HUNGARY: REFORM TESTED BY THE CREDIT CRUNCH

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP83-00857R000100130003-5
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 16
• Document Creation Date: December 21, 2016
• Sequence Number: 3
• Content Type: REPORT

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Hungary: Reform Tested
by the Credit Crunch
State Dept. review completed
Secret
Secret
EUR 82-10088
September 1982
222
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Directorate of
Intelligence
Branch,
coordinated with the National Intelligence
Council. Comments and queries are welcome and may
be directed to the Chief, East-West Regional Issues
Secret
EUR 82-10088
September 1982
Hungary: Reform Tested
by the Credit Crunch
Office of European Analysis. It was
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Secret
Hungary: Reform Tested
by the Credit Crunch
Key Judgments Despite its reputation as having the best managed East European economy,
In/ormation available Hungary is dangerously close to insolvency. After suffering cutbacks in
as oj3 September 1982 Western credits for over a year, Hungary is beginning to receive from
was used in this report.
Western governments, banks, and the IMF the loans needed to forestall
rescheduling in 1982. Nonetheless, Hungary is still well short of covering
its 1982 borrowing requirement and, without more funds, could fail to meet
obligations late this year. Even if Hungary raises all the loans it projects,
we believe it will face a financial crisis again next year unless its trade per-
formance or borrowing conditions improve. 25X1
Much of Hungary's plight stems from events beyond its control-Western
recession, high interest rates, and the collapse of bank lei g to Eastern
Europe. The Hungarians have tried to reduce their hard currency deficits
in recent years through deliberate economic slowdown and revitalization of
their market-oriented reforms. The reform program, however, has not
produced the expected gains in efficiency and competitiveness; as a result,
Hungary's trade performance has not improved sufficiently to offset rising
debt service. The prospect of continuing tight financial markets-coupled
with increasingly difficult trade relations with the USSR-forces Hungary
to reduce investment and economic growth even further and to demand
sacrifices from the consumer. Although external pressures may lead to a
strengthening of some central controls, we believe that Hungarian leaders
are committed to economic reform.
Secret
EUR 82-10088
September 1982
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Hungary: Chronology of
Sign cant Economic Events
November 1966
1 January 1968
1969-71
1971-73
Central Committee approves 1 January 1981. Three branch industrial minis-
New Economic Mechanism
implemented.
tries merged into single, leaner
Ministry of Industry. Bureau-
crats laid off Enterprises giv-
en greater autonomy.
Trade deficits increase artd in- 1 October 1981 Budapest unifies commercial
and noncommercial forint ex-
change rates and promises ul-
New Economic Mechanism timate convertibility of forint.
underfirefrom hardliners who
want to recentralize. Growth
remains high; some recentral-
ization begins.
Trade deficits soar-reach
$782 million in 1978. Hard
currency debt rises sharply.
4 November 1981 Hungary applies for member-
ship in IMF.
1 January 1982 Small business reform imple-
mented. Greater scopelor indi-
vidual initiative granted.
Government announces slow-
down in growth to achiev~> twin May 1982
goals of external equilibrium
and maintaining living stand-
ards. Reform increases
markedly.
Investment slashed. Consumer
prices raised, cost of living
climbs 9 percent. Growth slows
precipitously. Current account
deficit shrinks.
IMF membership attained.
Hungary draws down $210
million in credits from Bank
for International Settlements.
Hungary receives $260 million
commercial loan. Budapest
raises some food prices and
announces limits on imports.
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Secret
Hungary: Reform Tested
by the Credit Crunc
Background
Since the late 1960s, two major developments have
shaped Hungary's economy (see box):
? The New Economic Mechanism (NEM), by which
the regime sought to shift from a largely autarkic,
centrally planned system to a more open, decentral-
ized structure relying more on market mechanisms.
? Serious financial constraints, stemming from the
country's failure to ensure equilibrium in the hard
currency balance of payments and from unfavorable
developments in the world economy and within
CEMA.
The regime launched the NEM because it attributed
Hungary's economic stagnation of the mid-1960s to
growing inefficiencies of central planning. Hungarian
economists argued that the highly centralized eco-
nomic structure was proving increasingly inappropri-
ate for a country with a poor resource base and small
domestic market.' Like most other East European
countries at that time, Hungary turned to increasing
imports of modern technology and industrial materi-
als-from the West to improve economic performance.
But, in contrast to other Soviet Bloc regimes, the
Hungarian reformers also believed that decentralizing
decisionmaking and introducing more market forces
would accelerate growth by improving the economy's
efficiency and competitiveness in world markets. The
leaders shifted the government's role from direct
control toward regulation of the economy by:
? Expanding the authority of enterprise managers
over investment, production, and pricing decisions.
? Reducing subsidies and taxes-particularly on pro-
ducer goods-so that prices could more closely
reflect true economic costs.
? Setting more realistic foreign exchange rates so that
managers could make more economically rational
decisions in buying and selling
Hungary enjoyed good economic growth during the
first years of the NEM, but a flood of imports to
support surging investment led to balance-of-pay-
ments problems by 1971. Critics of the NEM took
this opportunity to challenge the reform: the inequal-
ity of widening wage differentials, the danger of
unemployment if inefficient producers shut down, and
the inappropriateness of profits as a performance 25X1
indicator in a socialist economy. In 1972-73, the
government tightened central control over prices and
investment, increased subsidies to unprofitable enter-
prises, and gave across-the-board wage increases. In
effect, the leaders held economic reform in abeyance
as they resorted to more traditional mechanisms to
deal with excess demand and balance-of-payments
deficits.~~ 25X1
The regime further tightened central controls as it
sought to shield the domestic economy from the
explosion of world prices for raw materials and energy
in 1973-74. Hungary's hard currency terms of trade
deteriorated by over 20 percent, and rising import
costs helped push the trade account even deeper into
deficit. Although the regime raised some prices, the
government largely offset the impact of world infla-
tion through increased consumer and producer subsi-
dies. 25X1
The regime's actions helped accelerate the growth of
foreign debt in 1975-78. The softness of Western
markets hurt Hungary, but the main problem was the
government's failure to restrain domestic demand and
provide incentives for exports. Price controls and
growing consumer subsidies sustained a rising tide of
imported consumer goods and limited the availability
of exports, particularly of food products. Continued
producer subsidies enabled enterprise managers to
invest without concern for efficiency. Controls on
imports of goods competitive with Hungarian prod-
ucts-instituted for balance-of-payments reasons-
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Hungary: Selected Economic Indicators
Government
and Services
Transportation
Agriculture
Growth in Investment
Percent Growth
-15 1976 77 78 79 80 81
Hard Currency Trade With
Non-Socialist Countries
Million US $
Exports
0 Imports
587357 8-82
Secret 2
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'Perms of Trade
Index: 1970=100
Hard Currency
Trade
80
70 1970
Growth in Personal Consumption
Percent
Hard Currency Trade With
Socialist Countries
Million US $
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25X1
Secret
25X1
25X1
ensured secure, protected markets for domestic enter-
prises. Hungarian managers thus lacked strong incen-
tives to produce quality goods or to enter competitive
Western markets
By 1977-78, Hungarian policymakers and Western
creditors realized that failure to control the hard
currency balance of payments was leading toward a
financial disaster. The regime responded by shifting
the focus of policy from economic growth toward
external equilibrium. While recognizing the need for
an economic slowdown, the government was still
unwilling to lower living standards. Thus the regime
sought to place the burden of adjustment on invest-
ment by implementing more restrictive domestic cred-
it policies in 1979. To improve trade performance,
Budapest channeled the reduced pool of investment
funds primarily toward export and import-substitut-
ing industries.
The regime also revived the reform program in an
effort to improve export competitiveness and to offset
reductions in imports and investment through greater
efficiency. Since 1978 Budapest has moved economic
management back toward the principles of the 1968
reform by:
? Adjusting domestic prices closer to world prices and
cutting producer subsidies.
? Liquidating or merging some unprofitable firms
with profitable enterprises.
? Breaking monopolies to increase competition and
allow greater flexibility.
? Permitting more small privately owned businesses.
Impact of Stabilization Measures
Hungary's stabilization program cut the growth of
GNP from an average annual rate of 2.7 percent in
1976-78 to less than 1 percent since 1978 (see table 1).
Investment, which had increased as a share of GNP
between 1968 and 1978, has fallen more than 20
percent over the past three years. Increases in con-
sumption have been the key source of growth. Real
private consumption increased by an average of 1.6
percent per annum in 1979-81, faster than in any.
other East European country except East Germany.
The decline in economic growth helped Hungary
improve its hard currency balance of payments in
1979-80. The current account deficit fell from $1.2
billion in 1978 to $365 million in 1980 thanks to a
$700 million decrease in Hungary's trade deficit with
the West and a $400 million increase in the hard
currenc trade surplus with socialist countries
~~I'he cutbacks in investment and the slow-
down in industrial production reduced imports of
capital goods and industrial materials and spurred
sales of semimanufactured goods (such as steel and
chemicals) to the West. Imports of consumer goods
continued to rise because of the high priority assigned
to maintaining living standards. At the same time,
strong agricultural performance helped Hungary in-
crease food exports to the West and meet rising Soviet
demand for hard currency purchases of meat and 25X1
grain.
Hungary's efforts to eliminate its current account
deficit have faltered over the past year and a half. In
1981, the current account deficit widened to $700
million as skyrocketing interest charges on debt over-
whelmed asmall additional increase in the hard
currency trade surplus. Although Hungary improved
its trade balance slightly during the first half of 1982,
continuing high interest costs leave Hungary's bal-
ance of payments in deficit.
Western recession and, to a lesser extent, a poor
harvest last year have hurt Hungary's exports in
25X1
25X1
1981-82. Sales to developed countries declined sharp-
ly in 1981 and were only partly offset by increased
hard currency exports to the USSR, Libya, Iraq, and
Algeria. Some Hungarian economists and economic
policymakers have argued publicly that the falloff in
z Although most of Hungary's trade with socialist countries is
conducted on a clearing account basis, approximately 20 percent of
imports and exports involve hard currency transactions or ex-
changes of goods otherwise salable in Western markets (so-called
hard goods). Most of this trade is with the USSR and, according to
Hungarian officials, mainly involves the exchange of Hungarian
grain, meat, and other agricultural products for Soviet oil outside
planned soft currency deliveries. Hungarian sources have never
directly indicated whether Budapest has actually received hard
currency from the USSR in settlement of its growing surpluses in
this trade. Nonetheless, Budapest and the IMF include these
surpluses in Hungary's overall hard currency balance of payments.
25X1
25X1
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Table 1
Hungary: Annual Rates of Growth of GNP by Sector of Origin
a Growth rates of construction reflect trends in investment.
exports to developed countries demonstrates the con-
tinuing failure of Hungary's reforms to foster ef:Fi-
cient, competitive industries capable of adapting to
tougher selling conditions. Despite the goal of shut-
ting down unprofitable enterprises, the system still
draws 'off resources from competitive firms to subsi-
dize inefficient producers. Furthermore, Hungarian
enterprises continue to enjoy a protected home market
and thus are able to ignore stiff competition from the
West.
The decline in exports and a simultaneous tightening
of credit have forced Hungary to reduce hard curren-
cy imports over the past two years. Cutbacks in
imports of energy, industrial materials, and food
products in 1981 more than offset increases in pilr-
chases of consumer goods, machinery, and equipment.
In January-June 1982, purchases of food products
were down by 30 percent compared with the Barrie
period a year ago while imports of industrial mat~;rials
and consumer goods have fallen by roughly 5 percent.
Only machinery and equipment show a'small in-
crease.
Mounting Financial Woes
Despite the increased payments deficit in 1981, 1-Iun-
gary suffered a liquidity crisis only when East-V~'est
credit relations deteriorated. Western bankers aI~-
plauded Hungary's determination to restore external
balance through austerity and market-oriented re-
forms and were encouraged by good results in 1979-
80. However, rising debt service obligations left Hun-
gary vulnerable to the collapse of bank lending to
Eastern Europe that followed the Polish and Roma-
nian crises.
Hungary's ability to raise new credits eroded rapidly 25X1
after mid-1981. After obtaining $550 million in two
syndications early in the year, Hungary failed to
secure a third major-loan and was forced to cover its
cash needs in late 1981 largely through reserve draw-
downs and shorter term borrowing at higher interest
rates. In the first months of this year, Western banks
withdrew some $700 million in short-term deposits
placed with the National Bank of Hungary while
CEMA and OPEC banks pulled out $450 million.
The Hungarian National Bank provided data to
Western banks in May showing that Hungary had to
reduce its reserves from $1.9 billion in 1981 to $374
million at the end of March 1982 to cover these
withdrawals and other obligations.
' The reserve drawdown involved the liquidation of both Hungary's
deposits in Western banks and some of its gold stock. Senior
Hungarian bankers have told US Government officials that Buda-
pest sold nearly half of its 75-ton gold stock and pledged much-if
not all-the rest as collateral for loans. Statistics from the Bank for
International Settlements (BIS) show that Hungary's deposits in
Western banks fell from $890 million to $470 million in the first
quarter of 1982. The reasons for the discrepancy between Hunga-
ry's reported reserves of $374 million and the BIS statistics are not
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A senior Hungarian banker told US Government
officials more recently that Budapest had raised $500
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million in credits (including supplier credits but ex-
cluding BIS funds) by midyear. While press reports
indicate that Budapest received a $100 million shoit-
term credit from Swiss banks against gold collsrteral,
we believe that most of these "credits" represent
short-term extensions on loans fallin? due and pay-
ment delays to suppliers.
pressure from British, French, and possibly West
German authorities convinced West European
banks to participate. According to these sources,
West European central banks and governments
feared that failure of the loan would lead to a debt
rescheduling that would threaten Hungary's pro-
The willingness of leading international banks to
cooperate on the $260 million loan should improve
chances for additional funds from other private
lenders. However, some bankers involved in the
medium-term credit have told US officials that they
are skeptical about Budapest's chances of reattract-
ing the $300 million in short-term deposits it
projects.
After much delay, Hungary has begun to raise some
of the needed credits, but it is still far short of its goal.
If they fail to raise these funds, the Hungarians will
have difficulty meeting their obligations late this year
and may have to request debt relief from their
creditors:
? A group of 15 major commercial banks provided a
$260 million medium-term loan to the Hungarians
in August: Press and US Embassy reporting indi-
cate that the loan was on the verge of collapse until
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With only a small increase in reserves at best and
rising debt repayments; Hungary's financial po~~ition
will remain tenuous next year. Hungary projecl:s a
borrowing requirement of $1.5 billion in 1983 to be
covered by credits from commercial banks and ;~uppli-
ers. However, the Hungarians apparently fear that
their borrowing needs may go higher or that they may
fail to raise adequate funds from private sources
because they plan to obtain-and hold in reserve-an
additional $500 million in IMF credits. Failure to
reach current account balance this year may heighten
the reluctance of commercial bankers to advance
more funds and probably will prod the IMF into
imposing stiff conditions for its credits. To win sup-
port from the banks and the IMF, Hungary will have
to reduce its financing needs, particularly by cutting
imports more. If it fails to improve trade performance
sufficiently and if borrowing conditions do not m-
prove, Hungary could require debt rescheduling; next
year
No Help From the USSR
In addition to the financial squeeze from the West,
Budapest faces more difficult economic relations with
the USSR. There are signs that the Soviet Uni~~n's
worsening economic situation has induced Mos~;ow to
become tougher in its dealings with much of E~istern
Hungary must also contend with worsening terms of
trade with the USSR (approximately a 6- to 7-percent
deterioration in 1981) and with the Soviet regime's
insistence that soft currency trade deficits with the
USSR be reduced. Because of rising Soviet prices, the
pressure to balance trade with the USSR, and a
falloff in imports from Poland, Hungary suffered a
4-percent decline in real imports from CEMA in 1981
while raising export volume by 4 percent. This trend
in CEMA trade has increased Hungary's need for
imports from the West and possibly reduced the
amount of goods available for sale in Western mar-
kets. Hungary must also anticipate that it will earn
less cash in its hard currency trade with the Soviet
Union if the Soviets insist that more hard goods be
delivered to offset deficits in soft currency trade.
Moving Toward Greater Austerity
Mounting economic pressures from Western creditors
and the USSR leave the Hungarian Government with
little choice but to accept a further slowdown in 25X1
growth and to back off from its policy of maintaining
living standards. We believe the regime almost cer-
tainly would prefer to assure sustained popular sup-
port by continuing- to favor consumption over invest-
ment. However, the need to ensure long-term growth
by improving the international competitiveness of
Hungarian industry limits the scope for more cuts in
investment and in imports of Western technolog
impose more austerity on Hungarian consumers.
leadership now is beginning to accept the need to
After temporizing through the first half of 1982, the
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difficult given the need for external equilibrium.
Hungarian economists have told the US Embassy that
the leadership is resigned to some decline in. living
standards.
Implications for Hungary
Hungarian officials have warned Western govern-
ments and banks that a financial crisis could- force ..
abandonment of reform and closer. integration with
the USSR and CEMA. These warnings seem.de-.
signed to win Western help. rather than to indicate
policy change. The leadership appears convinced that
decentralization and adjustment to world. economic
forces-not greater reliance on the USSR-are the
only solutions to Hungary's problems:
No major steps toward centralized management or
reimposition of administrative controls have been. 25X1
taken, as in the mid-1970s. The recently imposed
import restrictions involve some tightening of existing
controls but do not reverse already enacted reforms.
The US Embassy in Budapest sees no significant
faction advocating recentralization and and we be-.
lieve that changes in the party and government lead-
ership in fate June probably have strengthened. party
leader Janos Kadar's hand in pursuing reform. Fur-
thermore, Western creditors-would insist that Hunga-
ry continue its reforms in return for their help if
Budapest had to request debt relief.
As with earlier price increases, the regime has ex- is difficulties may require plans to increase enterprise
plained its recent actions and is warning that more authority and independence to be delayed. Party
austerity measures are likely. Officials stress publicly Secretary Havasi has also stressed that more rapid
that maintaining living standards will be increasingly
Hungary's economic problems, however, have re- 25X1
newed public debate about~accelerating reform. Some
liberals, such as the NEM's architect Rezso.Nyers,
argue that the government must speed up the intro-
duction of planned measures in order to improve the
economy's efficiency more quickly. Finance Minister
Hetenyi has urged an expansion of managerial au-
thority and a reduction in subsidies for unprofitable
enterprises even though "social pressures" may tempt
leaders to put off difficult decisions. By contrast Janos
Berecz, editor in chief of the party newspaper, con-
tended in an article published in August that econom-
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relaxation of central controls and elimination o1'subsi-
dies would worsen inflation, unemvloyment, and
balance-of-payments problems.
The regime's public insistence on maintaining living
standards and the caution of some officials about
speeding up reform underscore the leadership's con-
cern over the political consequences of the country's
economic problems. This summer's price increases
have not provoked serious discontent, and the careful-
ly orchestrated explanation of Hungary's problems
will probably win continued public acceptance of the
government's actions. Nonetheless, the party may
have received some criticism from the rank and file
for not consulting adequately on its recent actions.
The party newspaper has acknowledged that Hunga-
ry's "exceptional situation" requires the adopti~~n of
measures without full debate and a consensus. On
balance, however, the frank discussion of Hung;ary's
economic shortcomings and the open debate about
policy options argue that the regime remains confi-
dent about its control and the credibility of its
policies.
Implications for CEMA
The economic burden of Hungary's problems on
CEMA would seem small. The major threat is debt
rescheduling, which would further dampen the will-
ingness of Western bankers to lend to Eastern E'surope.
Cuts in Hungary's hard currency imports would be of
little immediate significance to CEMA partners.
These countries are already slashing their own im-
ports from the West because of the credit squeeze and
are suffering an economic slowdown. The Hungarians
have not indicated that their difficulties will prevent
them from meeting their export commitments to
CEMA partners. In fact, Hungary's deliveries to
CEMA have continued to increase during the first
half of 1982.
A possible rescheduling would tarnish the image of
Hungary's reform but would probably have little
impact on economic policymaking within CEMA. All
CEMA countries are contending with serious econom-
ic problems and any reform measures will be designed
to address their own situations. We have no evidence
that Hungary's financial problems have prej i d
decisionmakers elsewhere in Eastern Europe.
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