While soaking in the curative waters at the Gellert, the venerable Budapest spa, a European diplomat recently expressed amazement at how contemptuously Hungarian politicians of the left and the right still treat one another several months after the election. “It’s personal, not ideological,” said the diplomat. “‘Those people’ -- that’s the way they talk about each other, as if they were enemy aliens.”
Almost on cue, a commotion erupted in one of the spa’s two large hot-spring-fed pools between a group of middle-aged men who appeared to be militant members of the main right-wing opposition party, Fidesz, and a silver-haired fellow identified by the diplomat as an official of the Hungarian Socialist Partyled government. The argument started over economic issues -- something about who was to blame for the budget deficit -- but quickly degenerated into political name-calling and then a sexual slur. With all the dignity he could muster wearing the spa’s requisite flimsy loincloth, which left his buttocks exposed, the government official climbed out of the water and plunged into the adjoining pool, well away from his antagonists.
The ire between the major parties is becoming a serious political issue -- one that threatens Hungary’s robust growth and its ability to meet the economic standards required of a prospective member of the European Union. The acrimony is making it all the harder for Budapest to come to grips with a growing budget deficit, an overvalued currency and a falloff in foreign investment. “Hungary has become a very politicized country, and it’s certainly making economic reforms more difficult to carry out,” says World Bank economist Ryzard Petru.
“After the elections we had hoped to become a boring country, because that would make us more attractive and predictable from a business point of view,” Economy and Transport Minister István Csillag said in an interview with Institutional Investor (see box, page 30). “Unfortunately, it has been anything but boring.”
Hungary’s political clashes can have a vicious tone. Prime Minister Péter Medgyessy, a dour, 60-year-old economist who gained office last June after a coalition of the Socialist Party and the Alliance of Free Democrats unexpectedly won the election, has had to fend off opposition party allegations that he was once a spy for the Communist-era secret police. The charges -- which surfaced well after the campaign -- were given a prominent run in the right-wing press linked to the deposed prime minister, conservative Viktor Orbán, and his FideszHungarian Civic Party coalition. Meanwhile, leftists allied with the administration accuse Orbán of engaging in reckless nationalist rhetoric spiced with allusions to conspiracies between ex-Communists and international capitalists.
The mudslinging has extended to issues that until recently were considered above partisan politics. Orbán and his allies claim the new government is selling out national interests to gain membership for Hungary in the European Union. Although Orbán and other conservative politicians also support entry into the EU, Mihály Varga, a Fidesz leader in Parliament, clarifies that “we are trying to explain to people that it will cause problems in agriculture and heavy industry, for example.” Polls taken in January suggested that a majority of Hungarians would still vote for EU accession in an April 12 referendum. Yet the political polarization is eroding Hungary’s capacity to achieve a smooth economic transition into the club of rich Europeans.
The country’s budget deficit last year reached the equivalent of almost 10 percent of its $74 billion GDP. Left and right blame each other for causing the deficit and then impeding remedies. Meanwhile, a bitter dispute is taking place between the Medgyessy cabinet and the National Bank of Hungary over how to cope with an overly robust forint, the local currency, which is hampering exports. Government supporters intimate a dark plot by the central bank’s governor, Zsigmond Járai, an Orbán appointee, to torpedo the economy and subvert the left’s chances for reelection in 2004. Járai’s conservative defenders counter that the government is attacking the central bank’s independence.
All of these issues -- the ill feeling between conservatives and former Communists, budget deficits, strong currencies, waning enthusiasm for EU membership -- have surfaced in other Eastern European countries as they have transformed themselves from Soviet-style systems into free-market economies. But when Communism collapsed in the region in 1989, Hungarians already had a head start on their neighbors, thanks to semicapitalist reforms put in place two decades earlier. In the new era they sprinted ahead of the Czechs and Poles in privatizations, foreign investment and growth (see box below). Last year Hungary led the region -- and most of Europe, for that matter -- with 3.3 percent economic expansion.
Why then is political hostility here at its worst in recent memory? According to Attila Chikán, who served as minister of Economy Affairs in the Orbán government, not enough years have gone by to erase bitterness against the Communists. “It doesn’t take much for somebody to get emotions running high,” says Chikán, now rector of Budapest University of Economic Sciences and Public Administration.
That somebody, say critics of Orbán, is the charismatic, 39-year-old conservative former prime minister who sought reelection by alleging that his opponents were former Communists who had shifted their allegiance from Moscow to Brussels. “The same people who used to lecture us about Socialist internationalism now tell us how to be true Europeans” was one of Orbán’s campaign lines.
The slogan didn’t catch on. Neither did the accusations against Medgyessy, who admitted having worked for the Communist secret services on economic intelligence projects during the 1970s but denied ever having spied on his fellow Hungarians. For several months last year, it appeared that left-wing politicians would become targets of a witch-hunt. But conservatives lost enthusiasm after revelations that some of their own followers and relatives had ties to the Communist intelligence apparatus. “They made a mistake, and public opinion has turned against them,” says Krisztián Szabados, marketing director of Political Capital, a Budapest-based policy research and consulting institute.
Perhaps an even more important cause of continuing political strife than ideology is outrage among conservatives that former Communists have usurped their political and economic agenda. On Iraq, the burning international issue of the day, Prime Minister Medgyessy has sided firmly with Washington. Accusing the government of opportunism, Orbán strongly criticized an invasion of Iraq. “There has been a reversal of roles of left and right,” says György Surányi, former governor of the central bank and now head of Central and East European operations for Italian bank IntesaBCI. “The Socialists are the free marketers, while Fidesz has become populist and nationalist.”
It was a left-wing government in the 1990s -- led by former Communists, including Medgyessy in the role of Finance minister -- that carried out most of the privatizations of state-owned companies, eliminated many government subsidies and dramatically lowered inflation. And it was popular resentment over the resulting high unemployment rates that helped bring Orbán’s ostensibly right-wing Fidesz coalition to power between 1998 and 2002, with an economic program that stalled further privatizations, championed domestic businesses over multinationals, launched expensive road-building projects to help create jobs and doled out mortgages at subsidized interest rates.
Predictably, the budget deficit swelled. To forestall an inflationary surge, the central bank raised interest rates, pushing up the exchange value of the forint and angering Hungarian businesses, which depend on exports. “The gut reaction to Orbán’s defeat in last year’s election was definitely positive in the business community,” says Richard Lock, a partner in law firm Köves Clifford Chance Pünder, adviser to several large foreign investors in Hungary. “Though it may come as a surprise to outsiders, the Socialists are very much the party of business.”
The business sector has continued to side with the Socialist-led government in its jousts with opponents over economic policy. Chief among these opponents is Járai, the central bank governor. Before his six-year appointment to the central bank in 2001, he was Orbán’s Finance minister and thus was held responsible by the Socialists and their business allies for the budget deficit and inflation. But since joining the central bank, Járai has insisted that lowering Hungary’s 5.3 percent annual inflation rate should be the chief economic priority, and that until the government adopts more austere fiscal policies, the only instrument to keep inflation in check is a tight monetary policy.
But that strategy backfired when foreign investors pushed the forint to the upper limits of its 15 percent floating band against the euro by scooping up high-yield Hungarian bonds. The speculators were betting that Hungary would be forced to revalue its currency rather than stoke inflation by lowering interest rates. And they considered Hungary low risk because it is about to join the EU and intends to adopt the euro by 2007.
With the strong forint putting a brake on exports -- which account for 60 percent of GDP -- the leading business and industrial associations called for the resignation of the central bank governor in December. “The forint has appreciated about 25 percent against the dollar over the past year -- and that’s making exporters miserable,” says Péter Fáth, executive director of the American Chamber of Commerce in Hungary. “It won’t hurt the economy to have inflation of about 5 percent.”
In January pressures on the central bank grew unbearable. In a single day the bank was forced to spend roughly E5 billion ($5.3 billion) -- equivalent to roughly 7 percent of GDP -- to keep the forint from exceeding its band. That morning, January 15, Járai asserted that the central bank had no intention of lowering interest rates. But in the afternoon he carried out a cut of 100 basis points and then slashed another 100 basis points a day later, bringing the central bank’s interest rate down to 6.5 percent, barely 120 basis points above inflation.
The radical surgery worked, at least temporarily, foiling speculators and keeping the forint well within the limits of its band. But it gained few plaudits for Járai. “It’s not clear whether he’s contradicting himself just to intentionally mislead the market,” says Olivier Desbarres, a financial analyst specializing in Eastern Europe at Credit Suisse First Boston in London. “But the market isn’t enjoying it at all.” According to László Wolf, a deputy chief executive officer at OTP Bank, the largest Hungarian bank, it won’t take depositors long to realize that interest rates on their savings have fallen below inflation. “So the central bank is in a difficult position,” he says. “It will probably have to increase the rates soon yet somehow not allow the forint to strengthen too much again.”
The government seems determined to coax Járai to eventually resign and to replace him with its own appointee. But at the same time, it doesn’t want to be seen as violating the independence of the central bank. So it has pursued a good cop, bad cop routine: Government officials lament their frictions with Járai while Socialist parliamentarians savage the central bank governor.
Finance Minister Csaba László applauded the central bank’s interest rate cuts as a warning to speculators and a stimulus to noninflationary growth. But Socialist members of Parliament’s budgetary committee passed a resolution asserting that Járai bore responsibility for the speculative attacks on the forint. “With his pronouncements that created uncertainty, he provoked events that gravely threatened the stability of the financial system,” said the resolution, which sparked a walkout by conservative opposition parliamentarians.
Although the forint has taken center stage in economic policy, attention is now shifting to the budget deficit. The Medgyessy government shocked the financial community late last year by revising its forecast for the 2002 budget deficit to 9.6 percent of GDP -- up from an earlier estimate of 5.7 percent. Part of the revision was a result of the decision to make the budget more transparent. Under the Orbán government large debts linked to road, railway and stadium construction -- that is, projects aimed at wooing voters during last April’s national elections -- were hidden in the budget of the state-run Hungarian Development Bank.
But once the new government took office, it worsened the budget deficit by engaging in vote-getting tactics of its own in the months leading up to local elections last October. All pensioners were given an 8.3 percent hike in their benefits, and a majority of public sector employees received a whopping 50 percent wage increase. “If I had to apportion blame for the deficit, I would say two thirds of the fiscal lapse is due to the old government and a third to the new,” says former central bank governor Surányi.
Other financial analysts and economists aren’t interested in assigning blame, but they’re increasingly skeptical of the Medgyessy government’s plans to bring the deficit under control. The Finance Ministry calculates that by subtracting one-time spending measures associated with last year’s elections, it can reduce the deficit to about 6.3 percent of GDP, and then further shrink it to 4.5 percent by year’s end through spending cuts and revenues generated by higher economic growth.
“But we see no significant measures in the current budget that will reduce the deficit to that level,” says World Bank economist Petru. The International Monetary Fund urged the government to restrain wages, pensions and subsidies.
According to Michael Marrese, a banking analyst at J.P. Morgan Europe in London, the government will be lucky to hold the deficit to 6 percent of GDP this year. “If there is more fiscal slippage, the markets will see this as a dangerous sign and will become less patient with Hungary,” he says. “As it is, the government’s promise to adopt the euro by 2007 looks pretty hollow.”
Another looming concern is the low level of foreign direct investment, which last year fell to $700 million from $2 billion in 2001, mainly because of election year pressures. “The elections created political uncertainties, and new government officials weren’t in place to make decisions or negotiate with businesspeople,” says András Vertés, president of GKI Economic Research Co., a Budapest-based forecasting firm often hired by large businesses. “I expect FDI to double this year.”
That would still lag far behind the $3 billion annual inflows of the mid-1990s, when foreigners engaged in a feeding frenzy for state enterprises being privatized. “At one point, 35 of the top 50 manufacturing companies in the world bought plants or opened production facilities here,” says Tamás Simonyi, a partner with KPMG Hungária, which does accounting and management consulting. “But since most state companies have been sold, the only way to keep up the same FDI flows is to get the big manufacturers to double their investments here -- and why would they do that?”
Most big foreign investments are drawn to Hungary as an export platform, especially for EU markets. But according to GKI Economic Research, the appreciating forint and wage hikes have pushed up local labor costs on manufactured exports by 25 percent over the past two years -- way too much for Hungary to compete readily with neighboring countries like Bulgaria, Romania and Ukraine, or more distant ones like China. Hardly a month goes by without news of a foreign manufacturer cutting back its Hungarian operations: In November IBM Corp. announced the closing of a factory employing 3,700 people; in January 500 workers lost their jobs because Philips Electronics, the Dutch giant, shifted part of its production to new facilities in China.
The government has found this trend so worrisome that in December it dug in its heels in the final negotiations for EU accession in 2004 and insisted on maintaining tax holidays of up to ten years for foreign investors. “We were surprised at their intransigence,” says a foreign diplomat involved in the negotiations. “Hungary doesn’t have the size or clout of a Poland, but they were willing to risk delaying EU membership over the issue.” In the end, the EU negotiators caved. “Hungary was able to reach an agreement that allows almost all foreign investors to keep their tax advantages through a variety of methods,” says the American Chamber of Commerce’s Fáth. “That’s one big reason why this government is viewed so favorably in the business community.”
The government might be viewed even more favorably if it managed to reduce frictions with the opposition. But that’s not likely to happen unless one side or the other scores a solid majority in the 2004 elections. In the meantime, some talented technocrats of both right and left won’t consider a return to public service, because politics has become too highly charged. Chikán, the former economics minister who was perhaps the most respected senior official in the Orbán government, says he couldn’t wait to take up his post of university rector. “I taught here for 30 years, and I wouldn’t want to give it up again,” he says in his office overlooking the Danube.
Surányi, the former central banker, was widely admired by his peers in Europe but still has dreaded memories of constant verbal abuse by the opposition. Asked if he would consider another stint in government, the usually garrulous banker keeps his response to a single word: “Never.”
The best preparation for capitalism? Communism At a time when there are growing concerns in Hungary about low levels of foreign direct investment (story), some of the country’s largest, most successful domestic companies are beginning to invest abroad.
For their managers this is simply evidence of a natural progression from being inefficient state-owned monoliths to becoming private enterprises beholden to their stockholders. “Our main goal is to deliver increased value to our shareowners, and we believe many of the best opportunities are abroad,” says György Mosonyi, chief executive officer of Magyar Olaj-és Gázipari (MOL), the oil and gas producer that is Hungary’s biggest corporation.
At OTP Bank, the nation’s largest financial institution, the attitude is much the same. Deputy CEO László Wolf acknowledges that his bank is on the prowl for acquisitions in neighboring countries. “We’re quite satisfied with our domestic market share,” he explains.
Both enterprises have leveraged their Communist, statist pasts into capitalist advantages for the present. They started out as monopolies and continue to dominate their sectors even against much larger foreign competitors that have entered the Hungarian market. Abroad, they understand better than their Western rivals what it takes to transform a struggling state-owned entity in Bulgaria or Romania into a profitable private firm. “OTP went through the same experience a decade ago, so it can export its know-how to those countries,” says Zoltán Török, head of research at Raiffeisen Securities and Investment, a Hungarian affiliate of Austria’s Raiffeisen Bank.
With about one third of Hungary’s bank deposits and some $10 billion in assets, OTP sits comfortably at the top of the 40 banks operating in the country. After Hungary’s accession to the European Union in 2004, many analysts and bankers expect the domestic financial market to quickly become dominated by five or six major banks. “The rest -- maybe ten to 15 in all -- will be smaller foreign players who have followed their corporate clients but won’t try to become universal banks,” says OTP’s Wolf. Although foreign institutions own more than 60 percent of the banking sector, he points out that some, such as the Netherlands’ Rabo Bank and France’s Société Générale, have already left because the competition got too tough.
OTP is preparing for further challenges in the post-EU accession era by cutting down its exposure in less profitable sectors like agribusiness and pressing forward with mortgages, car financing and other consumer loans. Over the past five years, the bank has cut back from 15,000 employees to less than 8,500 while maintaining its 400 branches. “They have pursued enough innovations, like electronic banking and telebanking, so that their average customer has little inclination to move to another bank,” says Török. “And their market dominance allows them to charge above-market rates in terms of commissions.” OTP is expected to report net profits of $247 million for 2002.
Because of its virtual oil-and-gas monopoly, MOL has not been allowed to be as freewheeling a capitalist enterprise as OTP. Under the previous, right-wing populist government, MOL was forced to buy natural gas at higher prices than it charged to domestic consumers, leading to $1 billion in losses for its gas operations in 2001. Thanks to a strong forint that lowered the price of imports, its gas business broke even last year. And beginning next January the current Socialist coalition government has decreed that gas prices will be completely deregulated. The government has also announced that it will sell its remaining 23 percent share of MOL on the local stock exchange over the next few years.
In 2002 MOL achieved a net profit of $292 million. “Its results would look a lot better if it got rid of its gas business and acquired more oil assets in the region,” says Róbert Réthy, an analyst with CA IB Securities in Budapest. Although MOL hasn’t yet decided what to do about its gas operations, CEO Mosonyi points out that his company will be investing some $2 billion over the next three years in upstream and downstream operations ranging from petrochemical plants in Hungary to gasoline stations in Romania and the Czech Republic to oil wells in Siberia.
Those expansion projects could make MOL an attractive takeover target. “If our shareholders are in favor of MOL being acquired, then it will happen,” says Mosonyi. According to government officials, any Hungarian companies -- even “crown jewels” like MOL and OTP -- are available to the highest bidders. “We have no objection to their purchase by foreign companies, as long as the deals are transparent,” says Economy and Transport Minister István Csillag. Capitalism, clearly, goes both ways. -- J.K.
Why Budapest isn’t boring Hungary’s Economy and Transport minister, István Csillag, has emerged as the most outspoken cabinet member on such controversies as the overvalued forint, the ballooning budget deficit and the need to rein in public spending. The government’s chief economic policymaker, Finance Minister Csaba László, has adopted a cordial, diplomatic stance toward Zsigmond Járai, the former Finance minister and current central bank governor, but Csillag barely hides his disdain for Járai, whom he largely blames for the country’s economic quandary.
Csillag, a 51-year-old former lawyer and economic consultant who favors tweed suits that give him the look of a university don, sat down recently in his Budapest office for an hourlong interview with Institutional Investor Contributing Editor Jonathan Kandell.
Institutional Investor: You have been famously quoted on the benefits of turning Hungary into a more “boring” country.
Csillag: It hasn’t turned out that way because we have inherited -- what shall I say? -- an “interesting” situation from the previous government, especially concerning the budget deficit. They hid the true figures. They were constructing highways with funds that didn’t show up on the state budget, and that’s only one example. So we have had to confess for the sins of the previous government and reveal all those off-budget items to establish more transparency.
But didn’t your own government contribute to the deficit by raising public sector wages by 50 percent?
Those raises went mainly to health care sector employees and teachers. Foreign investors are always complaining about the shortage of skilled workers. That is linked to education, and it means we need good, better-paid teachers.
Has the surprise decision by central bank governor Járai to cut the interest rates stabilized the forint at a desirable level?
The current rate of exchange is at about the level that can be tolerated by exporters. But the market will be the ultimate judge of his performance. I would point out that [Járai] vowed at a conference one morning at 10:00 a.m. that the interest rate would remain unchanged, and within an hour he announced a 100-basis-point cut -- and then another the next day. In dealing with speculators, creating uncertainty is good up to a point. But those kinds of announcements can be destabilizing in the long run.
Is conflict inevitable between a new government and a central bank governor identified with the opposition?
A more creditworthy central bank governor would have been tolerated by this government. But the fact is, the overvalued forint is a consequence of the overspending [Járai] carried out as Finance minister. He reminds me of that old cartoon of someone who is directing a driver parking a car and causes him to have an accident -- and then blames the driver.
The government has said it will have to tighten its fiscal policies to cope with the deficit and control inflation, but your ministry has announced some ambitious public transport projects.
We will postpone the start of these plans until sometime in 2004. And it hurts. It feels like we’re performing surgery on ourselves. Fighting inflation should not be done only with an overly strong forint. There will have to be an end to subsidies, and that means unavoidable price increases in the short run. For instance, gas prices will be deregulated next January, and electricity deregulation will follow sometime during 2004.
Why has there been a decline in popular support for Hungary’s accession to the European Union?
As we get closer to accession, people realize that becoming an EU member will not solve all our problems in a fortnight. The opposition has decided to emphasize the risks involved, for small enterprises and farmers, for example. So it has been up to the government to press strongly for accession. We think that Hungarians have grown up during these years of transition and are more ready to join the EU than our opponents believe.
Can there be a return to the levels of foreign direct investment achieved in the mid-1990s?
Those levels were because of the large number of privatizations, and there are few state companies left to sell. Last year’s FDI was very low because it was an election year. By next year we can get back to $2 billion, which is considered normal. And after a few years as an EU member, we should achieve even higher levels -- as happened with Spain and Portugal after their accession.
