Hungary's economic transformation has now reached a critical stage, as researchers and policy-makers alike have come to recognize the extent of the changes required and the binding nature of the social constraints the government faces. It is now understood that this process will take significantly longer than originally expected, and the merits of the gradualist approach adopted to date which is likely to be pursued for the foreseeable future are now widely recognized. In 1990 Hungary achieved its first current account surplus in convertible currencies since 1984, inflows of foreign capital are larger than those elsewhere in the region, and its credit rating seems largely undamaged, but many problems remain unresolved. Privatization will have major economic repercussions and profound social and welfare consequences; and it is closely interrelated with other aspects of the economic transformation.

Many of these issues were discussed at a conference on `Hungary: An Economy in Transition', held in London on 7/8 February, which brought together some 30 economic researchers and policy-makers from Hungary and elsewhere in Eastern and Western Europe. The conference was organized by István Székely of the Budapest University of Economics, a Research Affiliate in CEPR's research programme on Economic Transformation in Eastern Europe, which is supported by the Commission of the European Communities under its SPES and ACE programmes and by the Ford Foundation. Further financial support for this conference was provided by Citibank and the Foreign and Commonwealth Office.

Regulation, Privatization and Competition Policy
Opening the first session with his paper, `10% Already Sold: Privatization in Hungary', Zsigmond Járai (James Capel, Budapest) contrasted the rapid growth of new private firms and `spontaneous' privatizations initiated by the enterprises themselves with the poor performance of the State Privatization Agency's own programme. Spontaneous privatizations raised some $500 million in 1991, which included several sales of majority stakes to major Western companies, but none of the 50 firms the SPA set out to privatize has yet found a buyer (and meanwhile some have gone bankrupt). Hungary received more foreign capital investment in 1991 than in the previous 30 years, with almost 90% of its privatization revenues coming from abroad. In contrast, domestic investors have played little part in `official' privatizations, since local capital markets remain undeveloped and loans are difficult to obtain. Indeed, Hungarian privatizations to date may have brought greater benefits to advisors than to investors.

In his paper, `Competition Policy in Transition', János Stadler (National Office of Economic Competition, Budapest) reviewed the provisions of the Hungarian Competition Law of January 1991, which has a broader scope than the antitrust laws of fully-fledged market economies. Investigations of cartels in response to complaints appear to have been more successful than those initiated by the Office, but its investigations of monopoly power appear relatively successful. Stadler stressed that privatization may endanger competition policy in cases where the new owner already has a significant market share. The current rules governing such `mergers' apply only to resident companies, not to resident individuals or foreign companies, and they will be significantly altered by the recent Association Agreement with the European Community.

In the ensuing discussion, John Bonin (Wesleyan University) attributed Hungary's success in attracting foreign direct investment to its relatively stable regulatory and legal environment. High domestic interest rates on rationed loans put the `small capitalist' at a disadvantage vis-à-vis the foreign investor typically a rival firm seeking to pre-empt competition, so privatization is likely to strengthen existing monopoly positions. Rumen Dobrinsky (Centre for Strategic Business and Political Studies, Sofia) stressed that simple legislation is essential for privatization to proceed unhindered by bureaucratic obstacles. Hungary is correct to adopt `Western' competition policy; but its implementation may require stronger actions to break up `unnatural' existing monopolies. Paul Seabright (Churchill College, Cambridge, and CEPR) emphasized that ownership transfer alone cannot resolve the present failures of corporate control. A fully laissez- faire industrial policy is impossible, since the state owns almost all industrial assets, and these require substantial restructuring before sale.

Foreign Trade
In the first of three papers on foreign trade, `Regional Cooperation in East Central Europe', Kálmán Mizsei (Hungarian Academy of Sciences) argued that the collapse of the Soviet Union has not fundamentally altered the process of European integration, which centres around the European Community. Establishing a multilateral payments union for Czechoslovakia, Hungary and Poland in 1990 could have avoided unnecessary trade destruction, but the political will to create such an institution was lacking. Scope remains, however, for regional cooperation on external trade policy and on infrastructure projects, while a trilateral free trade agreement might marginally increase trade and enhance incentives to foreign capital investment.

In his paper, `Economic Consequences of Soviet Disintegration for Hungary', László Csaba (Kopint Datorg Institute for Economic Market Research and Informatics, Budapest) contrasted the government's strictures against uncompetitive firms with its maintenance of an external trade regime that allows them to profit from exports to the largely insolvent Commonwealth of Independent States. He dismissed proposals to convert outstanding Soviet debt for equity in firms in Western Ukraine: Ukraine owes only 16% of the total CIS external debt and possesses no convertible currency reserves, and the January 1992 ban on virtually all commodity exports rules out payments in kind. A payments union of Czechoslovakia, Hungary and Poland alone would restrict commodity and factor flows, and announcing a policy of regional cooperation would give all the wrong signals to large enterprises still hoping to revive their exports to traditional `soft' markets.

Three factors will determine future HungarianCIS trade relations. First, the CIS is openly insolvent and in a severe recession, whose spillover effects from supply disruption to mass migration are likely to intensify, so the government should ward off rather than encourage high-risk business deals. Second, the Russian and Ukrainian transformation plans are expected to lead to a severe reduction in intra-CIS trade and a corresponding reduction in its external trade. Third, even the Russian Federation may not remain a single political unit, and until such political issues are settled, there can be no clear-cut division of competences, arbitration mechanism nor even a secure means of transferring money abroad.

Presenting their paper, `Export Demand and Import Demand in Hungary: An Econometric Analysis for 1968-89', László Halpern (Hungarian Academy of Sciences) and István Székely (Budapest University of Economics) noted that most attempts to estimate price, production and income elasticities for this period had produced insignificant parameter estimates and inconclusive results, by neglecting the special regulatory environment, export and import subsidies, and import restrictions. As a result of these subsidies, the implicit deflators derived from the national accounts statistics were misleading, so the estimated equations were misspecified and failed or at best resulted in biased estimations.

Halpern and Székely developed new models of export supply and import demand that took account of changes in the regulatory environment, differential subsidies to and tariffs on trade with both rouble and non-rouble areas, and the trade effects of inventories and restrictions. These estimates identified stable and well-defined behavioural relations and outperformed previous estimates derived from the same theoretical framework. The authors proposed to incorporate these new functions in a complete model of the Hungarian economy to simulate the impacts of a variety of monetary and exchange rate policies.

In his general discussion, Renzo Daviddi (Innocenzo Gasparini Institute for Economic Research, Milan) welcomed the inclusion of subsidies and restrictions in the trade equations, but he questioned the predictive power of a model that had such major structural breaks and a total regime change. Csaba might also have underestimated the harmful, long-run effects of the collapse of intra-regional trade if the expansion of exports to the European Community reflected preferential treatment rather than a real gain in competitiveness.

Tax and Legal Reforms
Kinga Pétérvari (Budapest University of Economics) then presented Tamás Sárközy's paper, `Legal Framework for Transformation of Systems in Hungary', which reviewed the development of Hungarian commercial law since the 1968 reform package. This established the basic institutions of a market economy, as the 1970s saw the abolition of compulsory planning directives, the integration of Hungary's commercial and civil law, and measures to protect the environment, patents and trade marks. These all enabled Hungary to embark on its current social transition with a much more sophisticated and market-oriented economy than its neighbours. More recent measures have allowed cooperative property to be split up for sale, removed remaining restrictions on individuals' rights to employ workers, and allowed the reopening of the Budapest Stock Exchange in 1990. The lack of a commercial culture and the professional skill base required to operate a successful market economy has led nevertheless to abuses and anomalies, and political considerations concerning the management of the governing coalition may now require a temporary slowing of the legislation needed to deregulate the economy.

Presenting his paper, `Tax Reform in Hungary', Jenö Koltay (Hungarian Academy of Sciences) noted that Hungary's taxation system has broadly resembled those of the developed market economies since the wide-ranging reform of 1988. This sought to shift the tax burden from enterprises on to consumption and personal income taxes, reduce the numbers of subsidies and exemptions, and establish a more stable, tax-neutral regulatory environment. The introduction of taxation on personal income at high marginal rates in a period of shrinking GDP and a tight fiscal policy significantly exacerbated inflationary pressures, however, and coordination with the expenditure side of the budget was poor. The tax reform may be suitable for the market economy to which Hungary aspires, but by itself it cannot substitute for that reform, and it may even exaggerate existing distortions.

Athar Hussain (LSE) maintained that a typical `West European' tax system is a reasonable long-term goal for the transforming economies, although there may be problems in the transition, particularly as revenue is likely to fall faster than expenditure can be cut.

The Political Economy of Transformation
In their paper, `The Economics of State Desertion: The Case of Hungary', István bel (Budapest University of Economics) and John Bonin (Wesleyan University) investigated the effects of the abrupt ending of the state's financial involvement in social and economic activities. They attributed current inflationary pressures to continued subsidies to inefficient domestic enterprises and the fiscal servicing of the sovereign foreign debt. These have been exacerbated by the change to hard currency payment for intra-CMEA trade, as enterprises seeking new markets now require foreign participation to provide entrepreneurial expertise, while foreign direct investment is probably essential for privatization revenues to contribute significantly to fiscal stabilization.

Labour Markets and Social Security
In his paper, `Everyday Power and After', János Köllö (Hungarian Academy of Sciences) maintained that workers' `everyday power' the ability to resist or evade managers' authority, through false compliance, feigned ignorance or even sabotage is not unique to `socialist' societies, but it has been particularly strong in post-war Eastern Europe. Prevalent labour shortages rendered mobility restrictions unenforceable; the substantial `second economy' encouraged workers to reserve effort in their `full-time' jobs; widespread input shortages made such shirking difficult to identify; and all these conditions increased the costs to firms of monitoring current workers' performance or hiring new ones in cases of dismissal. Köllö argued that the growth of unemployment has raised the expected cost of job loss, while firms' search costs must have fallen as unemployment rose, and the second economy is less important than previously. Small farming has been hard hit by the collapse of the Soviet market; the recession and the rise in interest rates have reduced the demand for `moonlighters' in construction. Altogether, the transition to a new system of wage bargaining is likely to be quite uncomfortable.

Maria Augusztinovics (Hungarian Academy of Sciences) then presented her paper, `The Social Security Crisis in Hungary', which noted that changes in pension legislation and increased participation ratios since the establishment of a single, unified system in 1949 had raised the ratio of `entry pensions' to final wages and expanded the social security system to cover the entire labour force. This tended to amplify the effects of the well- known `pension paradox': that pensioners normally become relatively poorer during retirement as each newly-retiring cohort with a higher pension entitlement replaces the oldest, but older pensioners benefit relative to the newly retired during recessions.

After 1978, the focus of economic policy switched from improving living standards to servicing the foreign debt, and the government reduced entry pensions and deliberately under- compensated pensioners for inflation. Hungary's pension scheme is financed by the government budget, but unlike public pension schemes in the West it has been backed by accumulated state-owned wealth. In principle this might be used to create a private, funded pension system as the government withdraws from economic activity. Measuring and securing agreement upon the retirement wealth of working and retired generations is difficult, however, and privatization to date has taken no account of pensioners' claims on revenues from asset sales, so social security will have to rely on guarantees from the government which it cannot afford when its own current account is in deficit.

David Winter (University of Bristol) noted how difficult it had been for the unemployed to return to the labour force in the UK in the 1980s and questioned whether Hungary's currently high and rising unemployment would prove transitory. László Halpern argued that the second economy would do little to absorb displaced labour since its own survival depends on the continued rigidity of the state sector. David Newbery (Department of Applied Economics, Cambridge, and CEPR) suggested that raising the retirement age (currently 60 for men, 55 for women) may be essential to solve the current underfunding of pensions, but this can have little short-run impact on the state budget in the face of rising unemployment. The political process is not well suited to mediate between completing claims on scarce resources, and pensioners may be in a weaker position than most to exercise such claims.

The Financial System, Monetary Policy and Savings
Presenting her paper, `A Short Run Money Market Model for Hungary', Júlia Király (International Banking School, Budapest) first reviewed the main features of this highly segmented market. `Vertical' markets for the auction of treasury bills and certificates of deposit have grown substantially, but they have not yet spawned secondary, `horizontal' markets among the commercial banks. Once the central bank ceases to quote forward rates for foreign exchange receipts, a deregulated interbank market in foreign exchange may become an important segment for monetary policy. The domestic, non-intermediated money market has grown significantly since 1989, both in absolute terms and relative to the established intermediated market in forint funds (in which both buyer and seller have contracts with the central bank). Király then presented her simple money market model, which distinguished the interest rates on refinance credit and on swap transactions (both policy variables) and that on the interbank market (determined endogenously by market forces). She found that an exogenous increase in the demand for forint funds led to a rise in the market interest rate, which may exacerbate or mitigate the increase in money demand, depending on the parameter values.

In her paper, `Modernisation of the Hungarian Bank Sector', Éva Várhegyi (Financial Research Ltd, Budapest) noted that the `first reform' in 1987 had freed the central bank from all direct relations with enterprises and enabled it to concentrate on its macroeconomic role, while the commercial banks now operated as independent, profit-making enterprises. Despite these institutional changes, the concentration of economic powers ensured that financial policy remained subordinate to fiscal policy. Financing the state budget required some three-quarters of central bank assets in 1987-9, thus depriving commercial banks of their credit sources. Overwhelming state ownership of commercial banks and the large, inefficient enterprises that account for most of their bad loans, together with the financial markets' heavily segmented structure, led to conflicts of interest that further impeded the sector's efficiency.

The `second' banking reform now under way includes measures to promote the central bank's legal autonomy and a proposed fiscal write-off of the bad loans inherited by the commercial banks. Privatization should overcome the obstacles to the first reform; but current proposals for banking regulation and supervision entail a dangerously high level of state involvement if any future government seeks to abuse its powers.

In their paper, `Household Portfolios in Hungary, 1970-1990', István bel and István Székely (Budapest University of Economics) argued that fluctuations in consumer prices had led to substantial volatility of real interest rates which had a strong impact on household saving and portfolio allocation throughout the period. They found that simple annual data on households' accumulation of gross wealth provide no support for the common view that they increased the shares of real assets in their portfolios to accommodate increased inflation. This can be substantiated, however, by also taking inflationary losses on stocks of financial assets and net wealth into account.

John Bonin pointed out that the reduction in the share of financial assets in 1979 was associated with the introduction of a restrictive fiscal policy, while the corresponding increases in 1984-6 and 1988 were both associated with the introduction of new financial instruments; supply-side and policy changes may therefore explain changes in household portfolios just as well as the demand-side changes in the real interest rate.

International Finance and Convertibility
In his paper, `Accumulation of Foreign Debt and Macroeconomic Problems of Debt Management: Hungary's Case', Gábor Oblath (Kopint Datorg Institute for Market Research and Informatics, Budapest) noted that Hungary had always fully serviced its foreign debt, unlike many East European and developing countries with comparable debt indicators. Oblath maintained that seeking to negotiate a debt service reduction with Hungary's Western partners would have serious short-term consequences for cash flow as credit flows were disrupted and deposits withdrawn.

He then reviewed the various macroeconomic policies available for the management of the external debt. With no inflows of foreign direct investment or unrequited transfers, implementing restrictive fiscal and/or monetary policies in order to offset the domestic inflationary consequences of the net outflow of funds may lead to a `vicious circle', as economic decline leads to rising fiscal deficits and the imposition of even more restrictive policies. If sustained private capital inflows are available and effectively channelled into productive uses, however, the domestic and foreign equilibria may be reconciled through the growth-enhancing effects of increased investments and imports. Significant resource transfers from official sources may also be needed, however, to assist the necessary structural changes and manage their social consequences.

In the final paper of the conference, `Managing Foreign Debts and Monetary Policy During Transformation', Werner Riecke (National Bank of Hungary) noted that underestimates of the small private sector's performance may lead to an overvaluation of the debt burden relative to GDP, while per capita debt ignores export performance and future growth prospects and is therefore unsuitable for international comparisons of debt's economic effects. Western creditors should also consider the `political return' on investment in Eastern Europe, which may help to secure a peaceful transition in the region. Deviating from Hungary's current policy of full debt service may secure a small reduction in payments on the principal, but it would also cut off its access to private Western capital markets, reduce foreign direct investment, and provoke capital flight from households' foreign exchange deposits. Increased exports and GDP will enable Hungary to `grow out' of its debt if supported by appropriate fiscal and monetary policies. Hungary achieved both domestic and external monetary equilibrium in 1991, but maintaining this will require a sustained reduction in the fiscal deficit as a proportion of new domestic credit.

L Alan Winters (University of Birmingham and CEPR) noted that foreign direct investment may leak into imports of equipment and inputs, leaving less available for debt finance. Richard Portes (CEPR and Birkbeck College, London) disagreed with Riecke: he argued that Hungary needed debt reduction, along the lines of Mexico's successful Brady Plan agreement with the banks. Debt service imposes a fiscal burden and a squeeze on consumption and investment that will be insupportable in the medium run, according the Portes. Hungary cannot grow out of debt unless output grows, and it has in fact been falling.

'Hungary: An Economy in Transition' edited by David Newbery and István Székely
Available from Centre for Economic Policy Research, 90-98 Goswell Road, London, EC1V 7RR
ISBN (hardback) 0 521 44018 1