Fidesz' Main Opposition Is Non-Inflationary Growth
Six months ahead of the next regular parliamentary election, the governing Fidesz-KDNP alliance remains on course towards an easy victory, with better-than-equal chances for a constitutional majority in the National Assembly. Amidst conditions of rapid wage and employment growth, there is hardly any significant labor action or civil discontent – strikes, street demonstrations, etc. – currently going on. Besides, the opposition continues to be too highly fragmented and non-cooperative for a meaningful and serious opponent for Fidesz to develop over the next six months.
PM Orbán’s relationship with the EU continues to be difficult, due to his stiff resistance to common policies on the distribution of refugees and other subjects. But Europe’s obvious weaknesses, such as Brexit, Catalunya, Poland and the most recent election results in Germany and Austria, make it practically impossible for the EU to step up against the Fidesz government in any serious concerted action. An early politically motivated penalty in the form of lower financial transfers is rather unlikely, but in the longer term, Hungary must count on potentially significant losses in terms of financial support under the EU’s 2021-2027 medium-term budget.
Under these circumstances, the main challenge facing the Fidesz government is not so much the EU or the domestic opposition, but its potential inability to secure satisfactory economic growth on a non-inflationary basis in the longer term. In this regard, the key negative fact is the continuation of Hungary’s excessive reliance on labor-intensive growth, and the resulting aggravation of labor shortages around the whole economy. Private investment and increasing productivity could be a solution, but cross-border FDI inflows are negative, and domestic investment appears insufficient.
The government is currently suppressing the low-potential-growth problem by flooding the economy with EU-backed development funds and pushing wage growth to a double-digit level annually. This appears to be sufficient to secure 3.5% GDP growth this year and slightly less but still significant expansion in 2018-2019, covering the whole of the upcoming two-year election period (parliamentary, EU and local). The current strengthening of the European economy also provides significant support this year, although manufacturing output growth is decelerating already, following a marked recovery at the outset of 2017.
However, this policy will not be sustainable for 2020 and beyond, mainly given the expected drying-up of EU transfers from that year. The risk of a major negative growth shock at that time is high. A key mitigating fact is the most recent strength of the government budget, which has been essentially balanced in 2016-2017, and is only running into a moderate deficit at year-end as the government is setting aside big amounts of EU-backed funds for tighter years. This trend has greatly increased the flexibility of fiscal policy at times when intervention is needed to prop up GDP growth.
Another mitigating fact is the lasting fundamental strength of the balance of payments. The trade balance is already deteriorating on both volume and price effects, but only moderately so. In 2017-2019, this trend will be superimposed by the massive inflow of EU transfers and by the reduction of investment income outflows as net external indebtedness is decreasing. For this period, it is very difficult to prepare a BOP forecast in which the existing massive external income surplus disappears or even shrinks substantially. 2020 and beyond will likely be different, as the income balance should move markedly towards zero if net EU inflows fall back or even nearly disappear temporarily.
There is significant inflationary pressure present already, as can be seen from the latest GDP deflator or prices on the property market. However, CPI-inflation remains below the official target for now, due to tight fiscal policy, some forint strengthening in the middle of this year and the continued lack of consumer enthusiasm. Core inflation slowly continues to rise by all existing measures, and the only big issue is when it will likely reach and surpass the 3% target level. We expect this to happen in Q2 2018, whereas the MNB maintains that this is only likely to take place one year later. Despite the evident strong upward pressure, the MNB may be easily right on this forecast if the government uses its fiscal flexibility to intervene through administrative price cuts, as is increasingly expected among analysts.
The MNB still maintains its bias towards loose policies, and this is not expected to change at all before mid-2018. Until then, the Bank is likely to keep interest rates unchanged and reduce monetary sterilization further. However, they have recently said that they would refrain from starting to regulate liquidity through credit, even though in principle they could do so already in Q1 2018, by which time the 3-month deposit stock will effectively disappear. Instead, the main regulatory tool is likely to be FX swaps, an instrument that has been actively used already in recent months. The MNB aims to develop its existing swap facilities further, e.g. by making longer-term swaps more attractive for banks.
Should we be right on the inflation forecast and major central banks proceed with monetary tightening, we would expect the MNB to start moderately tightening as well, through small interest rate hikes from H2 2018. However, these measures could come later if the government indeed decides to temporarily suppress inflation through administrative price measures. Meanwhile, the authorities will likely continue their policy to distort the yield curve downwards by paying substantially higher yields on special T-bills and bonds offered to households than on debt sold to ordinary investors on the market. Tightening monetary conditions through forint appreciation will be much less a realistic option, given existing competitiveness concerns and the significant constraints imposed by the MNB balance sheet.
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