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Hungary's Stimulus Flop Corners Orban Before IMF Talks Start

Hungarian Premier Viktor Orban’s negotiating hand going into bailout talks with the International Monetary Fund has been weakened after the economy slumped the most in three years, said economists from London to Budapest.

Hungary is headed toward joining the Czech Republic and Romania among eastern European countries in recession as the euro region’s debt crisis saps demand for their exports. That adds to pressure on Orban to obtain aid from the IMF and limits his ability to protect the flat personal income tax, a cornerstone of his economic policy, said Neil Shearing, chief emerging markets economist at Capital Economics in London.

“As long as the economy isn’t growing, the government’s room to maneuver in IMF negotiations is limited,” Shearing said by phone yesterday. “One of the red lines the government has drawn is that it’s not willing to debate the flat income tax, while the IMF has been fairly critical. Keeping the tax risks becoming self-defeating, creating a vicious cycle that’s difficult to break out of.”

The country, seeking a date to start aid negotiations six months after requesting financial assistance, is on the brink of its second recession in three years even after the government touted a “hidden” $5.3 billion stimulus package, according to data released yesterday.

Forint, Bonds, CDS

The forint fell 0.5 percent to 295.07 per euro at 10:22 a.m. in Budapest, its weakest in in three weeks, as Greek political parties failed to form a government and will hold new elections that may decide whether the country will be the first euro-area member to drop the common currency.

Hungary’s benchmark 10-year bonds dropped, raising yields to 8.49 percent, the highest since April 24, from 8.36 percent yesterday. Credit-default swaps, measuring the cost to insure government debt against default, rose to 566.024 basis points from 559.167 yesterday, according to data compiled by Bloomberg.

Gross domestic product plunged 1.3 percent in the three months to March from the fourth quarter, the most among the 19 European Union members that reported output data through yesterday. That followed economic stagnation in the October-December period.

The flat personal income tax cut budget revenue and drove Orban to squeeze companies for cash to close budget holes. The government approved taxes on banking, energy, telecommunications and insurance companies last week to allay EU concern that its budget was unsustainable and to unfreeze grants from the bloc.

Bailout Talks

The European Commission last month authorized the start of bailout talks after Orban pledged to change a central bank regulation to ensure monetary-policy independence. With parliament still debating the changes, the IMF hasn’t given a date for talks, which the government requested in November as the country’s credit grade was cut to junk, the forint fell to a record low against the euro and debt auctions failed.

Prospects of a bailout boosted the forint 6 percent against the euro this year, the sixth-biggest increase in the world, after a 16 percent drop in the second half of 2011.

In a country report published in January, the IMF said it was “concerned about the underlying composition of fiscal policy,” citing a “highly regressive mix” of tax and spending policies. It recommended Hungary “revisit” the levy on personal incomes.

Minimum Wage

The Cabinet raised the minimum wage by 18 percent this year and urged private companies to compensate lower-income earners who saw their pay cut by the flat tax, hurting competitiveness at a time when the jobless rate is at a two-year high.

Mihaly Varga, a former finance minister who is currently Orban’s chief of staff, will replace Tamas Fellegi as the minister in charge of IMF negotiations. The change shows the government’s focus on obtaining the bailout, said Luis Costa, a London-based strategist at Citigroup Inc.

“Varga is probably one of the last credible men in the government and so should give some impetus to the negotiations,” Costa said in an e-mail. “We also think that he has a mandate from Orban to move on some aspects of the talks, whereas his predecessor Fellegi did not.”

The 16 percent personal income tax introduced in 2011 failed to raise household spending last year after cutting the burden for higher earners. To bolster state coffers, the government nationalized private-pension fund savings and levied special taxes on financial, energy, telecommunication and retail companies.

Budget Deficit

The measures masked the deterioration of the budget, with the shortfall reaching 5.25 percent of GDP last year without one-time revenue, the European Commission said in a May 11 report. It prompted the EU executive to partially suspend development grants to Hungary from 2013 to enforce fiscal discipline as Greece teetering on the edge of default triggered investor concern about contagion to the rest of the euro area.

“While others gave in to temptation, we resisted and rejected austerity, which led the European Commission to charge that we ruined our structural balance by carrying out a 1.2 trillion-forint hidden economic stimulus last year,” Matolcsy said on May 9. “That led to a 6 percent increase in real wages, maintaining growth and boosting the employment rate in a very tough external environment. We are expecting the same for 2012 and 2013.”

The economy shrank in the third quarter of 2011 from the previous three months and stagnated in October-December, according to revised data published by the statistics office yesterday. The unemployment rate was 11.7 percent in the January to March period, the highest in two years.

‘International Trends’

The euro region’s crisis is hurting economies across eastern Europe, even as Germany, Europe’s largest economy, expanded 0.5 percent in the first quarter. Czech GDP dropped 1 percent that period, the third consecutive decline. Romania slipped into its second recession in four years after its economy declined 0.1 percent.

Hungary’s slump was “led by international trends” that “clearly show that Europe is still facing serious growth challenges,” the prime minister’s office said yesterday in a statement.

A dearth of lending is exacerbating Hungary’s woes, with the central bank warning last month of a “severe” credit crunch as commercial banks curb lending after paying special taxes and being forced to take losses on foreign-currency mortgages last year.

‘Negative Turning Point’

OTP Bank Nyrt., Hungary’s largest lender, yesterday reported that first-quarter net income plunged 66 percent to 12.8 billion forint because of a bank tax and losses on a foreign-currency loan repayment plan.

“We are witnessing a negative turning point,” the GKI research institute in Budapest wrote in a report yesterday. “The data suggest that the contraction can’t be explained by the external environment alone and that domestic demand and the economic policy behind that had a key role.”

Hungary’s economy will contract 0.3 percent this year, according to the European Commission, while Nomura International Plc forecast yesterday that GDP will decline 1.3 percent in 2012 and grow 0.3 percent in 2013.

A shrinking economy will make it more challenging for Hungary to meet its budget-deficit targets of 2.5 percent of GDP this year and 2.2 percent in 2013. The tax changes announced last week will probably hurt the economy, Ferenc Karvalits, a central bank vice president, said in e-mailed answers to questions from Bloomberg News.

“The impact of this sharply lower growth view is particularly pronounced on the fiscal outlook,” Peter Attard Montalto, an economist with Nomura in London, said in e-mailed comments. “In Hungary it erases many of the gains made by the convergence report and means a deficit of around 4 percent of GDP for this year is most likely.”

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