Hungary and the European Union are moving towards a compromise over the country’s frozen EU funds, observers say, with Prime Minister Viktor Orban’s regime increasingly desperate to tap the funding to climb out of recession and help close its worrying budget deficit.

After winning re-election for a fourth term last year with a big spending splurge, the Hungarian strongman has struggled to bring the deficit down, boosting inflation to the highest in Europe and leading to pressure on the forint.

The deficit problem has become even more urgent now that the EU’s Stability and Growth Pact has been revived from next year. This means Budapest will need to bring its deficit below the 3% of gross domestic product (GDP) threshold in 2024 from a revised target of 5.2% this year, or risk being penalised under the Excessive Deficit Procedure. This will force deeper austerity at a time when the economy has been stuck in recession since mid 2022.

Even hitting the revised 5.2% target this year after 6.1% in 2022 is going to be difficult, especially if the economy continues to splutter in the fourth quarter. Hungary’s economy declined 1.7% in the first half.

Economic growth has been far lower than the Fidesz government’s over-optimistic forecasts, causing the budget deficit to overshoot. In early October, the government bowed to pressure and amended the deficit target to 5.2% from 3.9% after the cash-flow deficit reached 97% of the full-year target in August.

The revision was long overdue as the analysts were saying as early as the summer that the government’s 1.5% growth targets were overly optimistic. Experts at the time were calculating with flat growth and, with just two months left from the year, economists are unanimously calling recession inevitable.

However, the government is still clinging to its flat growth scenario as it is betting on a Q4 rebound based on real wages turning positive from September after a year of decline. It also assumes 4% growth next year, which also appears overly bullish, according to analysts.

Raiffeisen Bank analyst Zoltan Torok in a recent note said that meeting the 2.9% deficit target in 2024 would mean that the primary balance needs to turn positive, a rather ambitious target given the fiscal developments in 2023 and Hungary’s rising debt service costs, likely to reach 4% of GDP next year.

Fitch has also warned that the government’s decision to raise the 2023 deficit target to 5.2% of GDP from 3.9% makes reaching 2004’s target “more challenging” and it expects the government to overshoot the target by 0.8pp at 3.7%.

The rating agency revised its 2023 target from stagnation in June to -0.9% earlier this month while it sees growth averaging at 3% in the following years, around 1pp below the government targets.

Disconnected from reality

The accuracy of the government’s budget forecast was always in grave doubt as the cabinet had continued its earlier practice of adopting the budget for the upcoming year in the summer. The argument was that this gives more time for businesses to plan ahead.

The main figures in the 2023 budget bill approved five months after the breakout of the war were completely unattainable and disconnected from reality, commented economist Zita Maria Petsching. The government and the Budget Council, which has no power to veto budgetary issues, shrugged off these warnings from economists, she added.

The government assumed that the war in Ukraine would end before the end of the year, energy prices and inflation would retreat from their peak and Hungary and the EU would secure an agreement over the transfer of EU funds.

The 2023 budget approved in July 2022 was therefore based on a 4% GDP growth and a 5.2% inflation target and the cabinet predicted that capital expenditures and consumption would continue to grow.

Policymakers could not have been more wrong in their forecasts. The war is still raging on, surging energy prices boosted Hungary’s energy net energy imports to €17bn in 2022 from €7bn in 2021 (though this is likely to retreat to €8bn-9bn in 2023), while inflation peaked at 25.7% in January. Headline CPI and the core inflation data have been among the highest in the EU since the end of 2021.

At the end of 2022, the finance ministry amended the budget in a decree, bypassing parliamentary debate, further adding to the lack of transparency. The growth projection was cut to 1.5% while the deficit target was raised from 3.5% to 3.9% and the inflation target to 15%.

Ten months later, even the revised targets look unattainable as inflation could average 3-4pp above the forecast. The government’s narrative has been to blame the war and sanctions for rising consumer prices.

For this year, the government was projecting a 22.1% increase in revenues and a 15.2% in expenditure, but both fell short of these expectations. The detailed report of the budget from September shows that the central budget’s revenue grew only 18.2% y/y to HUF25.8 trillion (€67.5bn) while expenditures rose at a faster pace, by 19.2% to HUF29.1 trillion in the first nine months.

Retail slump

There are several factors why Hungary’s fiscal balance deteriorated at a time when it boosted revenues by hundreds of billions in proceeds from windfall taxes: lower-than-expected tax revenues due to the fall in consumption, increased pension expenditures, elevated debt servicing costs, and the suspension of EU funds.

Retail sales across the board, from big-ticket items such as cars, and furniture to fuel and basic food staples have been falling since December 2022 and were down 10% y/y at the end of September.

During conferences, government officials openly admit that they were surprised by the significant decline in retail sales. Rising inflation tends to boost budget revenues but in Hungary, the record food inflation peaking at over 40% has set back consumption to 2021 levels. This has translated into a steep decline in VAT revenues.

The Hungarian tax policy regime has shifted from income to consumption since 2010, hence the budget relies heavily on proceeds from VAT. Set at 27%, except for a few basic food items, it is the highest rate in the EU and among OECD countries.

Strong economic growth and double-digit rise in real wages propelled tax revenues in good times but as the economy contracted and real wages fell, this has subsequently weighed negatively on the revenue side of the budget.

The latest figures show that net revenue from VAT edged up by only 0.4% y/y to HUF5.06 trillion in the January-September period at 71% of the year-end target. This alone has contributed to a HUF900bn-950bn hole in the budget.

Expenditures were also lifted by higher-than-expected spending on pensions, up 22% in the first nine months. This is above the rate of inflation but that does not automatically mean an increase in the purchasing power of the elderly as more people joined the system due to the unfavourable demographic trends.

Pensioners will receive a one-off top-up payment equal to roughly a third of their monthly pension in November to make up for undershooting inflation. This will increase budget expenditures by HUF200bn-250bn next month.

The energy crisis forced the Orban government just a few months after the election to review the retail utility subsidy scheme, a major cornerstone of its policy in place from 2014 when prices were frozen.

Despite trimming subsidies and making households pay well above the market price over a certain consumption threshold, energy subsidies still reached HUF1.1 trillion in the first nine months of 2023.

Spiralling borrowing costs

Spiralling borrowing costs have also put enormous pressure on Hungary’s public finances. Hungary has gross public debt of 76.1% of GDP – the worst in the region and the latest data by the finance ministry showed that net interest expenditures came to HUF1.54 trillion in January-September, HUF412bn more than in the same period a year earlier.

This is one of the reasons why the government is calling on the central bank to speed up rate cuts to bring down the highest interest rates in the EU.

The government clearly favours boosting growth even if it comes at the cost of higher inflation. Orban has proclaimed in numerous interviews that "2023 is the year of fighting inflation", while 2024 will be about restarting the engines of the economy.

The central bank – which has had to do the heavy lifting to damp down the economy –  cut its base rate by 0.75pp to 12.25% last month, but has said that further monetary easing will remain data-driven and will take into account rising external risks, such as high real interests in developed markets.

The erratic and highly unorthodox policies of the government and central bank have so far failed to reassure investors in Hungarian assets, leading to pressure on the forint and rising yields on government bonds.

Drying up of EU funds

The government has also pointed to the negative fiscal impact of the freezing of EU funds, as it continues to finance public investments from the budget, albeit at a slower pace.

The actual gap between project expenditures from the budget and transfers received from Brussels, mainly from the previous budget period and from CAP funds, totalled HUF832bn in the first nine months of 2023. The monthly increase in the gap was just HUF59bn, which reflects the deceleration in government expenditure for public investments.

After the 2022 election spending splurge, the government’s first measure to rein in the deficit was to cancel or postpone HUF2.5-3 trillion of state investments as EU funds dried up. This has helped to keep the deficit at 5% of the GDP, but with the acquisition of additional gas supplies from Russia by a state-owned company to boost reserves, the final deficit was raised to 6.1%.

The government introduced a special levy in sectors dominated mostly by foreign firms as a temporary solution. Without the freezing of state investments and the windfall tax on more than half a dozen sectors, the budget deficit would have jumped to close to 10% of GDP in 2022, analysts said.

The government also made a commitment to the EU to phase them out in 2024, but next year’s budget still relies heavily on these proceeds.

Given these fiscal developments, unfreezing EU funds will be absolutely vital for Hungary and the government apparently has made concessions to repair its damage to the rule of law that could pave the way for receiving the funds in the near future, according to MEP Istvan Ujhelyi.

Member states and the European Commission last December suspended and tied to conditions Hungary’s access to EU funds under various procedures due to the breaches of the rule of law and human rights. 

Some 55% of the funding from three operational programmes amounting to cc. €6.3bn was suspended. Under the conditionality mechanism, Hungary committed to meeting 17 criteria, from making public procurements more transparent to setting up an anti-corruption authority and reforms to guarantee the independence of the judiciary.

Finally, Hungary also needs to comply with horizontal enabling conditions set by the Charter of Fundamental Rights on issues such as the operation of public interest asset management foundations, many of them operating universities, various elements of the Hungarian asylum system, and the anti-LGBT law adopted in 2021, which violate the Charter. This involves ten operational programs with funding.

In an October 27 opinion piece on Index.hu website, a quasi-independent news site with owners close to Fidesz oligarch Lorinc Meszaros, Ujhelyi writes that, according to his EU sources, the government has shown willingness to compromise on some issues and to abandon its "freedom fight" against Brussels.

According to the former Socialist politician,  the disappointing election results for Orban’s allies in Poland may have played a part in the decision but the deterioration of the budget was the main reason why the government bowed to EU pressure.

According to Ujhelyi, the European Commission will soon approve the judicial reforms and will give the go-ahead for the transfer of €13bn over time. "It is important to note that this does not mean the immediate disbursement of the entire amount", he said.

The Financial Times and other Western media outlets reported in early October that EC intended to unfreeze about €13bn of funding for Hungary before the end of November on condition that Budapest agrees to support increasing the EU’s budget needed for providing more financial support to Ukraine. Ujhelyi notes that, while the government likes to use its blackmailing power, it won’t be required this time as the EC will likely approve of the judicial reforms.

"Every invoice sent by Budapest will be under scrutiny and the disbursements will be cut off immediately if the government fails to abide by its commitments," he stressed.

Hungary is eligible for €22bn from the EU budget between 2021-2027 and €5.8bn from the post-pandemic Recovery and Resilience Facility (RRF). In addition, the government submitted an application for the credit leg of the RRF, some €3.9bn at the end of August. Hungary needs to meet 27 super milestones to unfreeze these funds and there is still a long way to go to meet all criteria, according to experts.