Economic Analysis - Growth Model Threatened By Declining Competitiveness - MAY 2017

BMI View: Hungary ' s per capita GD P convergence with more developed economies in Western Europe will slow over the next decade relative to the pre-crisis period . Among the major headwinds dampening long- term growth prospects will be a shrinking labour force, low levels of capital investment , and weak productivity growth .

We expect the Hungarian economy to grow at a steady, but lacklustre, pace over our 10-year forecast period to 2026, underperforming relative to average growth rates in Central Europe (Hungary, Slovakia, Poland, and the Czech Republic). A number of structural headwinds will weigh on the country's long-term growth potential, meaning per capita GDP convergence with more developed economies in Western Europe will lag over the next decade. The Hungarian economy has benefited in the past decade from its cost competitiveness - largely stemming from low labour costs and an undervalued currency in trade-weighted terms - which alongside European Union (EU) membership has encouraged greater levels of investment and the development of a number of export-orientated industries, especially in the automobile sector. However, this export-led growth model will face headwinds in the years ahead from a shrinking labour force, rising labour costs, lower levels of capital investment and weak productivity growth, which will weigh on competitiveness.

Slower Growth Than Peers
Real GDP, % chg y-o-y
f=BMI forecast. Source: Eurostat, BMI Research

Over the next decade, we forecast real GDP growth in Hungary to remain below pre-crisis levels, averaging 2.4% annually between 2017-2026, below the 3.7% average for the 2001-2007 period. Hungary will thus underperform relative to other Central European (CE) economies, although long-term growth is set to remain marginally above the wider European aggregate ( see chart above). A relatively subdued pace of real GDP growth will ensure Hungary's convergence prospects lag behind regional peers. In 1995, Hungary had the third highest per capita GDP among economies in the CE region, however according to our forecasts, per capita GDP in the former is set to reach USD20,010 in 2026, compared to a regional average of USD23,542 ( see chart below).

Limited Convergence Ahead
GDP per capita, USD
f=BMI forecast. Source: Eurostat, BMI Research

Erratic Policymaking Will Not Help The Business Environment

Unpredictable policymaking and a slow pace of structural reforms have led to a deterioration in Hungary's business environment in recent years, and will continue to weigh on long-term growth potential. The current right-wing Fidesz government, under Prime Minister Viktor Orban, has taken an increasingly interventionist role in the economy, which will act as a barrier to investment. We expect the Fidesz government to win re-election in 2018, which implies it will dominate policymaking until 2022 at the earliest. The government has undermined the business climate by showing an unfavourable attitude towards investment in a number of sectors including banking, utilities and retail, by introducing arbitrary taxes on profits and a bias against foreign involvement. The unpredictability of the regulatory environment - along with policy instability, corruption, lack of government transparency and excessive bureaucracy - will be key deterrents for investment. In addition, a high public debt load of over 70% of GDP implies a long-term focus on fiscal consolidation will be needed and that government spending will not be an important driver of growth.

Hungary's education system in particular faces a number of challenges, and this is contributing to shortages of highly-skilled labour in key sectors of the economy. Specifically, tertiary education enrolment rates are falling, while limited efforts have been made to encourage enrolment in specialised degree subjects or vocational training which are in high demand by businesses. This will continue to be exacerbated by the distortionary effects of the government's public works initiative, which had reduced the pool of available labour and has seen limited success in transitioning employment from the public to private sector. Reflecting the deteriorating nature of the business environment, Hungary's BMI Operational Risk score underperforms its regional peers, dragged down by the 'Trade and Investment' and 'Security' subcomponents. Furthermore, the World Economic Forum's global competitiveness index ranks Hungary 69 out of 138 countries (a deterioration in the country's relative position over the past ten years), while the World Bank's 2017 Doing Business Report places Hungary a lowly 21st among all EU Member States.

Business Environment Generally Underperforming
BMI Operational Risk Index & Subcomponents
Source: BMI Research . Note: 100 equals the best score available, 0 the worst.

Demographic Trends Worsening

Critically, demographic trends in Hungary will also turn less supportive of growth over the longer term. According to our forecasts, Hungary's population will fall from an estimated 9.8mn in 2016 to 8.3mn in 2050, while the working age population as a percent of the total will fall from an estimated 67.3% in 2016 to under 58.0% by 2050. As a result, already prominent labour shortages in Hungary will become more severe. A shrinking labour force will also raise upward pressure on wages, which will undermine competitiveness in the absence of strong productivity gains.

Demographic Issues Ahead
Hungary - Population Statistics
National Sources/BMI

Productivity Gains Will Be Hard To Come By

Given the unfavourable demographic outlook, improving productivity will be crucial if Hungary is to enhance its growth potential and keep convergence prospects alive. However, we are sceptical that significant productivity gains will be achieved over the next decade, largely as capital investment fails to pick up substantially. While real labour productivity in the Hungarian economy grew by an annual average of 4.0% between 2000 and 2008, its growth rate dropped to 0.6% in the post-crisis period between 2010 and 2016. Rapid wage growth, in combination with weak productivity growth, will cause unit labour cost (ULC)'s to rise in the years ahead. Not only will this erode corporate profit margins, but rising unit labour costs will also damage the external competitiveness of domestically produced goods, threatening the country's export-led growth model. This is particularly critical given exports substantial share of GDP in Hungary, which we forecast to reach over 100.0% by 2026 from 92.5% in 2016.

Weak Productivity Growth
Real Labour Productivy Per Person Index, 2010=100
Source: Eurostat, BMI Research

We do not expect fixed investment - crucial for improving productivity - to return to pre-crisis levels in Hungary as a percentage of GDP, as capital spending is deterred by rising labour costs and a deteriorating business environment. Reflecting this, while total fixed investment stood at around a quarter of GDP before the crisis, it dropped below 20% thereafter - driven largely by a contraction in corporate investment - and we are forecasting it to reach just 17.8% by 2026. As Hungary's cost competitiveness suffers this is likely to precipitate a reorientation of FDI flows towards other countries in the region with lower labour costs, weighing on Hungary's export-driven growth model.

Investment Set To Remain Below Pre-Crisis Levels
Hungary - Fixed Investment, % of GDP
f=BMI forecast. Source: Eurostat, BMI Research.

It's Not All Doom And Gloom

That being said, total investment levels over the long term will be supported by disbursements from EU Structural Funds. Hungary is set to receive EUR25bn (around 3.0% of GDP per year on average) in EU cohesion funding over the 2014-2020 funding period, with funding largely directed towards social and physical infrastructure. Investment will also benefit from a more competitive tax code in Hungary - including a planned corporate tax cut - as higher corporate profits help make up for higher labour costs and encourage increased levels of capital expenditure.

On top of this, private sector deleveraging following a credit binge in the pre-crisis period has now largely run its course, which implies that credit lending to the real economy is in line to recover over the long term. A recovery in credit growth will support private consumption, which is set to be the main contributor to headline GDP growth over the coming decade. While potentially weighing on exports, rising wages will drive gains in household purchasing power and the steady development of services-oriented domestic industries.

Another bright spot is Research & Development (R&D) spending in Hungary, which has come in above a number of regional peers in recent years - standing at 1.3% of GDP in 2015. A continuation of this trend will be crucial in enabling Hungary to gradually transition from lower to higher value added manufacturing and services sectors and offset the impact of rising wages and ULCs in the years ahead. However, we note that this transition up the manufacturing value chain will be a slow process and is highly dependent on appropriate government policies, underpinning our more cautious outlook.