Monetary Policy in Hungary, in an economy in transition

(Economic and institutional framework, instruments and implementation)

Erzsébet Láng - Werner Riecke (*)


After more than 20 years of a reform process, when the centrally planned economic system was in many aspects gradually readjusted to the requirements of a market-like economic system, Hungary in 1989-90 started to establish the framework of a democratic society, of a Western-style political system and of a market economy.

Remarkable results has been achieved within a few years in this country in this transition process. Modern legislation and institutions needed for a market economy were created, clear and transparent rules govern the environment for the business community. In the past five years, Hungary accomplished an ambitious program of privatisation: currently more than half of total GDP is produced by the private sector.

Nevertheless, the transition process proved to be longer lasting and more costly than it had been thought at first. Although Hungary had 20 years of experience in practising market-style economic management, the restructuring costs are nevertheless enormous. Declining real GDP, rising unemployment, external debt and inflation are inevitable concomitants of the transition, as it is evident from the experience of nearly all the countries in the region.

In this respect, the worst seems to be over in Hungary: after four years of declining output, real GDP is estimated to have grown by 2-3% in 1994, unemployment is gradually decreasing (10.4 per cent after 12.1 per cent at end 1993). Inflation has been kept under control: after its peak in 1991 (35%), consumer price inflation was 18.8 per cent in 1994. Industrial production and investments were growing (9 and 21 per cent, respectively). Volume of foreign direct investments has reached about US$ 8.5 bn by the end of 1994; since 1990 about US$ 1.5 bn per year - in 1993 US$ 2.4 bn - has been invested from abroad in Hungarian projects.

Due to about 30 bond issues abroad Hungary received around US$ 7 bn within 2 years. The maturity structure of the Hungarian external debt (short-term debt represents about 8% of the total debt), the level of foreign reserves (US$ 7 bn, covering about 6 months of imports) guarantees Hungary's continued access to capital markets.

Although the restructuring process resulted in the establishment of a Western-style market economy in many aspects, structural adjustment of the macroeconomy has not been accomplished yet. Restructuring and adjustment of the fiscal policy is still an overdue business. Regarding the underlying structural distortions in the budget, inherited from the earlier centrally planned economic system, this wait-and-see policy created a fiscal deficit in 1993 and even more so in 1994 (5.6 and 7.5 per cent of GDP, respectively) which could be met only on the cost of an unprecedented current account deficit (US$ 3.9 bn, 10 per cent of GDP at end 1994.).

The stabilisation program, announced on March 12, 1995 is evidencing the firm commitment of the Hungarian government to stabilise and strengthen the economy. The primary goal of this program on the long term is to establish stable economic conditions for a sustainable growth of 4-5 per cent annually with an acceptable level of price stability. The implementation of this national program for economic growth is the only chance for this country to overcome its structural problems and to join the club of developed countries.

On the medium term this program aims at lowering the twin - internal and external - deficits, fighting inflation, reduce the speed of domestic consumption growth, stimulate household savings and exports, give impetus to the business sector's activities and give incentives for investments by shifting resources from government and household sector to the business sector.


Degree of independence and the role of the central bank

From 1947 until 1987, the National Bank of Hungary operated as the central bank and as the sole commercial bank in Hungary. In 1987, as one of the first steps of restructuring the economic system, the two tier banking system was established. In this process, the National Bank of Hungary (NBH) retained its central banking functions, whereas it ceded nearly all its commercial banking activities to the newly established commercial banks. Now, nearly all commercial banking services in Hungary are provided by other banks. In the meantime the banking system has experienced rapid development and transformation and by now it meets the requirements of a market economy.

The primary objectives and powers of the Bank, as set forth in the Hungarian Constitution and in the Act on the National Bank of Hungary, enacted on December 1, 1991, include the issue of Hungary's national currency (the forint), the protection of the stability of the value of the forint, primary responsibility for monetary policy, and shared authority for regulation of the Hungarian banking system. The Act shifted direct oversight of the Bank to the Parliament. While the Bank is expected to support the Government's economic policy through, among other means, the Bank's monetary policy, it gave the Bank independent authority to formulate and implement monetary policy. Prior to the adoption of the Act, the Bank operated under the direct supervision of the Government.

Foreign exchange policy, however, is determined jointly by the Government and the Bank. Pursuant to the Act, the President of the Bank reports to the Parliament on its activities annually or at other times if requested by Parliament. It is current practice to invite the President of the Bank regularly to attend cabinet meetings as a non-voting participant.

Development of a network of commercial banks and other specialised financial institutions

As of 1987, as Hungary's banking system was divided into two tiers, the banking system has gone through a rapid transformation, and there has been a huge increase in the number of commercial banks: at the end of 1994 there were 44 banks in Hungary; out of them there were 22 in partial or full foreign ownership.
In addition, the Financial Institutions Act, which became law also on December 1, 1991, established a regulatory and supervisory framework based on the principles and guidelines of the Bank for International Settlements.

The Financial Institutions Act provides for four types of banks in Hungary. Such banks are differentiated by the functions they are licensed to perform and the capital required for their establishment and operation.

Commercial banks are licensed to engage in the widest range of banking functions, traditionally performed by large commercial banks. Commercial banks, with appropriate licenses, are also empowered to borrow and trade in foreign currencies. Specialised financial institutions are licensed to perform only limited banking functions. Savings banks, which include only local savings co-operatives, are generally licensed to take deposits and make loans to individuals and Investment banks, which are banks authorised generally to take long-term deposits and make long-term loans.

As the banking system has developed, the control of banking activities has strengthened. Control by the central bank involves adherence to the legal regulations concerning the turnover of money, bank lending and foreign exchange management, and to regulations of the NBH on how to carry them out. The State Banking Supervision which is independent from the NBH is entitled to check whether the banking and bank representation activities are compatible with the act on financial institutions and other legal regulations on banking.

The financial sector has been strengthened by several newly created institutions like the National Deposit Insurance Fund, established in 1993, the National Fund for the Institutional Protection of Savings Co-operatives, created in 1993 by integrating the majority of savings co-operatives.

The establishment of the Credit Guarantee Corporation is aiming to improve the conditions for founding small- and medium-size businesses and their operation. The Credit Guarantee Corporation guarantees credits to small- an medium-size businesses, and thus alleviates and partly assume the lending risk of financial institutions. The Hungarian Export-Import Bank was founded in the spring of 1994 as a 100% state-owned joint stock company, together with the Hungarian Export Credit Guarantee Corporation, which assumes sovereign, exchange rate and other financial risks.

Stock exchanges

The Budapest Commodities Exchange (BÁT) was founded in 1989. The Hungarian securities market, however, is mainly concentrated in the Budapest Stock Exchange (BÉT), which was founded in 1990. Only member broker firms may trade here. A total of 130 securities are traded at the BÉT, including stocks, compensation vouchers, government securities and company bonds. The BÉT is a self-governing body, whose regulations are made by the general assembly and the Stock Exchange Council elected by it. The legal supervision of the stock exchange and the securities traders is carried out by the State Securities and Exchange Supervision.

In 1993, the National Bank of Hungary, the Budapest Stock Exchange and the Budapest Commodity Exchange established the Central Clearing House and Depository Co. Ltd. (KELER), which was registered as a clearing house with a limited banking license.


Some basic issues of the monetary approach to the balance of payments

In recent years Hungary's economy has become close to the standard model of a small open economy with a fixed exchange rate where domestic prices are determined by the world market prices and the exchange rate. Prior to the liberalisation period (up to 1989) the application of the monetary approach to the balance of payments of Hungary had to observe the requirements of the specific institutional system. Excess creation of domestic credit due to ambitious investment decisions or simply by the need to finance the budget deficit led only to an outflow of foreign reserves if the additional demand for imports could have been satisfied by a permissive treatment of import licenses. If the administrative control of imports was more restrictive, then excessive domestic credit creation led to an increase of the amount of money which was finally justified by an increase of the domestic price level. A devaluation in order to restore international competitiveness was unavoidable in this case. One should note that in this mechanism devaluation was caused by the increase of the domestic price level and was not a cause of inflation by itself.

In the period of controlled foreign trade - which ended after the 1989-91 liberalisation period - economic policy characterised by excessive credit creation did always face the trade off between higher domestic inflation and the further increase of foreign indebtedness.

After the almost full liberalisation of foreign trade Hungary had still a pegged, but adjustable exchange rate, which should not be viewed as equal to a fixed exchange rate. The reason for this is, that the inflation could not have been yet brought down to Western European standards. This implies also that there was some room for independent interest rate policy: short term capital in- and outflows depend on the interest rate differential compared to the devaluation expectations.

The exchange rate of the Hungarian currency - the forint - is pegged to a basket, which consists now of 70% ECU and 30% USD as weights. The former basket was a composite of 50% DEM and 50% USD. In Hungary, in recent years, it has become usual to devaluate the forint 2-5 times a year, occasionally by 1.5 to 9%. As part of the stabilisation program following the 9 per cent devaluation in mid-March 1995, it was announced, that the forint in 1995 will be devalued against a basket of foreign currencies by exactly 1.9 per cent per month in the first half of the year and by 1.3 per cent in the second. Overall, the total preannounced "crawling peg" devaluation for 1995 is set to amount to 28.8 per cent. This turned unavoidable, since speculation preceding devalutions were reflected in the interbank foreign exchange (FX) market where the NBH maintains an +/- 2.25% intervention band. However, speculation of commercial banks against the forint are restricted by the so-called open position regulation which allows banks up to 30% of their capital to run a position against the domestic currency in their balance sheets.

Enterprises are not allowed to take part in the interbank FX market, but are allowed to take part in the FX forward market, they are able to delay incoming export revenues or may pay importers immediately.

Exporters and importers may also follow practices of over- and underinvoicing. As of April 1. 1995, however, there is no surrendering any more: firms no longer have to convert their foreign exchange income into forints, their hard-currency earnings can be deposited in FX accounts at Hungarian banks. All this means, that despite the fact that Hungary has still exchange rate controls regarding capital flows, the balance of payments has become very sensitive to interest rate differentials and devaluation expectations.

Redefining intermediate targets

The National Bank of Hungary had to redefine the intermediary targets for monetary policy after 1991. Until the end of 1991 it was relatively clear and can be easily demonstrated simply by empirical data that external equilibrium was controllable by domestic credit creation. This does not mean that monetary policy was always successful, because in some years monetary policy might have been kept so intentionally loose or the public sector borrowing requirement was so large, that the NBH was unable to achieve an appropriate reduction in credits to the enterprises sector. This means only that the deterioration or improvement of the external position of the country could be explained by the differences between demand for money and domestic credit creation.

After the enforcement of the Banking Act at the end of 1991 commercial banks were forced to obey the 8% capital adequacy ration within some years, they were forced to qualify their loan portfolio and they were forced to make provisions against substandard, doubtful and non-performing loans.

The credit crunch, created by these circumstances made it unnecessary for the NBH to control domestic credit creation, which was much less than what would have been consistent with the aimed external position. In 1992 net domestic credit grew by 10%, while broad money increased by more than 25%. In such a situation, the banking sector had to deal with a large amount of excess liquidity, interbank money market interest rates went down and it was too easy for the budget to use commercial banks excess liabilities to finance an increasing deficit.

The fall in interest rates lasted until the middle of 1993 and by that time it became clear that the fall in interest rates was a disincentive for final savers in a period when the public sector borrowing requirement was still high.

The underdeveloped capital market in Hungary features an other difficulty: the demand for money is very unstable. If private households are not familiar with saving opportunities provided by government securities, then they are bringing their money to commercial banks anyway and commercial banks become the main investors for government treasury bills. In this case the demand for money has a positive interest rate elasticity. Once the capital market starts to develop and the institutional framework is more open to final savers, private households and other institutions are expected to reduce their cash balances and start to invest directly into government securities. In this case the interest elasticity of the demand for money function would become negative.

The problem of financing the large budget deficit partly by direct central bank credit is also connected to the relatively high required minimum reserve ratio imposed by the NBH on the commercial banks. This ratio is 16% in May 1995. Compared to international standards this is very high, increasing financial intermediation costs and giving better enterprises an incentive to raise funds by bond issues and through commercial papers programs, which are means to circumvent the banking system.

High interest rates and high intermediation costs also provide an incentive to raise funds directly from abroad.

Taking all this into account, the NBH decided to give more emphasis on the amount of central bank refinancing to commercial banks and the budget, and took this as the main intermediate target. It is to be known that the NBH is forced by the Act on NBH and by the yearly Budget Acts to buy a certain amount of newly issued government securities. This means that the monetary program for 1994 could only be kept on track by sufficient reducing of the refinancing of commercial banks. Because this is a clear case for crowding out, it has become acknowledged by the government that economic stabilisation cannot be achieved by monetary policy measures alone. Suitable fiscal policy measures were needed and the initial steps towards this direction were made in March, 1995 by launching the stabilisation program.

New instruments of monetary policy

At the beginning of 1993 the NBH started to base commercial bank refinancing on repurchase agreements with maturities ranging from overnight to one year. Reverse repurchase agreements were offered with maturities from 1 month to 1 year. NBH was offering FX swap facilities with interest rates aligned to the interest rates of repos. All these facilities were offered at posted interest rates which means that:

a) there is an interest rate tunnel for interbank money market rates and
b) NBH does not have an intermediate control over quantities since the use of these refinancing facilities is at the discretion of the commercial banks.

After the introduction of the repo technique some further adjustments had to be made. NBH scrapped the 12 and 6 month, than the 3 month and finally the 1 month repo facility and narrowed the swap facility first from 1 year to 1-3 months, then for 1 month, and in December, 1994, ceased this operation. The reason behind this was that controlling liquidity by the central bank should be done at shorter maturities, while the budget should raise funds at longer maturities. This was necessary since there was always a pressure from the Treasury to keep the repo rate below the yield of Treasury Bills of the corresponding maturity and this way the budget deficit was financed purely by money creation. The only way to avoid such a situation is to finance the budget deficit with debt instruments of longer maturity, while the NBH provides liquidity only for the short term.

An other problem is the presence of posted interest rates, which can be adjusted only via a trial-and-errorprocess, if the NBH do have clear quantity targets. A way of meeting quantity targets directly would be the introduction of repo and reverse repo tenders. Rather for experimental reasons, the first step was done in this directions with the introduction of a regular 2-week reverse repo tender. The danger of introducing tender techniques to all repo and reverse repo maturities is that the interest rate volatility will become much higher. The other problem is that tender techniques for the strict quantity control of central bank refinancing assumes that the central bank has an exact, say weekly, breakdown of the monetary program.

This is still an unsolved problem.


(*) Magyar Nemzeti Bank/National Bank of Hungary. Szabadsàg tér 8/9, 1850 Budapest Hungary.