National Bank of Hungary
An unambiguous breakthrough occurred in the development of inflation in 1998: year-on-year inflation declined from 18.4 per cent in December 1997 to 10.3 per cent in December 1998 and further to 9.4 per cent in February 1999, a better than expected result. Domestic financial and macroeconomic developments affecting the inflation rate were broadly in line with previous projections; a large part of the lower than expected inflation rate can be attributed to lower world prices. For the first time in this decade, inflation substantially declined in three successive years, while the rate of economic growth accelerated and external equilibrium remained stable. Since the beginning of transition the Hungarian economy has undergone huge structural transformations that have enabled the economy to proceed along an equilibrium growth path.
In 1999 economic policy offers a realistic chance for achieving single digit inflation figures that may contribute to cooler inflation expectations. By its very nature, monetary policy may promote sustainable economic growth only through the reduction of costs associated with inflation. Both the central bank and the Government of Hungary lay strong emphasis on sustainable inflation reduction that does not lead to deteriorating external imbalances. The National Bank of Hungary believes that this is the only way to combat inflation successfully in the medium term and in fact this policy has led to its success since 1995.
Industrial output was 12 per cent higher than in the previous year, Gross Domestic Product (GDP) growth is probably in the five per cent range (no data available yet). The most favourable features were the high increase in both exports and imports, especially with the European Union (EU), and dynamic growth of investments. Investments growth accelerated to double digit rates in 1998 and reached the share of 25 per cent in GDP. However, the strong investment boom led to a deterioration of the current balance. The US$2.2 billion deficit was only partially covered by the net foreign direct investment (FDI) inflow of 1.3 billion, but the level of gross external debt has still decreased.
The primary surplus of the 1998 and 1999 State budgets that exceed two per cent of GDP satisfy public debt sustainability requirements and are in line with the policy objectives for economic growth, external equilibrium and inflation. Nevertheless, the high interest burden of public debt brings the overall deficit into the range of four per cent of GDP in 1999. To keep control over the deficit requires strong growth rates in the future.
***Insert diagram: Government budget and external deficit***
Money and capital market developments
Since the summer of 1997, international money and capital markets witnessed recurrent disturbances. Problems in south-east Asia, Russia and South America increased financial risks all over the world and affected the domestic economic policies of all countries. Nonetheless, in the experience of the National Bank of Hungary, investors tend to make a greater distinction between individual countries than before and examine their fundamentals more carefully, like external equilibrium, real exchange rate, budget deficit, foreign debt and foreign exchange reserves.
The fundamental aim of economic policy is maximum safety in planning revenues and, through this, to ensure a cyclically balanced budget within a reasonable time limit.
The larger room for manoeuvre required by international uncertainty needs an increase of international reserves and an adequate balance in the Treasury account, which provides reserves high enough to meet the financing needs of the budget, even in the case of transitory decline in the demand for government securities. Similarly, the risks for economic policy are kept low by the fairly long maturity of the outstanding foreign debt and a policy that strives for a reduction of the level of external debt. This policy ensures Hungary's position in international rating and in distinguishing and favouring the Hungarian economy when international capital markets are upset due to events independent of the domestic market. The general reserve in the 1999 budget, which is much larger than ever before, enables fiscal policy to react more flexibly if economic growth turns out to be lower than the forecast or if external equilibrium deteriorates unexpectedly.
General developments in the Budapest Stock Exchange (BSE) and the Foreign Exchange Market
The BSE was established in 1990 and continues to be one of the favourites in the emerging markets. The BSE is regarded as a safe, well regulated market with developed market infrastructure. A favourable macroeconomic and regulatory environment coupled with a healthy corporate sector encouraged most western institutional investors to continue investing in Hungary. As the information content of stock market valuation and the risk premium demanded on stock exchange investment depends on the liquidity of the shares, a most welcomed development is that the liquidity of the BSE has reached the level of mature western markets. The average daily turnover is 0.38 per cent of the capitalisation, which is considered to be high in emerging markets, and sufficiently liquid for major institutional investors.
As compared to Anglo-Saxon markets, domestic institutional investors are still weak; they account for approximately three per cent of stock market capitalisation. Nevertheless, this is changing by the day. The amount invested in mutual funds grew from $524 million to $1.4 billion in 1997 and the first half of 1998. Within the portfolio of the funds there was a marked shift of preference in favour of shares. Stock investment by investment funds grew from $7.7 million to $243 million and as a result, shares currently account for 17.3 per cent of the funds portfolio, up from 1.4 per cent since the end of 1996.
Similar phenomenon can be observed in the insurance sector as well; unit linked products and other stock exchange-based insurance contracts are gaining popularity. The new pension system that was launched this January is expected to bring further improvements to the Hungarian capital markets. The pension reform has proved to be much more popular than expected. So far, well over a million people joined the three-pillar system, and it seems that a considerable proportion of the working age population would choose to switch to pension funds. The market-based system is compulsory for the generation entering the labour market after 1 January 1998. Transition from the 'pay as you go' system to pension funds will liberate the government budget from the implicit pension liabilities which is a significant proportion of the public sectors liabilities. Transferring them to private capital markets will help to maintain the autonomy and flexibility of government budget. As pension funds will enjoy a liberal regulatory environment, it is expected that they will hold a significant part of their portfolio in equities and this will have a beneficial effect on the stock market.
Derivative exchanges can play a very beneficial role by providing markets for pricing and redistributing risk. This enables economic participants to hedge their exposure against foreseen contingencies which promotes social welfare by lowering risk premium and providing a more favourable risk-return combination on savings. The BSE has a derivative section for index, individual stock price, interest rate and exchange rate futures and is currently preparing to introduce index options. The Commodity Exchange has a meat, grain and financial section, the financial section offering interest rate and exchange rate futures. The interest contracts of the Commodity Exchange are identical to those of the BSE. This standardisation of contracts is considered to be a prelude to the full integration of the two exchanges.
The year 1998 happened to be a highly volatile period in the BSE. This phenomena can be attributed mostly to external factors. After the Hungarian parliamentary election and the first Russian stock market crash in May 1998, stock prices fell, but these events had only transitory effects. The worst came later. Serious meltdown started in August, by the time the Russian Government had announced a moratorium on debt payments. This might be regarded as a textbook case of a psychologically-based 'sunspot' contagion. On a fundamental basis, the crisis in Russia might affect the Central European countries through three channels: loss of export markets, competition on third markets and losses in the banking system due to exposure to Russia. All available data suggest that one can safely regard these factors to be far from serious in the case of Hungary. As the economic trends further improved, the foreign investment funds returned to the Hungarian market.
***Insert diagram: Stock Exchange Market Indices in Central Europe and Hungary***
The same phenomenon was observed on the Foreign Exchange Market. Hungary has maintained a crawling band system since March 1995. Since then, the rate of depreciation has been gradually reduced to 0.6 per cent per month effective 1 January 1999. The reductions in the rate of crawl have been pre-announced several weeks ahead of time to allow markets to adjust. The NBH devalues the forint relative to the basket every day according to the announced monthly rate of crawl. The corresponding forint/foreign currency rates are calculated on the basis of cross rates in world markets. The NBH has only committed itself to intervene at the upper and lower edges of the (2.25 per cent intervention band around the central rate, though it has also reserved the right to intervene within the band. Until September 1998 the NBH has intervened exclusively at the upper (most appreciated) edge of the band. In September the shock effect of the international financial turmoil led to an intervention of about $2 billion to defend the forint. After this event, markets calmed down. The exchange band of forint backed by strong fundamentals was not seriously challenged. The rate returned to the strong side of the band.
***Insert diagram: exchange rate within the band***
Forecasts and targets for 1998-1999