Commission Report 2002 (Hungary)

The capacity to cope with competitive pressure and market forces within the Union

The ability to fulfil this criterion depends on the existence of a market economy and a stable macroeconomic framework, allowing economic agents to make decisions in a climate of predictability. It also requires a sufficient amount of human and physical capital, including infrastructure. State enterprises need to be restructured and all enterprises need to invest to improve their efficiency. Furthermore, the more access enterprises have to outside finance and the more successful they are at restructuring and innovating, the greater will be their capacity to adapt. Overall, an economy will be better able to take on the obligations of membership the higher the degree of economic integration it achieves with the Union before accession. Both the volume and the range of products traded with EU Member States provide evidence of such integration.

The degree of macroeconomic stabilisation and the advanced stage of structural reforms allow economic agents to make decisions in a climate of stability and predictability. Macroeconomic stability has continuously strengthened over the review period, but has recently been marked by growing fiscal imbalances. Macroeconomic policy has been conducted with a high degree of predictability to allow proper decision-making by economic agents. co-ordination of economic policies between different institutions in combination with increased macroeconomic stability have contributed to a steadily improving environment for economic activity.

The quality of its labour force is an important asset in Hungarian competitiveness and growth. Hungary ranks high with regard to all major education indicators. The percentage of the 25-64 year-old population with university education, which indicates the share of highly-skilled human capital, is 14%. More importantly, the trend has been continuously rising since the start of transition. Enrolment in tertiary education at 72%, and the net entry rate to university education at over 50%, point towards a continuation of this very favourable development. A high standard of education contributes to growth not only through the improvement of human capital as a factor of production, but, more importantly, as a determinant of the rate of change of total factor productivity. The good quality of professional education of the labour force is a clear advantage when competing for foreign direct investment. However, there is still a need to further improve the transition from education and training to work.

Employment policy measures are intended to reduce regional disparities, and raise low participation and employment rates. A package that has been implemented since 2001 comprises a mix of actions to address shortcomings in the labour market. Rules on eligibility for and duration of unemployment and welfare benefits have been tightened up, while considerable minimum wage increases have helped to ``whiten` parts of the grey labour market. Pension income has been exempted from the tax base, encouraging retirees to start participating again. Certain segments of the labour market have been opened to foreigners. On the demand side, social security contributions for employers have been lowered in several steps, and tax relief is being granted to employers of disabled persons. The labour market is slowly reacting to this active labour market policy, although there have been cyclical setbacks. Unemployment levels within what are considered high-risk groups are finally going down. However, the slowly rising trend of employment rates over the past few years has been interrupted by the economic slowdown. Combined with a shrinking population and the low mobility of the Hungarian labour force, this could create a bottleneck for growth in the longer run.

Hungary has experienced reasonably high levels of gross fixed capital formation over the entire review period. Fixed investment as a percentage of GDP grew from 22.2% in 1997 to 24.2% in 2000, and declined again to 23.4% in 2001. The additions to the capital stock in combination with early corporate restructuring are bearing fruit, and the physical infrastructure has gradually and visibly improved. Investment by central and local government declined from 4% of GDP in 1997 to 3% in 2001. This trend reflects a streamlining of public spending, but also an increasing share of off-budget spending for infrastructure.

Hungary has constantly received high FDI inflows. Average annual inflows have been 4.3% since 1997. Despite a strong drop in overall corporate investment in 2001, FDI net inflows - both in the form of inter-company loans and primarily greenfield investment oe remained high, at 4.7% of GDP. Cumulative FDI inflows per capita at the end of July 2001 amounted to EUR 2,400. Since privatisation is no longer a relevant source of FDI creation in Hungary, these figures reflect the attractiveness of Hungary as a location for foreign investment, based on competitive total labour cost, a liberal foreign trade regime and a predictable and business-friendly policy framework. The quality of the investment is becoming increasingly high-tech and service-oriented. Under its national development plan, the government is trying to diversify further the pattern of specialisation towards services, and in particular tourism and business services, and also to attract foreign investors to underdeveloped regions.

Infrastructure gradually improves. A massive road construction programme is under way to open up the backward north-east of the country to investment. Progress on speeding up the relatively underdeveloped railway network has been slow. Expenditure on research and development has grown slightly from 0.7% of GDP in 1997 to 0.8% in 2000, the overwhelming and growing share of which is generated in the manufacturing and business services sectors. There are encouraging signs of innovation initiatives to improve the creation of research-industry networks.

The process of enterprise restructuring has been uneven. Restructuring of export-oriented firms in foreign ownership has been proceeding considerably faster than that of domestic firms. As a result, the process of rapid modernisation did not spread evenly over the entire economy, but led to the development of ``modern islands` that are concentrated in certain sectors and regions. Large multinational corporations, often operating in industrial free zones, have represented the backbone of growth and external trade in Hungary since the second half of the 1990s. By now, roughly two thirds of machinery exports and about one half of machinery imports derive from these industrial free zones. While the vast majority of industries have already recovered from the transitional shocks, restructuring of the steel sector and the airline industry, among others, still has to be tackled.

Shifts in the sectoral structure of the economy have changed Hungary's economic landscape. In 2001, agriculture was a surprise contributor to growth, and its share in GDP increased to around 5% due to a record harvest. In previous years, the share of agriculture in GDP had dropped from 5.9% in 1997 to 4.1% in 2000. The sector`s share in total employment also declined from 7.8% in 1997 to 6.1% in 2001. While the share of industry remained rather stable around 33% of GDP and 34% of total employment, the share of services over the same period expanded somewhat from 61.4% to 62.6% of gross value added between 1997 and 2000, and from 59% to 59.6% of total employment.

The importance of small and medium-sized enterprises (SMEs) has been growing constantly, in terms both of GDP contribution and of employment. The SME sector accounts for roughly two thirds of total employment and half of GDP. In 2001, there was a slight trend correction in the growth contribution by sectors, when for the first time the export volume of regular Hungarian companies grew faster, at about 12%, than that of the industrial free-zone enterprises, at about 8%. It is not yet possible to say whether this development is purely mirroring the global business cycle, to which the export-oriented enterprises in the free zones are more exposed than SMEs, or whether the figures point towards a sustainable redirection of economic contributions.

A micro-credit scheme and the provision of business know-how are addressing some of the most pressing problems that have been restraining the economic potential of the SME sector. In 2001, the government adopted a number of measures to further enhance the economic environment for SMEs, in particular through a scheme that provides small and micro companies with access to business advice and credit. Commercial banks had long remained cautious in lending money to SMEs. In the framework of the new scheme, the government started a credit card programme in mid-2002, giving very small companies fast access to inexpensive credit backed by state guarantees. The scheme is available to almost 700 000 micro and small companies, and allows cardholders to receive HUF 1 million (EUR 4,100) of revolving credit for a three-month period at subsidised nominal interest rates of around 10%.

Through an active investment promotion policy, Hungary created new industry clusters, in particular in the electrical machinery, automotive and electronics industries. Thanks to the high level of foreign direct investments and the openness of the Hungarian economy, industrial free zones play a significant role in the economy. However, some of the existing support schemes have been marked by a lack of transparency. Legislation aiming at redirecting investment incentives was presented to Parliament before the summer. The new rules would phase out implicit support through tax breaks in favour of explicit budgetary support, in order to align investment incentives with EU rules on state aid by 2003. The new policy also focuses on the creation of industrial parks, and the provision of employee training and skills development to foreign investors and Hungarian start-up companies.

Hungary is a small open economy with a high degree of trade integration with the EU. The Hungarian economy has been steadily becoming more open. In 2001, exports and imports of goods and services amounted to 123.1% of GDP, compared with just 91% in 1997. As regards the commodity structure, machinery, transport equipment and other manufactured products remain the main traded goods. In 2001, the Hungarian export basket contained 68% of high value-added, technology-intensive and know-how-intensive products. Hungarian exports to the EU accounted for 74.3% of total exports in 2001, while imports from the EU were 57.8% of the total. In general, trade with developed market economies has intensified over the entire period. Intra-industry trade with the EU is around 60%. Large enterprises working in industrial free zones played a significant role in the development of Hungary`s external trade, especially in machinery exports, where they account for two thirds of exports and roughly 50% of imports. Overall, these industrial free zones account for roughly one third of Hungary`s exports and a quarter of imports.

After a period of considerable wage restraint during the stabilisation period, real wages started to rise faster than productivity, a trend that will not be sustainable over a longer period of time. Public wages, previously at low levels that had put a strain on the ability of the public sector to attract and retain a high-quality workforce, were increased most rapidly, by an average 50% since 2001. At the same time, minimum wages were raised significantly in two steps, to roughly EUR 200 a month, which lifted them to a level of about half of national average wages. With inflation declining more rapidly than projected, the private sector has also been slow in adjusting wage growth to the disinflationary environment. As a combined result of all these effects, real wages in the overall economy increased by 6.4% in 2001, and by 11.3% year-on-year during the first half of 2002. The upcoming tripartite consultations will be crucial with regard to the adjustment of corporate wages with the country`s overall economic development.

Hungary's sustained export performance, in the context of strong real appreciation of the currency and a global economic downturn, is a clear indicator of the competitiveness of the country's manufacturing base. By starting reform early and accumulating a large stock of FDI, Hungary obtained a considerable competitive edge. The real exchange rate based on unit labour costs, which had depreciated by a total of 52% over the second half of the 1990s, jumped by 9.1% in 2001, with wages growing more rapidly than labour productivity. The CPI-based real effective exchange rate increased by around 10% in 2001. While such rapid appreciation can result in a loss of external competitiveness, it has considerably contributed to bringing down inflation via lower imported price inflation, and thus improved the overall macro-economic balance of the economy. In fact, the appreciation appears to have been broadly absorbed by very high enterprise profits of around 13-15% of GDP over the past five years. In addition, the resilience of exports to the strengthening currency as observed since mid-2001 confirms that, as Hungary is a small, open and industrial-processing-based economy, currency appreciation leads to its competitiveness being as much improved by cheaper imports and lower inflation as it is impeded by costlier exports.

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