The Hungarian economy has achieved strong growth, averaging 4 ¼ per cent annually since 1997. This good performance has relied on a dynamic export sector largely made up of foreign-invested firms, and a rapid integration into European production networks. Since 2001, very strong domestic demand has been underpinned by a surge in minimum wages and public sector pay as well as strong public-sector investment. However world-trade growth has slowed and gains in export-market share have diminished substantially so that, overall, GDP growth has weakened. The continued rapid real convergence of the Hungarian economy with that of the European Union will first and foremost require maintaining, and indeed strengthening, the competitiveness of the Hungarian economy in a broad sense of being an attractive location for developing business activities. This is key to assuring that highly productive export-driven firms continue to expand, that the linkages between these firms and Hungarian suppliers continue to deepen, and a high rate of enterprise creation and development is maintained to respond to the domestic market opportunities generated by rising incomes. However, continued strong growth cannot rely on high productivity growth alone but will also require a more intensive utilisation of labour resources. The Hungarian economy is characterised by a very low overall employment rate and a sharp regional divide between the booming central-western part of the country, where growth has been concentrated and labour shortages are emerging, and the poorer, less dynamic north, south and east. Increasing labour force participation, enhancing labour mobility and broadening the economic boom to currently less prospering regions thus constitutes another challenge for Hungary...

Hungary has posted strong growth since the mid 1990s, principally through establishing itself as part of the supply chain for European manufactured goods funded by foreign direct investment (FDI). The international competitiveness needed to become part of the supply chain both in terms of production costs and the wider considerations of investors, has not only been helped by a policy of low corporate taxation but also by other incentives for FDI. In addition, privatisation, regulatory reform and successful policies in bringing down inflation from high levels in the early years of transition have provided investment opportunities and made for a more business-friendly environment. For the foreseeable future, this supply-chain activity is the most viable major route towards generating sufficiently strong growth for catch-up to average living standards in the rest of Europe. Maintaining the international competitiveness necessary for continuing this growth strategy is therefore the key challenge for the authorities. Success on this front requires policies that prevent excessive rises in production costs, for example through wage increases, as well as attention to the business-environment in general. Business assessments will be particularly sensitive to macroeconomic performance in the coming years as Hungary positions itself for entry to the euro area in 2008. And, more generally, how the authorities manage euro entry will have economy-wide effects both in the short and, potentially, the long term. Given a need to bring inflation and government deficits down to meet the criteria for entry, combined with concerns about entering at an optimal exchange rate, this is a difficult task and is the second major policy challenge for the authorities at the present time. Reaping the full benefits of international competitiveness and a successfully managed euro entry is complicated by Hungary’s problem of low labour force participation and highly regionalised labour market. Mobilising untapped labour resources is the third major policy challenge. It requires further attention to the not only to the degree of work-orientation embodied in the taxbenefit system but also the incentives for employers to hire the predominantly low-skilled and often poorly experienced population of non-employed...

As outlined in Chapter 1, the main challenge facing macroeconomic policy is that of successful entry to the euro area. Not only do the assessment criteria on inflation, deficit and long-term interest rates have to be met but the authorities also need to avoid entry to Exchange Rate Mechanism (ERM II) at an inappropriate exchange rate. Furthermore, all these objectives need to be met without severe short-run costs in terms of economic output. In fiscal policy a patchy track record in deficit discipline has been seen in recent years, particularly in 2002, and the authorities have yet to make substantial inroads in reducing the overall size of government spending in GDP. Monetary policy has recently been distracted from inflationary goals and markets have found it difficult to read its current strategy...

Growth has been rapid since the mid-1990s, averaging 4¼ per cent annually since 1997, but per capita income in Hungary is still less than 57 per cent of that in the European Union (at purchasing power parities) although about 12 percentage points higher than 10 years ago. While the growth performance demonstrates significant achievement, the level of GDP per capita illustrates the enormous challenge that still lies ahead. Indeed, designing a coherent structural policy strategy that can lead to continued successful catch up and promote macroeconomic stability and fiscal consolidation will require continuing comprehensive structural reforms. This chapter reviews recent progress in a number of key policy areas and points to outstanding problems and options for further growth-enhancing reforms. As outlined in Chapter 1, increasing the employment rate is one of the most important challenges. This requires reductions to the tax wedge, particularly at the bottom end of the labour market, but also changes to the transfer system. Reduction in the tax wedge could be helped if avenues for shifting the burden of taxation towards capital are exploited — within the constraint of keeping business taxes favourable for international competitiveness. In this regard, this chapter also examines the other policies used for attracting FDI as well as measures targeting SMEs. Transport policy is also investigated, being of particular relevance for the reduction of Hungary’s wide regional disparities in growth and living standards. A review of financial sector issues includes analysis of the subsidised mortgage loans, which are another element driving regional disparities. The chapter also looks at the implications for the banking sector of the subsidised credit and loan schemes for businesses. The key recommendations for further structural reform are summarised in Table 3.1...

The establishment of competitive markets has been one of the cornerstones of Hungary’s structural policy over the past decade, alongside a successful policy of attracting foreign investment in some sectors. In terms of privatisation, competition law, sector-specific regulation, subsidies and public procurement, the approach to competition in many respects now differs little from many OECD countries. However, certain sectors of the economy inevitably get left behind in the wake of such rapid structural change. Hungary has effectively developed a two-speed economy. On the one hand it has a highly competitive and technologically advanced export sector, largely foreign-owned and run. On the other hand it has a large number of relatively small-scale, low productivity domestically owned manufacturing and service industries that have been less exposed to competition in the course of the transition process. Also, in terms of network industries, significant efforts are still needed to create competitive markets in electricity, gas and telecommunications and the process of liberalisation in rail and postal services has barely begun. With much of the policy work to fulfil EU-accession guidelines over, policy-makers can now focus their attention on some of the fundamental issues the country needs to address to ensure its living standards continue to catch-up to those of leading OECD countries...

There is growing concern that long-run sustainable development may be compromised unless measures are taken to achieve balance between economic, environmental and social outcomes. This section looks at three specific issues of sustainable development that are of particular importance for Hungary: climate change, air pollution and sustainable retirement incomes. In each case, indicators are presented to measure progress and the evolution of potential problems, and an assessment is made of government policies that affect the issue in that area. The section also considers whether institutional arrangements are in place to integrate policy-making across the different elements of sustainable development (see Box 5.1)...