FDI-Related Policies in Hungary 1990-2001

FDI-Related Policies in Hungary 1990-2001

Introduction

The aim of this paper is to provide fuel for discussions on foreign direct investments, and their activity in Hungary. The paper tries to pick up the most relevant issues of discussions and provides some necessary background knowledge on these. It is very difficult to remain neutral concerning foreign investments and foreign ownership. The author confesses to being an advocate of foreign investment, but also admits that there are considerable drawbacks, negative tendencies that deserve attention. This is exactly the reason why it makes sense to openly discuss issues of foreign investments.

Some Facts about Hungary

• Inhabitants: 10 million, 93 % Hungarians, 5 % Roma, 2 % other nationalities.
• GDP per capita: 6000 USD, average monthly gross salary USD 330.
• Education: (Of persons employed) 17,2%: higher education; 65,3%: secondary education; 16,7 %: primary education; 0,7 %: no completed education.

Brief Overview of Macroeconomic Context

Main macroeconomic indicators

The main macroeconomic indicators are presented in Table 1. As can be seen, Hungary underwent a rather deep transitional recession period during 1991-1995. At its deepest level, GDP reached less than 85 % of the last pre-transition years’ level. The recovery started rather slowly and started to accelerate in 1998. All in all, the Hungarian economy reached the pre-transition performance level after 10 years. This is still much better (a shorter recession period), than in many other transition economies of Central Europe. Other indicators of Table 1 such as inflation, unemployment, per capita real income, budget and BOP deficits also indicate the magnitude of decline.

Table 1. Various macroeconomic indicators of Hungary

1991 / 1993 / 1995 / 1997 / 1998 / 1999 / 2000
GDP growth (1990=100) / 88,1 / 84,9 / 88,6 / 93,9 / 98,5 / 102,6 / 108,0
Inflation % / 35,0 / 22,5 / 28,2 / 18,3 / 11,4 / 10,0 / 9,4
Unemployment % / 7,5 / 12,3 / 10,4 / 7,8 / 7,0 / 6,3 / 5,6
Investments (1990=100) / 87,7 / 88,4 / 94,2 / 107,5 / 121,2 / 127,6 / 137,2
Exports (1990=100) / 95,1 / 83,4 / 105,3 / 143,2 / 175,3 / 203,3 / 247,5
FDI stock* / 1459 / 5269 / 10869 / 14937 / 16872 / 18523 / 20323
Trade acc. deficit (% GDP) / -4,1 / -9,4 / -5,7 / -4,7 / -5,8 / -6,3 / -8,5
Current a. deficit (% GDP) / 0,8 / -9,1 / -5,5 / -3,3 / -2,0 / -4,4 / -3,2
Budget balance (% of GDP) / 0,0 / - 6,0 / - 4,6 / -4,0 / -4,8 / -3,7 / -3,4
Per capita real income (1990=100) / 98,4 / 90,2 / 88,6 / 89,4 / 92,7 / 93,5 / ..

*Cumulated value of FDI payments through the banking system

Source: CSO, National Bank of Hungary

Other measures also highlight some of the important features of structural change in the Hungarian economy. Transforming from central planning to market economy required the exchange of economic activities developed under the logic and rule of the former to ones responding to demands of the later. This deep structural change is shown in the rather fierce growth of investments, FDI and exports. Consequently, the sectoral structure of the economy changed to the one presented in Annex 1. The sectors “electrical and optical equipment” and “transport equipment” increased their shares by several times, meanwhile sectors traditionally important for centrally planned economies, like heavy industries, lost share.

Investment Flows

The main driving force of economic restructuring in Hungary was FDI. Hungarian governments and firms gathered experience with foreign firms through various co-operation links. Licence transfers, creation of joint ventures, regular supplier contacts were developed as early as in the 1970’s. This was an important achievement of the Hungarian economic reform movement. Also, foreign firms had some knowledge and experience in Hungary. Thus, the intensification of business contacts was a rather natural phenomenon after the transition process started. FDI was strongly promoted through various channels, which will be discussed later on. Consequently, Hungary became one of the most popular investment targets in Central and Eastern Europe. Table 3 contains the most important FDI figures.

Table 3. Selected indicators of foreign direct investments in Hungary (US$mn)

1991 / 1992 / 1993 / 1994 / 1995 / 1996 / 1997 / 1998 / 1999 / 2000
Inward FDI / 1459 / 1471 / 2339 / 1147 / 4453 / 1983 / 2085 / 1935 / 1651 / 1800
Privatization FDI / 435 / 492 / 1163 / 103 / 3370 / 618 / 1451 / 485 / 295 / 0
% share of privatization in total FDI / 29,8 / 33,4 / 49,7 / 9,0 / 75,7 / 31,2 / 69,6 / 25,1 / 17,9 / 0
% share of FDI in total privatization revenue / 79,6 / 61,0 / 48,2 / 8,9 / 86,9 / 52,1 / 78,1 / 67,9 / .. / 0
% share of foreign firms in exports / .. / .. / .. / 54 / 58 / 69 / 75 / 77 / 80
Outward FDI / .. / .. / .. / .. / 43 / 0 / 431 / 481 / 249 / 532

Source: Hungarian National Bank, State Asset Holding Plc.

As it is seen from the figures of Table 3, the level of foreign investments varied basically according to major privatization deals. There has been a rather steady level of investment to the tune of some USD1-1.5bn annually. On top of this, privatization revenues pushed the level of FDI higher, until the late 1990s. Then, the privatization process decelerated but FDI still continued to flow in. Meanwhile, outward FDI also gained momentum. Part of this outward FDI is relocation of foreign capacities to other transition economies and to China. Another part is due to Hungarian capital owners’ investments in neighbouring countries. Relocation of simple, unskilled labour-intensive activities and attraction of new, more sophisticated ones marks a new epoch of FDI in Hungary.

Table 4 illustrates this shift. The figures here demonstrate the very deep penetration of foreign capital in most economic sectors. The gap between earnings in foreign and Hungarian-owned companies is rather wide in most branches. We interpret this gap as a sign of superior performance. Foreign firms are able to cream the labour market. Above average figures in manufacturing are due to very low wage levels of Hungarian firms. The narrower gaps in engineering may be also due to some kind of a demonstration effect. Wages in the foreign owned sector push up wages in domestic firms as well.

Table 4. % share of foreign companies in Hungarian economic sectors (1999)

in paid in capital / in employment / in net sales revenue / gaps in per capita earnings*
Agriculture, forestry, fishing / 7,5 / 4,4 / 8,9 / 123,3
Mining and quarrying / 34,4 / 23,9 / 38,2 / 111,4
Manufacturing / 60,6 / 46,5 / 73,0 / 130,2
Food, beverages and tobacco / 60,5 / 41,5 / 59,8 / 136,9
Textile / 51,4 / 36,9 / 54,7 / 132,4
Rubber and plastic products / 55,6 / 48,1 / 57,0 / 120,7
Machinery / 53,8 / 43,5 / 55,0 / 113,1
Electrical machinery / 72,1 / 66,1 / 88,9 / 111,8
Transport equipment / 74,4 / 62,8 / 93,8 / 113,0
Electricity, gas, steam, water supply / 28,1 / 34,6 / 51,7 / 112,1
Construction / 29,1 / 9,8 / 21,3 / 196,8
Trade and repairs / 43,3 / 22,6 / 42,7 / 189,6
Hotels and restaurants / 28,0 / 19,4 / 26,8 / 152,7
Post and telecommunication / 67,0 / 11,7 / 40,7 / 200,2
Total / 37,9 / 27,4 / 50,0 / 160,7

*average earnings in foreign employment as a % of earnings in Hungarian employment

Source: CSO

As far as the countries of origin are concerned (Table 5), the bulk of the inward stock is owned by firms of the European Union (EU). Non-EU owners also registered through their European headquarters. Therefore, the Hungarian economy is rather strongly integrated in European corporate networks. This phenomenon is completely in line with UNCTAD’s description of the evolution of the triad in world economy, with fairly clearly separated interest areas. Central Europe became the most important backyard of EU-based multinational companies.

Table 5. Major countries of origin of inward FDI stock, 1999 (%)

Germany / Holland / Austria / USA / France / Italy / Belgium
27,3 / 22,5 / 12,1 / 8,8 / 6,2 / 2,7 / 2,5

Source: CSO

Figures in Table 6 demonstrate that although Hungary enjoyed a clear advantage in attracting FDI to Central Europe, its dominance was lost by the late 1990s. It seems, that the amount of capital available for investments in the region exceeds the amount Hungary can absorb. Therefore, other more developed countries like the Czech Republic and Poland caught up with Hungary.

Table 6. Selected Central and Eastern European Countries’ cumulated stock of FDI (USDmn, 2000)

Poland / Czech R. / Hungary / Russia / Romania / Latvia / Estonia
38000 / 23300 / 21254 / 20757 / 6426 / 4307 / 2106

Source: WIIW database

Overview of Main Policy Trends

Hungary has a small open economy with a relatively small sales market. The number of inhabitants is slightly over 10 million people. Moreover, the purchasing power of the population is not very strong. The per capita GDP is about half of the EU average. But the wealth of Hungarians is growing and purchasing power is increasing. The Hungarian economy is an open economy with a share of exports of GDP of about half. This openness increases the dependence of the country’s economic development on the features of its main export markets in the EU.

As all other Soviet-oriented countries, Hungary had a centrally planned economic system. This meant that instead of market mechanisms, it was the state that directed the activity of firms. Socialist enterprises had no right to take independent decisions. They had to fulfill the orders of the state authorities, the Planing Office and different Ministries. Foreign trade, and relationships to foreign firms were also centrally controlled. The state control was not pushed completely into the background even in the period of the Hungarian Economic Reform, when Hungary experimented with the partial introduction of market forces in certain areas of the economy. But the reform was not aimed at breaking with central control, thus, despite partial success (for example slightly higher standard of living), it did not change the fundament of the socialist economic system. This system proved to be inefficient and inferior to the market economy, and was quickly replaced in the process of transition during the 1990s.

Economic transition in Hungary was rather quick and straightforward. There was a nationwide consensus about the important milestones of the process. Everyone hoped that the introduction of fully fledged market economic system will quickly turn around the economy, and also the economic agents, companies. Though the process lasted perhaps longer, than it was expected, still it was perhaps the quickest in Central and Eastern Europe. Today Hungarian transition process is finished with a few exceptions. Transition process provided a lot of opportunities for foreign investors. It was therefore Hungary where foreign capital started to invest first in the region. Hungary received the most foreign investment until 1996 among countries in transition.

The first step in the transition was the liberalization of economic activity, foreign trade, prices, foreign investment. For the small open economy this meant a sudden increase of deliveries from developed countries that could provide superior quality of goods sometimes at lower prices than domestic firms. Competition on domestic markets increased tremendously, because of both increasing competitive imports, and increasing competition among local suppliers. An important question and point of discussion is if a slower, more gradual liberalization had been applied, would that have provided more time and some temporary protection for local firms to grow and match foreign competitors? There is empirical evidence that firms did not utilize such an opportunity in other transition economies. They rather tried to pressure governments when they suspected the liberalization measures were not credible. Strong competition on the other hand forced a number of Hungarian firms to undertake major restructuring efforts in order to become more competitive.

Macroeconomic decline took shape on firm level as a massive wave of market exit. There were different forms of market exit, for example formal bankruptcy and liquidation. The Hungarian bankruptcy practice was exceptionally harsh in 1992-93: all debtors with obligations past due by more than 90 days were legally forced to declare bankruptcy. Another, less draconian form of market exit was even more important: downsizing, voluntary market exit. The question can be put: What was the real impact of institutional changes? Were these responsible for the economic decline, or they were rather necessary instruments of economic restructuring? Evidence indicates that the decline of economic activity was a system specific feature of transition rather, than the result of economic policy mistake, or false institution building. But the speed of the process could have been slowed or the extent of decline reduced through the use of other policy measures.

Massive downsizing, both in domestic and foreign markets necessarily led to a decline of cooperation networks. Since former market links simply vanished, they had to be replaced, in many cases through new contacts with multinational companies. The process was especially strong in the small, open Hungarian economy. Liberalization of trade and economic activity increased both domestic and foreign competition. In order to improve or regain competitive strength, Hungarian firms soon started to replace suppliers of inferior quality and reliability. This process started well before and independent of the bankruptcy wave of 1992. Replacement of suppliers usually meant imports from developed economies. Improved supplies substantially increased competitiveness for numerous Hungarian firms. Increased competition had stimulating effects on the Hungarian economy. There were fundamental changes in downstream direction as well. Hungarian firms’ sales markets altered from CMEA sales to OECD, especially EU sales. The later strong economic growth however, was mainly driven by greenfield investments of multinational companies. This also meant an increasing role of foreign supplies in Hungarian production facilities. Hungary’s role in the international labour division changed: it became an integrated part of global (mostly European based) business.

Privatization and foreign investment

Privatization was also an important factor of corporate networks’ development. Hungarian privatization policy favored sales to foreign strategic investors. The logic of this decision was that foreign firms possessed the necessary technology, know-how, market share and capital for the successful restructuring of Hungarian firms. The state also needed cash revenue in order to finance growing trade balance deficits. Privatization primarily developed along existing business links, speeding up the process and making matchmaking unnecessary. Management of Hungarian firms was also provided an active role in shaping privatization practice. This role was often used to support the sale of firms to previous foreign cooperating partners. In these cases cooperation links were further strengthened even before the privatization deal was concluded. Later, when the deal was accomplished and the Hungarian firm became an affiliate, up- and downstream business links were reconsidered, and usually substantially changed.

The spectacular success of Hungary in attracting FDI in the early 1990s was largely based on FDI preference in privatization policy. Until 1994/1995, FDI was mostly conducted through either the establishment of joint ventures, or privatization. Even some greenfield investments started in the privatization process. For example, GM purchased a workshop from the privatization agency to put up the Szentgotthárd Opel works.

Privatization related FDI meant in most cases an interest of investors in corporate assets like facilities, workforce, products and brands, markets, even suppliers in some cases. The level of local supplies is markedly higher in these cases than for greenfield investments. In food industry, for example, the purchase of processing plants automatically meant access to local agricultural output. In the case of food industry this fact is even a topic of discussions, since agricultural producers feel exposed to superior economic power of foreign owned food processing companies. This could have been avoided with farmers’ access to some ownership rights in processing units. Since however, foreign owners usually gradually increased their ownership share towards even exclusive rights, it is not very likely, that they would have allow significant Hungarian ownership. Besides, many Hungarian manufacturers were acquired by larger foreign companies during the 1990s, as in the dairy industry. On the other hand, farmers’ fears of replacing their supplies with imports did not materialize. Still, a more powerful competition policy might be applicable in certain markets where concentration is very high (e.g. vegetable oils, sugar, tobacco, etc.).

The pioneering role of Hungary in developing policies of transition was also evidenced in privatization. Hungary was the first economy to open up markets and sell firms in services such as telecommunications, energy and water supply and banking and finance. This required a redefinition of market regulation. New laws on telecommunication, on concessions, on energy and water supply were passed with specific sales agreements for buyers of the services firms. These contracts closely described the duties of the service provider, and contained also guidelines and statements for the state for the further development of the regulatory framework. When prices were kept under government control, the principles of setting prices contained mechanisms of securing a certain level of profit for the new owner’s activity. The contracted obligations of the state contradict sometimes with other economic goals, such as anti inflation and welfare measures. The services privatization is therefore frequently criticized.

Foreign investment policy

Government policy towards foreign investors has been one of the most favourable in Central and Eastern Europe. The origins of the policy traced back a decade before transition started. Inviting FDI to Hungary, mainly in the form of joint ventures was a major policy aim during the 1980s and a fairly large number of JVs were established.

In the beginning of the nineties parallel with the liberalization of trade and economic activities a generous legal framework was created for foreign investors. Establishment of joint ventures with foreign capital participation was promoted by allowances of corporate income tax. State subsidies were offered for large-scale investments in certain high technology sectors (electronics, automotive, biotechnology, communications, etc.) and in tourism, for investments in depressed regions with a requirement of certain amount of job creation, and for increasing exports. Later, investment subsidies were expanded to domestic companies as well. But conditions based on investment size and cost-sharing mean that it is mainly foreign firms who are able to apply.. The scope of subsidized investments was further increased in the new Hungarian development plan (the Széchenyi Plan). Among others, creation of industrial parks, industrial clusters, incubator houses, establishment of R&D facilities, R&D cooperation between industry, university and academia are supported. Cash subsidies must be withdrawn soon, since they do not conform with EU regulations. The question emerges if the attraction capacity will decline?

Another tool of investment promotion relevant to foreign companies and especially to assemblers is the regulation of industrial free trade zones. Regulation was introduced in 1982 with the aim of attracting export-oriented, high technology FDI to Hungary and to integrate these companies into the host economy. The risk of developing a dual economy through regulation was recognized. It was decided therefore that there would be no geographical restrictions for the zones. A company simply requires a license from the customs and finance authorities. The zones are ex-territorial from the aspect of customs and excise duties, VAT on machinery, foreign exchange and other legislation. This is an extremely favorable regulation for assemblers which require only labour as a local input, as it enables them to import high value equipment free of duty. They were also allowed to keep books and accounts in foreign currencies that allowed them overcoming of currency exchange risks.