areas in successful economic convergence

Chart 1-1: Central- and Eastern-European countries’ per capita GDP relative to EU15

Chart 1-2: Relative income per capita in Hungary

Chart 1-3: Changes in GDP per capita between 1970 and 2011

Chart 1-4: Additional growth relative to USA since 1960

Chart 2-1: Growth rates and total factor productivity in select Asian and European countries (1990–2007)

Chart 2-2. Hierarchy between the top 50 countries based on the Economic Complexity Index (ECI) in 2014

Chart 2-3: Factors of production in the period of convergence

Chart 2-4: Government expenditure on education (per cent of GDP)

Chart 2-5: Labor force with tertiary education (percentage of total)

Chart 2-6: Structure of employment by sector in South Korea (1963–2014)

Chart 2-7: Sectorial breakdown of manufacturing in South Korea (1963-2006)

Chart 2-8: GNI per capita, Atlas method in South Korea since 1962

Chart 2-9: Structure of employment by sector in Taiwan (1987-2014)

Chart 2-10: GNI per capita in Taiwan since 1951

Chart 2-11: Sectorial breakdown of manufacturing in Singapore (1975-2011)

Chart 2-12: GNI per capita, Atlas method in Singapore since 1962

Chart 2-13: Changing Sectoral Structure in Austria (1964-1977)

100

Chart 2-14: GDP per capita in Finland, Sweden and EU15 between 1960 and 2000

103

Chart 2-15: Developments of economic structure (upper graph) and growth contributions of productive sectors (lower graph) in Finland between 1945 and 2003

104

Chart 2-16: Convergence process (the evolution of GDP per capita)

106

Chart 2-17: Economic openness, export and purchasing power parity

108

158

The papers and our recommendations are based on the data available on 15 January 2016.

— 815 —

List of charts and tables Chart 2-18: Supply side of GDP

109

Chart 2-19: Demand side of GDP

110

Chart 2-20: Evolution of GDP per capita (USD) and real GDP growth

113

Chart 2-21: Developments in economic structure (production side)

115

Chart 2-22: Relationship between the service sector and GDP per capita

117

Chart 2-23: Employment by sectors as a proportion of total employment

117

Chart 2-24: Evolution of budget deficit

119

Chart 2-25: Real convergence of Southern European countries (real GDP/capital, PPP, Germany = 100)

121

Chart 3-1: Relationship between saving and investment rate on cross-sectional data (average of 1990-2013)

145

Chart 3-2: Relationship between the ratio of the capital stock financed from domestic savings and economic growth

146

Chart 3-3: Illustration of the risks linked to various forms of financing

152

Chart 3-4: Developments in gross national income in the region

154

Chart 3-5: Link between FDI and economic development

158

Chart 3-6: Developments in FDI* and GDP growth in EU countries

159

Chart 3-7: Investments and savings, and developments in the current account in Southeast Asian countries

162

Chart 3-8: Structure of the influx of funding in Southeast Asian countries

164

Chart 3-9: Financing structure of Austria’s convergence (1964–1976)

166

Chart 3-10: Financing structure of Finland’s convergence (1964–1979)

167

Chart 3-11: Developments in the fundamental determinants of the current account in Ireland

169

Chart 3-12: Structure of external financing in Ireland, transactions as a percentage of GDP

170

Chart 3-13: Real growth in the components of GDP in the region

171

Chart 3-14: Developments in the fundamental determinants of the current account in the region

172

Chart 3-15: Net lending of various sectors within the region, transactions as a percentage of GDP

174

Chart 3-16: Structure of external financing in the region, transactions as a percentage of GDP

175

Chart 3-17: External debt indicators in the countries of the region

176

— 816 —

List of charts and tables Chart 3-18: Investments, savings and the current account balance in Mediterranean countries and economic growth

179

Chart 3-19: Structure of the influx of funding in Mediterranean countries

180

Chart 3-20: Indicators as a percentage of GDP of successfully converging and Mediterranean countries

182

Chart 4-1: Size of the banking system and the stock market between 2001 and 2008

191

Chart 4-2: The effect of financial development on growth

193

Chart 4-3: The impact of funding channels on the growth of GDP per capita

195

Chart 4-4: Predicted marginal effect of the bank-market ratio on GDP growth

198

Chart 4-5: Level of development of capital markets and banking systems in 2011

199

Chart 4-6: Stock market capitalisation

203

Chart 4-7: Total assets of banking system

204

Chart 4-8: Annualised growth rate of private loans

205

Chart 4-9: European comparison of banking system concentration in 2014

206

Chart 4-10: Share of foreign ownership in the banking system in 2007

207

Chart 4-11: Loan-to-deposit ratio in the convergence period

208

Chart 5-1: Development of the budget balance and the public debt in the studied countries and Hungary

213

Chart 5-2: Education expenditure and the redistribution rate in Hungary and in the studied countries

214

Chart 5-3: Evolution of the GDP per capita, measured at purchasing-power parity, of the studied countries compared to Germany

216

Chart 5-4: Korea’s budget and central government balances (1970–2012)

218

Chart 5-5: Korea’s gross public debt (1958–2011)

219

Chart 5-6: Budget revenues and expenditure of Korea (1970–2012)

222

Chart 5-7: Public debt and budget expenditures in Ireland (1960–2014)

230

Chart 5-8: Budget balance in Ireland (1970–2014)

232

Chart 5-9: Budget balance in Austria (1970–2014)

237

Chart 5-10: The redistribution rate in the european countries (1999)

238

Chart 5-11: Budget balance, public debt and GDP growth in Finland (1961–2014)

239

Chart 5-12: Enrollment ratio in the primary education (1971–1990)

241

Chart 5-13: Taxes on income and consumption (1965–1984)

242

— 817 —

List of charts and tables Chart 5-14: Budget balance in Poland (1995–2014)

244

Chart 5-15: GDP growth in Poland and in the V4 countries

246

Chart 5-16: Taxes on labour and consumption as a percentage of total taxation (1965–1984)

248

Chart 5-17: PISA scores in OECD countries (2009–2012)

250

Chart 5-18: Slovakia’s budget deficit (1995–2014)

251

Chart 5-19: Slovakia’s gross public debt (1995–2014)

252

Chart 5-20: Development of fiscal revenues of Slovakia (1995–2014)

254

Chart 6-1: Evolution of GDP per capita in new EU member states comparing to old member states

265

Chart 6-2: Convergence based on GDP and GNI

267

Per capita GDP and GNI at purchasing power parity compared to the EU15 countries

267

Difference between GNI and GDP in the Visegrád countries

267

Chart 6-3: Decomposition of changes in GDP per capita (1990–1995)

271

Chart 6-4: Decomposition of participation in Visegrád countries (1990–1995)

271

Chart 6-5: Evolution of GDP per capita in Visegrád countries (1995–2011)

273

Chart 6-6: Employment rate and index of human capital per capita in Visegrád countries

275

Chart 6-7: Growth of capital stock per capita and total factor productivity in Visegrád countries

276

Chart 6-8: Potential growth in the Hungarian economy

277

Chart 6-9: Foreign direct investments and export performance in Visegrád countries between (1995–2013)

281

Chart 6-10: Development of economic growth, external balance and budget balance

283

Chart 6-11: Old-age pension expenditures in percent of fiscal expenditures

286

Chart 6-12: Evolution of household loans

289

Chart 6-13: Actual and finance neutral potential output growth

290

Chart 6-14: Sectoral composition of value added in Visegrád countries and Austria

291

Chart 6-15: Exports by technological level in Visegrád countries

293

Chart 6-16: Yields of main cereals in Hungary and the Czech Republic

294

Chart 6-17: Labour productivity of Hungarian corporations in percent of similar sized German corporations in 2012

296

Chart 6-18: Investment rate relative to GDP, financing and real growth in Hungary

298

— 818 —

List of charts and tables Chart 6-19: Developments in the balance of payments relative to GDP

299

Chart 6-20: Structure of fund inflows relative to GDP

300

Chart 6-21: The structure of debt ratios

301

Chart 6-22: Issuance of long-term goverment securities (monthly data)

303

Chart 6-23: Developments in net lending from the current and capital account’s side

303

Chart 6-24: Developments in the trade balance and its components

304

Chart 6-25: Net borrowing of the private sector

305

Chart 6-26: Changes in net lending of the sectors in SNA terms

306

Chart 6-27: The financing of net borrowing

307

Chart 6-28: Developments in net external debt and short-term external debt

309

Chart 6-30: Net FDI and debt-type financing inflows in converging countries

313

Chart 6-31: Average investment and external debt financing as a percentage of GDP

314

Chart 7-1: Changes in regional concentration of GDP within countries (2004–2011)

332

Chart 7-2: GDP per capita in the NUTS 2 regions of the Visegrád Group (2013)

333

Chart 7-3: GDP per capita in the NUTS 2 regions of the EU, and real GDP growth in the Member States (2013, 2014)

335

Chart 7-4: Share of Budapest and Pest County in certain socio-economic indicators

337

Chart 7-5: Value of the EU’s economic and enterprise development funds disbursed per resident, by the location of the projects

343

Chart 7-6: Regional disparities in GDP at the county level based on the Hoover index (1994–2014)

345

Chart 7-7: GDP per capita in absolute terms and relative to the EU average in Hungarian counties (2013, 2014)

348

Chart 7-8: GDP per capita in Hungary between 2000 and 2014

350

Chart 7-9: Contribution of the counties to the country’s GDP growth between 2000 and 2013 (at 2000 prices)

352

Chart 7-10: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2000 and 2013 (at 2000 prices)

353

Chart 7-11: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2000–2008 and 2009–2013 (at 2000 prices)

354

Chart 7-12: Contribution of the counties to the country’s GDP-growth per 1000 inhabitant between 2011 and 2013 (annual average, at 2000 prices)

355

Chart 7-13: Changes in the value of investments relative to GDP in the counties between 2008 and 2013

357

— 819 —

List of charts and tables Chart 7-14: Value of investments per capita in Hungarian counties (2008, 2011, 2014)

358

Chart 7-15: Impact of the major factors of economic growth (2000–2013)

359

Chart 7-16: Impact of the major factors of economic growth (2009–2013)

361

Chart 7-17: GDP/capita PPS in 2009 and the growth until 2013 in the NUTS 3 regions of the Visegrád Group

362

Chart 7-18: Unemployment in Hungary (2008-2014)

365

Chart 7-19: Unemployment rate among people aged 15–24 (2008, 2011, 2014)

366

Chart 7-20: Average life expectancy at birth and per capita GDP in the counties of Hungary (2014)

367

Chart 7-21: Average life expectancy at birth in Hungarian counties (2005, 2010, 2014)

368

Chart 7-22: Natural population growth, ageing index, internal and international net migration in Hungary (2014)

370

Chart 7-23: Natural population growth, internal and international net migration and ageing index in Hungary (2001-2014)

371

Chart 7-24: Knowledge society in Hungary

373

Chart 8-1: Distribution of the Hungarian population by age groups (1960–2060)

388

Chart 8-2: Decomposition of the change of the Hungarian population (1990–2014)

389

Chart 8-3: Total fertility rate in the countries of the European Union (2000–2013)

390

Chart 8-4: Difference between the life expectancy of persons with tertiary education and secondary education at age 30 (2012)

391

Chart 8-5: Ratio of 65 years and older in the countries of the European Union in 2015 and in 2060

396

Chart 8-6: Expected development of the headcounts of working age population between 2015 and 2060 in Hungary according to different population projections

398

Chart 8-7: Growth impact of the change in the working-age population compared to 2000–2009 (based on production function)

401

Chart 8-8: Average effective retirement age in Visegrád countries (2000–2012)

402

Chart 8-9: Dependency ratios in Hungary

403

Chart 8-10: Change in the share of tertiary educated persons within the working-age population and GDP growth between 1994 and 2007

406

Chart 8-11: Activity rate of population ages 15–64 by educational attainment (2014, per cent)

407

Chart 8-12: Unemployment rate by educational attainment

409

Chart 8-13: Share of tertiary graduates in the population and the relative wage gap (2012) 411

— 820 —

List of charts and tables Chart 8-14: Distribution of population ages 25–64 by educational attainment in Hungary and in the countries of the European Union

412

Chart 8-15: Share of tertiary graduates among population ages 25–64 in the countries of the European Union

413

Chart 8-16: Share of tertiary graduates in certain age groups (2014)

414

Chart 8-17: Tertiary graduates in science and technology per 1 000 inhabitants aged 20–29 years

415

Chart 8-18: Share of population with upper secondary educational attainment level in population ages 25–64 (2014)

416

Chart 8-19: Number of languages spoken (2011)

417

Chart 8-20: Structure of secondary education in the European Union

418

Chart 8-21: Results of PISA test in mathematics

420

Chart 8-22: PISA test results in Visegrád countries between 2003 and 2012, mathematics

421

Chart 8-23: Average PISA test scores and per capita spending on primary and secondary education

422

Chart 8-24: Public spending on education in 2011 (as a percentage of GDP and as a percentage of budget expenditures)

423

Chart 8-25: Public expenditure on education in converging countries and spending on education in Hungary

424

Chart 8-26: Development of public spending on education (2005–2012)

425

Chart 8-27: Total expenditure on education by level (2011)

426

Chart 8-28: Spending on education per student by levels, 2011 (equivalent USD, PPP)

427

Chart 8-29: Preston curve on the data of OECD countries (2012)

429

Chart 8-30: Life expectancy at birth in the countries of the European Union (2013)

431

Chart 8-31: Development of life expectancy at birth in Hungary and in EU28 countries (2002–2013)

432

Chart 8-32: Healthy life years expected at birth in the countries of the European Union (2013)

433

Chart 8-33: Potential years of life lost (2012)

436

Chart 8-34: Public and private spending on health care (2013)

437

Chart 8-35: Life expectancy at birth and spending on health care as a percentage of GDP in the OECD countries (2013)

438

— 821 —

List of charts and tables Chart 8-36: Participation rate in EU countries

439

Chart 8-37: Participation rate by highest level of education in EU countries (2014)

441

Chart 8-38: Participation rate by age groups in EU countries (2014)

441

Chart 8-39: Participation rate of women aged 15-49 in EU countries (2014)

442

Chart 8-40: Comparison of participation rate in Visegrád countries

443

Chart 8-41: Comparison of participation rate in Visegrád countries

444

Chart 8-42: Proportion of inactive people in 15 to 64 years population by reasons for not seeking employment (2014)

445

Chart 8-43: Contributions by groups resulting from differences in participation rates (2014)

446

Chart 8-44: Proportion of different groups in the Hungarian population (2014)

447

Chart 8-45: Kaitz index in international comparison (2014)

448

Chart 8-46: Proportion of inactive people in 15 to 25 years population by the main reason for not seeking employment (2014)

450

Chart 8-47: NEET-ratio in OECD countries (2013)

451

Chart 8-48: Developement of participation rate of young people

452

Chart 8-49: Developement of participation rate of people over 50 years

453

Chart: 8-50: Contribution to the total deviation of participation rate of Hungarian women to EU28 (2014)

454

Chart 8-51: Ratio of part-time workers in EU countries (2014)

455

Chart 8-52: Employment rate in EU countries

456

Chart 8-53: Changes in employment structure

457

Chart 8-54: Evolution of employment in the private sector

458

Chart 8-55: Tax wedge of single workers earning 67 per cent of average wage childless/with two children, international comparison (2014)

459

Chart 9-1: Developments in the total investment rates in regional comparison

468

Chart 9-2: Developments and decomposition of the investment rate relative to GDP in the region

469

Chart 9-3: Material-technical decomposition of the investment rate in the region

470

Chart 9-4: Outstanding corporate loans since the crisis

473

Chart 9-5: Developments in corporate investments in the region by sectors

476

Chart 9-6: Decomposition of domestic real investment growth in the private sector (contribution in percentage points)

477

— 822 —

List of charts and tables Chart 9-7: Competitiveness of the Hungarian economy according to certain international rankings

479

Chart 9-8: Developments in households’ outstanding loans relative to disposable income

481

Chart 9-9: Distribution of the utilisation of EU funds in Hungary by sectors and purposes 483 Chart 10-1: Real GDP growth compared to neighbouring countries

488

Chart 10-2: Sectoral GDP growth compared to the average for the Visegrád countries since 2004

489

Chart 10-3: Contribution to intra sector GDP growth of manufacturing industries in percentage points

490

Chart 10-4: Contribution to intra sector GDP growth of market services sectors in percentage points

492

Chart 10-5.a: Number of employed and hours worked since 2004

494

Chart 10-5.b: Number of employed and hours worked since 2004, by hours worked

494

Chart 10-6.a: Sectoral employment growth compared to the average of the Visegrád countries since 2004

495

Chart 10-6.b: Sectoral employment growth compared to the average of the Visegrád countries since 2004, by hours worked

495

Chart 10-7.a: Real labour productivity, per employee

498

Chart 10-7.b: Real labour productivity, per hours worked

498

Chart 10-8.a: Sectoral productivity growth compared to the average of the Visegrád countries since 2004

499

Chart 10-8.b: Sectoral productivity growth compared to the average of the Visegrád countries since 2004, by hours worked

499

Chart 10-9: Decomposition of value added growth in the national economy: regional comparison

501

Chart 10-10: Decomposition of value added growth in manufacturing: regional comparison

501

Chart 10-11: Decomposition of value added growth in market services: regional comparison

502

Chart 10-12.a: Aggregate TFP in the region

503

Chart 10-12.b: Aggregate TFP in the region

504

Chart 10-13: GDP and aggregate TFP growth in manufacturing

505

Chart 10-14: Decomposition of manufacturing growth

505

Chart 10-15.a: Regional decomposition of GDP proportionate investment rates

507

— 823 —

List of charts and tables Chart 10-15.b: Results of SME loan applications (2014)

507

Chart 10-16.a: Innovations in the years 2011-2014 – share of respondents (product innovation)

510

Chart 10-16.b: Innovations in the years 2011–2014 – share of respondents (prod./sales innovation)

510

Chart 10-16.c: Innovations in the years 2011–2014 – share of respondents (organisational innovation)

511

Chart 10-16.d: Innovations in the years 2011-2014 – share of respondents (marketing innovation)

512

Chart 10-17: R&D expenses to GDP, by sector

512

Chart 10-18.a: Difference in labour productivity of the highest and lowest deciles of Hungarian firms (manufacturing)

514

Chart 10-18.b: Difference in labour productivity of the highest and lowest deciles of Hungarian firms (market services)

514

Chart 10-19: Static reallocation across sectors of the economy

516

Chart 10-20.a: Employment decomposed by firm size (2012)

517

Chart 10-20.b: GDP decomposed by firm size (2012)

517

Chart 10-21: Average labour productivity of enterprises compared to large enterprises, 2010–2014 average

518

Chart 10-22: Decomposition of manufacturing productivity reallocation

520

Chart 10-23.a: Concentration of exports in goods

522

Chart 10-23.b: Concentration of exports in services

522

Chart 10-24: Share of most important product groups in the value of exports (2007–2014)

523

Chart 10-25: Distribution of the value of exported services over service categories, 2010–2014 average

524

Chart 11-1: Proportion of bank financing within bank and market financing in an international comparison

531

Chart 11-2: Factors of the banking system

534

Chart 11-3: Private sector credit as a percentage of GDP in an international comparison

538

Chart 11-4: Corporate loans as a percentage of GDP and developments of the structural lending gap

539

Chart 11-5: Developments in the stock of commercial real estate loans by currency denomination

540

Chart 11-6: Outstanding loans as a percentage of GDP by industry

541

— 824 —

List of charts and tables Chart 11-7: Changes in credit conditions in the corporate segment

542

Chart 11-8: Interest rates on new corporate loans

543

Chart 11-9: Changes in loan demand in the corporate segment

545

Chart 11-10: Growth rate of credit to the corporate sector overall and to the SME sector

546

Chart 11-11: Household loans as a percentage of GDP and developments of the structural lending gap 547 Chart 11-12: Average maturity, LTV and initial estimated PTI ratios of new housing loans 548 Chart 11-13: Ratio of foreign currency loans in the household loan portfolio

549

Chart 11-14: Changes in credit conditions in the household segment

550

Chart 11-15: Annual percentage rate of charge on new household loans

551

Chart 11-16: Changes in loan demand in the household segment

552

Chart 11-17: New household loans in the entire credit institution sector

553

Chart 11-18: Banking system ROE between 2008–2014 in an international comparison

556

Chart 11-19: 12-month rolling pre-tax ROE and ROA indicators of the banks and branches 556 Chart 11-20: Capital adequacy ratio of the banking system

557

Chart 11-21: Developments in the loan-to-deposit ratio and external liabilities

559

Chart 11-22: Liquidity reserve and regulatory liquidity requirements

561

Chart 11-23: Cost-efficiency in the EU according to cost-to-asset ratio

563

Chart 11-24: CHF outstanding mortgage loans APR and its hypothetical values, with spreads fixed at the time of the contract

565

Chart 12-1: Fluctuations of the deficit around a hypothetical deficit trajectory (1995–2014) 577 Chart 12-2: Interest balance vs. deficit – primary balance (1995–2014)

580

Chart 12-3: Objectives of convergence programmes vs. actual performance

581

Chart 12-4: Changes in deficit in different years and according to different methodology

583

Chart 12-5: Gross Hungarian public debt

585

Chart 12-6: GDP, PPS per capita vs. gross government debt in 28 Member States of the European Union (at 2014 current prices)

590

Chart 12-7: Gross public debt in the European Union and the region

590

Chart 12-8: Structure of gross Hungarian government debt

591

Chart 12-9: Distribution of gross public debt by ownership

592

Chart 12-10: Interest expenditures of the

595

— 825 —

List of charts and tables Chart 12-11: Tax revenues from the private sector (left panel) vs. net primary expenditures (right panel) (moving averages; as a percentage of GDP)

598

Chart 12-12: Estimated expenditures on allocation (left panel) and cash transfers (right panel) (moving averages; as a percentage of GDP)

600

Chart 12-13: Percentage share of taxes on consumption, labour and capital in total tax revenues in Hungary and in Visegrád countries

601

Chart 12-14: Consolidated revenues from taxes on consumption, labour and capital in Visegrád countries

604

Chart 12-15: Expenditures on healthcare (left panel) and education (right panel) in Visegrád countries

606

Chart 12-16: Expenditures on healthcare services and medical products in Visegrád countries

607

Chart 12-17: Expenditures on research and development (left panel) and higher education (right panel) in Visegrád countries

608

Chart 12-18: Components of social protection expenditures in Visegrád countries

609

Chart 12-19: Primary general public service expenditures in Visegrád countries

611

Chart 12-20: Distribution of net expenditures by age group in 2007 and the direction of the changes (2007–2014)

613

Chart 13-1: Revenues from individual tax types in 2012

627

Chart 13-2: Composition of the tax wedge in 2014 for average income earning, single taxpayers without children

629

Chart 13-3: Composition of the tax wedge in 2014 for average income earning, single taxpayers with two children

629

Chart 13-4: Employment rate in certain key social groups

631

Chart 13-5: Participation rate in various social groups

633

Chart 13-6: Distribution of those leaving public employment by status after 180 days

635

Chart 13-7: Participation rate of the working age population and the workers close to retirement in 2014

637

Chart 13-8: Proportion of part-time employees relative to total employees

639

Chart 14-1: Estimated size of the hidden economy in European Union countries in 2003 and 2015

644

Chart 14-2: Monthly developments in corporate tax revenues

650

Chart 14-3: R&D spending as a percentage of GDP (top), per capita R&D spending in EUR (bottom)

659

— 826 —

List of charts and tables Chart 14-4: Sources of R&D funding by sectors

660

Chart 14-5: Sources of R&D funding by sectors

660

Chart 14-6: Proportion of workers performing R&D activities relative to the employed labour force

663

Chart 14-7: GDP per capita in Hungary’s counties (2011), and GDP per capita in the regions (PPS) as a percentage of the EU average (2013)

674

Chart 14-8: Changes in the world market price of Brent crude oil since 2010 (USD)

680

Chart 15-1: General government spending on general public services (2013)

685

Chart 15-2: Proportion of workers employed in public administration, defence and the compulsory social security branch

685

Chart 15-3: Background institutions controlled by the ministries*

688

691

Chart 15-5: Index measuring the efficiency of settling legal matters

692

Chart 15-6: Managing public administration matters over the internet (percentage of the 16–74 age group)

693

Chart 15-7: Number of procedures necessary for obtaining construction permits

695

Chart 15-8: Days it takes to connect to the electric grid

696

Chart 15-9: Recovery rate of bankruptcy proceedings

698

Chart 16-1: Distribution of the Hungarian population by age groups (1960–2060)

701

Chart 16-2: Expected developements of dependency ratios in Hungary (2015–2060)

702

Chart 16-3: International comparison of per capita health care expenditures based on data 2013

706

Chart 16-4: Distribution of Hungarian physicians by age (2012)

708

Chart 16-5: Wages of physicians in international comparison as a ratio of average wage in the national economy (2013)

708

Chart 16-6: Preston curve on the data of OECD countries (2012)

711

Chart 16-7: Life expectancy at birth in the countries of the European Union (2013)

711

Chart 16-8: Sources of incomes of the over 65s in OECD countries, late 2000s

717

Chart 16-9: Net replacement rate in OECD countries in 2014, males

718

Chart 16-10: Public spending on education in 2011 (as a percentage of GDP and as a percentage of budgetary expenditures)

720

— 827 —

List of charts and tables Chart 16-11: Average PISA test scores and per capita spending on primary and secondary education

721

Chart 16-12: Distribution of total budgetary expenditures on education by levels of education (2011)

723

Chart 16-13: Results of PISA test in mathematics

725

Chart 16-14: PISA test results in Visegrád countries between 2003 and 2012, mathematics

725

Chart 16-15: Share of students learning English and German language as a foreign language in the secondary school (2012)

727

Chart 16-16: Distribution of number of languages spoken, 2011 (self-reported data)

728

Chart 16-17: Share of tertiary graduates among population ages 25-34 in 2000 and in 2013

729

Chart 16-18: Share of tertiary graduates in certain age groups (2014)

730

Chart 16-19: Tertiary graduates in science and technology per 1 000 inhabitants aged 20-29 years

732

Chart 16-20: R&D expenditures by sectors (2013)

733

Chart 17-1: EU transfers between 2004–2014

741

Chart 17-2: Composition of government sector investment expenditures

741

Chart 17-3: Relative size (A) and efficiency (B) of of financing of categories

747

Chart 17-4: Share of economic development resources according to certain thematic objectives in the programming period of 2007–2013 and 2014–2020

753

Chart 17-5: Utilization of the Cohesion Policy financial framework in Hungary according to the planned estimated allocation to the thematic objectives in the 2007–2013 and 2014–2020 programming period

754

Chart 17-6: Cross-border cooperation programmes and their designated areas in which Hungary participates

772

Chart 17-7: Territorial distribution of the funding contracts signed by the EIB in 2014 (left panel) and in 2010-2014 (right panel)

774

Chart 17-8: European Investment Bank credits provided to Hungary in sectoral breakdown (2010–2014)

775

Chart 18-1: Average daily turnover of the Budapest Stock Exchange

783

Chart 18-2: Seasonally adjusted net savings of households*

788

Chart 18-3: Households’ cumulative net government securities purchases by type

789

— 828 —

List of charts and tables Chart 19-1: Annual growth rate of the outstanding borrowings of the corporate and SME sector

793

Chart 19-2: Volume of home construction to GDP in 2014

795

Chart 19-3: European capital adequacy ratios in 2014, consolidated data

797

Chart 19-4: Distribution of return on equity in the EU banking sectors

799

Chart 19-5: Volume and ratio of the banking sector’s loans past due by over 90 days

801

Chart 19-6: High ratio of non-performing loans and the lending activity of the banking sector

802

Chart 19-7: Cost-to-income ratio in EU banking sectors

805

Chart 19-8: Concentration of European banking sectors in 2013

807

— 829 —

List of charts and tables

List of tables Table 1-1: Features of growth in countries with successful convergence

Table 2-1: Sectoral Shares in GDP

101

Table 2-2: Real GDP growth in Visegrád countries

113

Table 2-3: Social protection in Visegrád countries (as a percentage of GDP)

120

Table 4-1: Countries and country groups in the comparison and their convergence periods

202

Table 5-1: South Korea’s central government expenditure as a percentage of GDP

221

Table 5-2: Government expenditures as a percentage of GDP

249

Table 6-1: Evolution of GDP per capita in 1991 and 2014 in new EU member states comparing to old member states

264

Table 6-2: Decline in GDP per capita after the political changeover and the speed of recovery

268

Table 6-3: Banking crises in CEE countries in the 1990s

272

Table 7.1: Major economic approaches to regional economic growth

326

Table 7-2: Changes in GDP per capita, productivity and employment by urban region types in 2000–2008 and 2008–2011 in the EU13

334

Table 7-3: Position of the Hungarian regions in the ranking of the EU28’s 272 regions based on GDP per capita

342

Table 7-4: Position of Budapest and its agglomeration among the capital regions of the Visegrád Group

347

Table 7-5: GDP per capita at purchasing power parity as a percentage of the EU27 average

351

Table 8-1: The expected extent of ageing in certain country groups of the world

385

Table 8-2: Expected headcounts of the Hungarian population until 2060 according to different population projections

393

Table 8-3: Hypotheses of the Hungarian population projection

394

Table 8-4: Expected development of the headcount of the working age population (2010–2059)

399

Table 8-5: Expected development of the share of working age population (2010–2059)

400

Table 8-6.a: Standardized death rates in Hungary and Visegrád countries, men (2012)

435

Table 8-6.b: Standardized death rates in Hungary and Visegrád countries, women (2012)

435

— 830 —

List of charts and tables Table 10-1: Employment and productivity of exporting firms relative to non-exporter firms

525

Table 11-1: Developments in the indicators defined in the MNB Occasional Paper entitled the Hungarian Banking System in Transition

567

Table 14-1: Households’ use of electronic payment instruments in Hungary and the EU

648

Table 14-2: Corporate R&D spending by industries in 2012

664

Table 14-3: Percentage of companies successful in innovation

665

Table 16-1: Standardised mortality rates in Hungary and the Visegrád countries, males (2012)

712

Table 17-1: Obtained amount of the mainstream diretly managed funds outside the national cohesion policy frameworks in Hungary between the 2007–2013 period

768

Table 17-2: The mainstream nine diretly managed funds outside the national cohesion policy frameworks in Visegrád Four countries in the 2007–2013 period

769

Table 17-3: Available amounts outside the member states cohesion policy framework between 2014–2020

770

— 831 —