Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-4796-HU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INDUSTRIAL SECTOR ADJUSTMENT LOAN TO THE HUNGARIAN PEOPLE'S REPUBLIC IN AN AMOUNT EQUIVALENT TO US$200 MILLION May 27, 1988 Industry and Energy Operations Division Country Department IV Europe, Middle East and North Africa Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit - Forint (Ft) Average Exchange Rates (Forints per US$) 1983 1984 1985 1986 1987 1988 (Jan.) US$1.00 = Ft. 42.7 48.0 50.1 45.8 47.0 47.2 WEIGHTS AND MEASURES Metric System ABBREVIATIONS CMEA Council for Mutual Economic Assistance DRC Domestic Resource Cost NBH National Bank of Hungary NPO National Planning Office R&D Research and Development TFP Total Factor Productivity FISCAL YEAR January 1 - December 31 FOR OMCIAL USE ONLY HUNGARY INDUSTRIAL SECTOR ADJUSTMENT LOAN Table of Contents Page No. Loan Summary i-ii PART I - THE ECONOMY 1 A. Recent Economic Developments 1 B. Prospects for 1988 and Beyond 4 PART II - BANK GROUP OPERATIONS IN HUNGARY 6 A. The Bank's Lending Strategy 6 B. Status of Bank Group Operations 8 PART III - THE FRAMEWORK FOR INDUSTRIAL POLICY REFORM 8 A. Structure and Performance of Industry 8 B. Strategic Issues in the Industrial Sector 10 C. The Economic Stabilization and Structural Reform Program 11 D. Industrial Policy Reforms 12 PART IV - THE PROPOSED LOAN 21 A. Loan Features and Implementation 21 B. Monitoring and Tranche Release 22 C. Coordination with the IMF 23 D. Social Costs 24 E. Risks 24 PART V - RECOMMENDATION 25 Annexes 1. Social Indicator Data Sheet 26 2. Key Macroeconomic Indicators 30 3. Balance of Payments in Convertible Currencies 31 4. Status of Bank Group Operations 32 5. Macroeconomic Program, 1988-90 34 6. Letter of Sector Development Policies 35 7. Supplementary Loan Data Sheet 56 Map IBRD 17361R1 This document has a restricted distribution and may be used by re- . only in the performance of their official duties. Its contents may not otherwise be disclosef withow World Bank authorization. - i - HUNGARY INDUSTRIAL SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: Hungarian People's Republic. Amount: US$200 million equivalent. Terr 15 years, including five years of grace at the Bank's standard variable interest rate. ObJectives and Description: The loan would support the Government's program of economic stabilization and structural reform with industrial sector policies being a central part of the policy reforms. The objective of the program is to increase the efficiency and international competitiveness of the industrial sector to enable increased Hungarian exports to the convertible currency markets. Policy objectives being supported by the loan cover: (i) increasing domestic and external competition in the economy, (ii) tightening financial discipline in the enterprise sector, and (iii) facilitating the mobility of capital and labor to enable restructuring of industry. These reforms are an integral part of the 1988-90 economic program approved by the Government in September 1987 and being supported by a Standby Arrangement of SDR265 million with the IMF. The loan would provide US$200 million equivalent to finance general imports of goods. Benefits and Risks: Industrial policy reforms are expected to lead to efficient restructuring and growth. While the focus of the reforms is on the industrial sector, many of the reforms are systemic in nature and would have an economy-wide impact. Successful implementation of the reform would lead the economy to a path of sustainable growth by improving the efficiency, flexibility and market-responsiveness of the structure of production. The main risk of the policy reform program is the possiblity of inadequate implementation of the macroeconomic stabilization policies which would provide the conditions for a strong supply response from industrial policy reforms. The strong commitment by the -i i- Hungarian authorities to implement the stabilization program while accelerating the industrial restructuring program reduces the risk. The feasibility of the program is anhanced by the fact that a new leadership, committed to the reform, has been put in place for its implementation. Overall, while there are risks in the implementation of a reform program in a climate of austerity, the level of risk is acceptable. Nonetheless, implementation of the program will require intensive monitoring by Bank staff. Estimated Disbursements: The loan will be disbursed in two tranches. The first tranche of $100 million would be available for disbursement at the time of loan effectiveness, and the second tranche is expected to be released in early 1989, on the basis of : (i) satisfactory progress in the implementation of the 1988 economic program, and the adoption of a 1989 Annual Plan and Central State budget, including a public investment plan, which would (a) reduce the budget deficit further and facilitate halting the growth of external debt by 1990; and (b) reduce producer and consumer subsidies and financial support by at least l0X annually from the 1988 level; and (ii) satisfactory progress in the implementation of critical measures which form part of the agreed industrial sector policy reform measures. Economic Rate of Return: Not applicable. Appraisal Report: None. M P: IBRD 17361R1 REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INDUSTRIAL SECTOR ADJUSTMENT LOAN TO THE HUNGARIAN PEOPLE'S REPUBLIC 1. I submit the following report and recommendation on a proposed Industrial Sector Adjustment Loan of US$200 million equivalent to the Hungarian People's Republic. The Loan would be amortized over a period of 15 years, including a grace period of five years. The Loan would be at the Bank's standard variable interest rate. PART I - THE ECONOMY 2. A Country Economic Memorandum (Report No. 5951-HU) was circulated to the Executive Directors in 1986. A mission to update the Country Economic Memorandum visited Hungary in July 1987. The findings of the mission were discussed with the Government in October 1987 and January 1988. The following assessment is based on the findings of the mission. The report of the mission is expected to be distributed to the Executive Directors shortly. Country data sheets are attached as Annex 1. A. Recent Economic Developments 3. Following an economic crisis in the late 1970s and early 1980s, Hungary had stabilized its economy by the end of 1984 with the help of two IMF Standby Arrangements which enabled the country to avert a liquidity crisis. The current account was in surplus, as was the Central Government budget. The stabilization was mainly due to tight demand management, including administrative restrictions on imports, which however had created pent up demand. In 1985 the Government initiated a vigorous renewal of the economic reform program, which had been begun in 1968. Reforms to further the goals of decentralization and reliance on "indirect regulators", or market-based signals, to guide economic actions were instituted. 4. The macroeconomic environment in which the reforms were implemented was, however, not supportive. The authorities judged that, following the stabilization period, a more expansionary demand management policy was justified. This led to a rapid growth of monetary and credit aggregates due to the expansionary fiscal stance, which increased Government expenditures (Figure 1) and fiscal deficits. Part of the reason for the growing fiscal deficits was the increase in State financial support to enterprises. Increased support to enterprises reduced financial discipline and insulated enterprises from the effects of the reforms, and rest%lted in poor performance in the enterprise sector. Consequently, economic performance was poor: real GDP declined by 0.32 in 1985 and grew by only 1.5% in 1986. Nonruble exports fell by 6.62 and 3.82 respectively (Annex 2). - 2 - Figure 1 Central Govt. Revenue and Expenditures so (pert of crent puce GM '57 66 A a s - e 56 54- 62 - s lla 1061 1062 1063 1904 1966 1066 1967 5. Nonruble exports suffered from the contraction of export markets in the Middle East and some developing country markets, and the effects of poor weather on agricultural production, especially of grain. In addition, the profitability of sales to the convertible currency area compared with the domestic market declined in 1985 and 1986. Nonruble import volume increased by an average of 1.7% per year in 1985-86. There was also a cumulative 8.2% deterioration in the terms of trade. The deterioration was due to the heavy concentration of raw materials and semi-finished goods and bulk agricultural products, where world prices were declining, in Hungary's exports. In addition, since a significantly higher proportion of Hungary's exports are denominated in US dollars compared with imports, the depreciation of the dollar against other major currencies worsened the deterioration. As a result of these forces, the trade and current account balances deteriorated sharply. 6. Starting from a surplus of US$329 million in 1984 (Annex 3), the convertible currency current account deficit reached US$1,419 million in 1986 (6.02 of GDP). The growing current account deficits were financed by higher foreign debt. In addition, however, the resulting increase in external indebtedness was exacerbated by the sharp movements in the cross-currency exchange rates that began in 1985 and the shift in the composition of new borrowings into currencies that subsequently appreciated against the US dollar. As a result of the increase in debt and the poor supply side performance, three key creditworthiness indicators - the net debt to GDP ratio, the net debt to exports ratio, and the debt service ratio - all deteriorated in 1985-86 (Figure 2). - 3 - Figure 2 CoedItworthInoss Indlcators 1.4- 1.3- 1.2 0.91 1.0 0.4- 0.41 0.2- md , fu -0.1 1081 1982 1089 1984 1s86 1986 1087 7. A major part of the problem in 1985-86 was the unsatisfactory supply response in the industrial sector. Industrial value added fell by 1.31 per year in those years, and relatively strong growth was recorded only in the service sectors, partly because of the continued dynamism of the private sector. The poor overall performance, especially of industry, may be related to the protracted decline in fixed investment, which began in 1979. That decline exposed deficiencies in the composition of investment, which were less noticeable when investment was growing more rapidly. Inefficient investments, particularly those in the coal mining and heavy engineering industries, have been a burden on the economy in the 1980s. 8. Corrective Measures. Throughout the 1985-86 period, the authorities attempted to improve macroeconomic management and implement the economic reform. The maintenance of a sound macroeconomic environment was emphasized in the first Industrial Restructuring Project (Loan No. 2700-HU), which became effective in mid-1986. As the seriousness of the macroeconomic situation became evident by mid-1987, the authorities decided, with Bank advice, on a quantitative target for reducing the fiscal deficit in conjunction with the second Industrial Restructuring Project (Loan No. 2834-HU). Corrective measures were taken in mid-1987 to reduce the budget deficit to Ft35 billion (2.9% of GDP) from the planned level of Ft44 billion, to tighten financial conditions for enterprises, to reduce domestic demand and thus improve the convertible currency current account balance. In March 1987, consumer price subsidies were reduced to contain the fiscal deficit, and the Forint was - 4 - devalued by 8%. Punitive taxation of wage increases in excess of productivity gains was applied. Further reductions in consumer subsidies were implemented in July 1987 and the Forint was devalued by a further 5% in November. These measures were effective in reversing the deterioration in internal and external balance, though the extent of the improvement was somewhat less than the authorities' expectations, partly due to a continued increase in household consumption. 9. Real household consumption in 1987 grew by 2.8% compared to the planned reduction of 0.5-1.0%. Part of the reason for the unplanned increase in consumption was anticipatory buying before the introduction of a value-added tax in January 1988 which, when announced in mid-1987, was expected to raise consumer prices by an average of 15% in 1988. In sharp contrast to 1985-86, however, strong domestic dem.land did not result in a decrease in nonruble exports, which are estimated to have grown by 5% in 1987 as compared to a fall of 6.6% and 3.8% in 1985 and 1986. A major reason for the better export performance was an improvement in the profitability of nonruble exports. The active exchange rate policy that began in 1986, and the change in the domestic pricing system in March 1987 to permit nominal devaluations to increase the profitability of nonruble exports compared with domestic sales, contributed to the improvement in export performance. 10. The turnaround in the performance of nonruble exports was a principal cause of the improvement in the convertible currency trade balance from a deficit of US$539 million in 1986 to a US$3 million surplus in 1987. The trend has continued in 1988. The improvement in the trade balance led to an almost equal improvement in the convertible currency current account, which ended the year with a deficit of US$847 million - a reduction of US$572 million (40%) from the 1986 level. Despite these improvements, there was a further large increase in gross and net external indebtedness, mainly arising from continued valuation losses caused by the depreciation of the US dollar. 11. The supply side of the economy also improved in 1987 as GDP growth .ccelerated to 3.4%. Industrial production grew by 4.1%, reversing the trend of the previous two years. In addition, the service sectors continued to grow faster than the economy-wide average for the same reasons as in 1985-86. Wheat production was again adversely affected by the third consecutive year of drought, but higher meat production kept value-added in the agriculture sector as a whole from falling. B. Prospects for 1988 and Beyond 12. In order to strengthen and sustain the turnaround in economic performance in 1987, the Government developed a medium term Economic Stabilization and Structural Reform Program for the 1988-90 period described below (paras. 36-38). The main goal of the program is to stop the growth of external debt by the end of 1990. The central feature of the program is a sharp contraction in domestic demand in order to bring about a significant improvement in the convertible currency current account. The main instruments for achieving the objectives of the program are: a strict limit on nominal - 5 - wage increases, further reduction of the budget deficit, ceilings on the growth of credit aggregates, an active exchange rate policy, and an active interest rate policy to raise household and enterprise savings rates. 13. Medium term macroeconomic projections on the basis of the implementation of the medium term program are attached as Annex 2. Projected changes in key macroeconomic indicators are depicted in Figure 3, showing the turnaround achieved by the economy in 1987, ai the targeted stabilization in 1988. The program is expected to lead to a steady improvement in the current account balance until a near balance is reached in 1990. The Government's net financial position is expected to continue to improve, due partly to reductions in support to enterprises. The continued improvement would support the stabilization of the economy, and improve its responsiveness to the reforms. Gross capital inflows are projected to average US$2.0 billion annually in 1988-90, down sharply form tuie 1985-87 levels. Lower capital inflows and the improved supply side performance are expected to lead to improvements in the creditworthiness indicators. Overall, the implementation of the economic reform, including measures to improve the efficiency of investment (see below) is expected to lead to a sustainable growth path. Figure 3 Projection of Key Indicators (Percent of current prce ODP) 16- 14 - 12- svwo 10 1 , p4 -2 - 0S -4Aoun aaxP -s 1982 1983 1964 1985 1986 1987 1066 1069 1990 1991 1992 14. The Public Investment Program. The public investment program for 1988-90 calls for increased allocation of investment favoring the manufacturing industries where Hungary is potentially competitive. In 1986 there was a shift in investment composition toward the manufacturing industries and away from the basic materials and electric energy subsectors. - 6 - Estimated 1987 results indicate that the favorable trends observed in 1986 continued. Fixed investment increased by 5.52. The share of mining continued to decline, but the share of electric energy, reflecting the large expenditure on the construction of the Paks nuclear power plant, grew. 15. The Government has agreed to carry out a review of the 1989-90 public inivestment plan, under terms of reference agreed with the Bank by the end of 1988. The result of the review will be reflected in the public investment plan for 1989. The authorities' efforts to improve the structure of investment include reducing investments financed by the Central Government budget from 44% in 1981 to 31% in 1988 and increasing the share of investment financed by enterprises, which should result in better investment choices as a consequence of tightened financial discipline. In 1987 there were 8 large Central Government projects each exceeding Ft500 million, down from 13 in 1984. The authorities envision no new large projects for the remainder of the Plan, and have reduced and stretched out expenditures on some of the existing projects. In 1988, expenditure on large projects is projected to fall by 15 percent in nominal terms, which would imply a cut of nearly 50 percent since 1983. Expenditure on Central Target investments, which are mainly for coal mining, development of the electricity network, rail and road transport, and the communications system has fallen slightly since 1983. The Plan for 1988 shows total target investment spending rising slightly. A third group of public investments are concentrated in services such as public health, social services, education, culture and others. Spending on this group has also fallen sharply since the early part of the decade. PART II - BANK GROUP OPERATIONS IN HUNGARY A. Bank Lending Strategy 16. Since lending to Hungary began in 1983, the Bank's strategy of assistance has focussed on supporting Hungary's program of structural adjustment in the economy to make it more efficient, flexible, market responsive and competitive in external markets, particularly in the convertible currency area. Until 1985, this strategy was reflected in lending operations focussed on selected sectors, i.e. agriculture, industry, energy and transport. Institution building measures, such as the establishment of project analysis capacity, studies and analysis of road user charges, strengthening of capacity to analyze relative efficiency of industrial subsectors, relative prices in agriculture, development of least cost investment programs and application of long-term marginal cost pricing in the power subsector were implemented. 17. Extensive economic and sector work in the agriculture, energy industry, financial and transportation sectors provided the analytical basis for the Bank's policy dialogue with the Government. Apart from such sector specific reviews, a review of public investment1' and the 1984/86 Country 1/ Hungary - Investment Issues and Options (Report No. 5585-HU, dated August 25, 1986). - 7 - Economic Reports and memoranda have focussed on economic policy issues. These studies have been the basis for the gradual deepening of the ?ank's dialogue on management of the economy and the design of the economic aId industrial policy reforms. A study1' of the policies, performance and constraints in the industrial sector carried out jointly with the Government was particularly instrumental in this respect. 18. The 1985-90 industrial policy reforms, which form the cornerstone of the Bank's lending to Hungary, were designed in close collaboration with the Bank. The main vehicle of Bank support to the reform has been the two industrial restructuring projects, with a "hybrid" design which combined subsector and enterprise restructuring with support to policy changes to encourage competition, tighten financial discipline and enhance resource mobility in the economy. As the economy deteriorated during 1985-86, the Bank advised the Government to accelerate the reform process while further strengthening the macroeconomic and sector policy content of lending operations. The proposed loan with its explicit coupling of the economic stabilization and structural reform objectives is an evolution of this process in response to the current economic situation. 19. The close collaboration between Hungary and the Bank in the design of the economic reform program has resulted in close correspondence between Hungary's development strategy and the Bank's program of assistance. Future lending operations will support the goals of the economic reform. During 1988-90, the Bank's program of assistance will focus on adjustment, particularly in industry but also of broader aspects of the economy such as the incentive system and the regulatory framework for trade. There is a strong complementarit; between adjustment lending and investment lending in Hungary. Investment operations in the industry sector are planned to: promote needed restructuring of enterprises and subsectors toward improved international competitiveness; foste- growth of small and medium enterprises as well as feeder industries required to deepen Hungary's industrial structure; strengthen technological development capacities; and more important, support development of the evolving financial institutions. Systemic reform supported by adjustment operations will provide a supportive policy and institutional environment and increase the likelihood of success of inves ::.ent operations. 20. Investment operations in agriculture, energy and infrastructure have been designed to further restructuring in those sectors, while the knowledge and experience gained from the implementation of investment lending operations has been an important input into the development of the reform program and the proposed loan. Improvements in the capital stock resulting from the investment operations in the productive sectors of the economy are also needed to establish a sustainable supply response. 21. The Bank also plays a role through the catalytic effect of its assistance program on other international lenders. This will be a particularly crucial role in 1988-90 when Hungary needs access to international capital markets. Successful stabilization combined with the 1/ Hungary - Industrial Policy, Performance and Prospects for Adjustment (Report No. 6124-HU, dated September 30, 1986.) - vigorous and consistent implementation of the economic reform will improve Hungary's creditworthiness and its standing among international lenders. The Bank s role as a catalyst for other lenders will gradually decrease, and after 1990 the overall level of lending to Hungary is expected to be at a level consistent with continued support for economic reform and structuring, which is a medium-term process. The Bank's exposure in Hungary is relatively modest. The Bank's share of the disbursed and outstanding debt of Hungary is projected to be 10.7% in 1993, and its share in debt service will reach 8.7%. Measured by the exposure indicators, the risk to the Bank will remain manageable. B. Status of Bank Group Operations 22. The Bank, as of March 31, 1988, had provided 19 loans for a total of US$1,312.5 million (Annex 4). These include six B-loans with a Bank share of US$136 million. Of the total Bank commitment, 43% was in the industrial sector, 32% in the agricultural sector, 16% in the energy sector, and 8% in the transport sector. 23. The Bank was successful in mobilizing six commercial cofinancing syndications for the Bank-assisted operations in FY83 to FY85. They helped to mobilize nearly US$1.2 billion, including the Bank's contribution of US$136 million. In all these cofinancing operations, the Bank was able to improve the terms over the most recent Hungarian borrowings and to introduce the country to commercial banks from which it had not borrcwed previously. The Bank's participation in B-loans was discontinued in 1985 after Hungary had regained adequate access to financial markets on favorable terms. 24. Project implementation in general has been satisfactory. Disbursement performance has been good. Total disbursements at the end of March 1988 amounted to US$820.4 million. The disbursement ratio (calculated as total disbursements in a fiscal year divided by the undisbursed amount at the end of the previous fiscal year) has been good at about 40%. 25. Since Hungary joined IFC in April 1985, IFC's activities focussed on promotion of direct foreign investment through joint ventures and in the cooperative sector. IFC participated in the establishment of a private joint venture bank and in financing two industrial ventures. IFC's total commitment in these operations amounts to US$19.3 million. It is actively seeking to participate in other projects, especially those requiring technical collaboration with foreign partners. IFC's participation would also help develop new financial instruments and activities such as leasing. PART III - THE FRAMEWORK FOR INDUSTRIAL POLICY REFORM A. Structure and Performance of Industry 26. Industry is the largest sector in the economy. It accounts for about one third of GDP, employment, and fixed investment and for about 75% of - 9 - total exports (Table below). The sector can be divided into the energy (coal, gas and oil) and basic materials subsectors, which represent 20-252 of industrial value added, and the manufacturing subsectors. The former group includes the "smokestack" industries of Hungary, coal-mining and ferrous metallurgy. The poor performance of these industries has been a drain on the economy. The authorities have recognized the need for restructuring these subsectors, and a restructuring plan for metallurgy that will eliminate the need for Government subsidies after 1990 is being implemented. Restructuring the coal-mining subsector is more difficult, principally because of ti Larger number of workers involved and the potential localized area impact. Nevertheless, the authorities recognize the need to close unprofitable pits and are developing a restructuring plan for the coal-mining subsector which will be finalized by the end of 1988 (para. 49). Selected Data on the Industrial Sector (1986) (Ft billion and Percentages) GDP Investment Nonruble Exports Amount % Amount X Amount X Mining 49.1 15.5 16.6 22.9 1.2 0.8 Electric Energy 28.5 9.0 13.6 18.8 0.0 0.0 Metallurgy 9.8 3.1 4.1 5.6 20.7 13.2 Engineering 110.2 34.9 8.7 12.0 40.9 26.0 Building Materials 46.2 14.6 2.2 3.0 24.0 15.3 Chemicals 42.5 13.4 12.5 17.3 36.3 23.1 Light Industry 14.8 4.7 5.7 7.9 2.8 1.8 Food Processing 10.3 3.3 8.8 12.2 30.5 19.4 Other 4.6 1.5 0.2 0.3 0.7 0.4 Total 316.0 100.0 72.4 100.0 157.1 100.0 27. A study of the policies, performance and constraints affecting the industrial sector was carried out collaboratively by the Government and the Bank (para. 49) to analyze the international competitiveness of Hungarian industry. Most of the manufacturing industries were found to be potentially competitive as measured by a domestic resource cost (DRC) below 1.1. Hungary is also competitive in construction materials, chemicals and light industry. Total factor productivity growth during 1980-85 was positive in these subsectors, a marked contrast to the energy and basic materials subsectors. The study also concluded, however, that growth in productivity in the manufacturing subsectors, especially in capital productivity, was below international norms. 28. Industrial production grew by 4.12 in 198?, a marked improvement over 1985-86. Within the industrial sector, the chemicals, electric energy, engineering and machinery, and construction materials subsectors recorded better than average growth. Part of the improvement is attributable to the - 10 - estimated 6.0% growth in nonruble exports by units in these subsectors, with a particularly strong growth in the chemical and light industry subsectors. This export performance indicates improvements in the competitiver.ess of the sector. 29. Improved performance of the industrial sector is a key to the success of the program in the medium term. There is evidence that performance of industry is improving following two disappointing years in 1985-86. While some of the improvement was due to strong domestic demand, nonruble exports also increased by an estimated 5%, a change from earlier years when domestic demand had the effect of crowding-out nonruble exports. The improvement in incentives for nonruble exports compared with either domestic sales or ruble exports accounts for some of the improvement. The Government intends to maintain the incentives for nonruble exports through an active exchange rate policy. B. Strategic Issues in the Industrial Sector 30. One of the primary reasons for the poor performance of industry has been the policy environment within which the sector has operated. The economic reform replaced the physical planning system with a new system of economic planning and management linked to markets. While this important achievement enhanced economic efficiency in industry, some strategic issues remain. These are: (a) limited domestic and international competition, (b) limited resource mobility, and (c) the lack of financial discipline and weak autonomy of enterprises. These issues are discussed below. 31. Competition. Limited domestic and international competition has sharply curtailed incentives for improved performance and productivity resulting in an adverse impact on technological, quality and cost competitiveness. The regulatory, financial, and other barriers to free entry and exit of enterprises created a highly concentrated industrial structure and limited the degree of domestic competition and resource mobility. Legal forms of enterprises acceptable to social ownership were limited. Credit allocation preference was given to large state enterprises, crowding out small and medium enterprises. Liquidation of state enterprises was traditionally considered to be incompatible with the principle of the indivisibility of social property and with the guarantee of full employment. Failing enterprises were either subsidized or merged with other enterprises. 32. The most important instrument that limited international competition, both at home and abroad, was the state regulation of international trade until 1986. Competition among the state foreign trade organizations was weak. Regulatory barriers to entry included restrictions on product categories of the trading organizations, and severely limited trading rights granted to other enterprises. Increased competition in international trade activity was therefore one of the earliest reform measures under which producing enterprises were given the right to engage in export trade without going through a foreign trade organization. Quantitative restrictions on imports, which severely limited import competition, were reversed in 1985. 33. Resource Mobility. Structural adjustment in industry has been impeded by institutional and policy constraints on the reallocation of - 11 - resources away from uneconomic activities and towards activities where Hungary has a dynamic comparative advantage and the potential for increased convertible currency exports. The capital market as such had not existed during most of the post-war period and securities as instruments for resource mobilization and investment were introduced only recently. Competition in banking began to develop with the banking reform of 1987, when independent commercial banks were set up to take over credit activities of the National Bank of Hungary (NBH) but is still modest. These conditions have in general limited efficient mobility of capital in the economy. Among important factors that limited resource mobility, particularly out of uneconomic activities, were the barriers to exit of enterprises. 34. Since 1981, most industrial products have been placed under pricing rules designed to align them with world market prices, reflecting the actual or potential import or export prices of the convertible currency area. From 1987, the only pricing rule that exists is the limitation that domestic prices should not exceed the cost of comparable imports plus tariffs. These pricing rules represent a major departure from the preceding regime, where most prices were set administratively on the basis of production costs. Wage policy, implemented historically through wage level guidelines and heavy taxation on wage increases, resulted in small wage differentials which reduced labor mobility. 35. Enterprise Discipline and Autonomy. The above constraints combined with the framework in which state enterprises were managed, including no bankruptcy risk until 1986 and limited managerial autonomy, molded enterprise behavior away from attention to market demand, profits, and cost and quality performance. Instead, enterprises focussed on bargaining with the State, which was reflected in their organization, planning, marketing and financial management capability. A high tax incidence on profits further reduced the profit orientation of industrial enterprises. This past environment resulted in little premium being attached to profitability, financial prudence, innovation and productivity improvement. C. The Economic Stabilization and Structural Reform Program 36. The Government has recognized that an industrial policy reform could proceed and result in the required supply response only under the framework of supportive macroeconomic policies. It was evident from the disappointing performance of the industrial sector during 1985-86 that the macroeconomic policies needed to be tightened to support industrial policy reform. Recognizing the shortcomings of past macroeconomic policies and the need to contain and eventually halt the increase in convertible currency debt, the authorities developed an Economic Stabilization and Structural Reform Program in mid-1987 that shifted the focus of the Seventh Five Year Plan (1986-90) toward a greater emphasis on stabilization and acceleration of structural reform. The main goal of the program, which is summarized in Annex 5, is to stop the growth of external debt by the end of 1990. The central feature of the program is a sharp contraction in domestic demand to brir.g about a significant improvement in the convertible currency current account. The authorities acknowledge that past stabilization efforts have set back the economic reform and are determined to avoid a repetition of a similar occurrence by pursuing accelerated implementation of structural reforms in parallel with the economic stabilization program. - 12 - 37. The Macroeconomic Program. The Parliament approved the Government's program in September 1987. The program for 1988 requires a reduction in domestic absorption of 1.25%. Real wages are to decline by 9%, and household consumption by 2.0-2.5%. The program's acceptance of real cuts in household consumption is a major policy shift, as household consumption has not fallen in over thirty years. There is political consensus that these developments are unavoidable if economic stabilization and recovery is to be achieved. 38. In September 1987, the Government requested IMF support to its program. Agreement was reached in January 1988 on a one year Standby Arrangement of SDR265.35 million (about US$365 million), which was approved by the IMF board on May 16, 1988. The Government has agreed to implement (a) a reduction in real wages, household consumption, and domestic absorption to bring down the budgetary and current account deficits to FtlO.4 billion (0.8% of GDP) and US$500 million (1.9% of GDP) respectively in 1988; (b) strict limits on credit expansion; and (c) use of an active etchange policy. In addition to these macroeconomic stabilization features, the agreement supports a number of broader medium term structural reform measures. These include: a ceiling on support to loss-making enterprises; tax, wage and price reforms; liberalization of export trade; a flexible interest rate policy, banking reform, and capital market and corporate legislation reform. D. Industrial Policy Reforms 39. Within the overall economic stabilization and structural reform program, the three issues of strategic importance for the industrial sector (paras. 31-35) have been formulated into comprehensive industrial policy reforms by addressing them through both the factor and product markets in which industrial enterprises operate. This approach has been supplemented by strengthening the basic building blocks of competitive and efficient markets -- liberal entry, free exit, and freedom of production and exchange by autonomous economic entities. The industrial policy reform consists of the following eleven components which are central to the reform of the Hungarian economic system: entry of enterprises; liquidation; international trade; pricing; taxation; wage differentiation and worker mobility; capital market development; the banking system; enterprise management system; direct foreign investment; and technology development. 40. The objectives, major elements and the medium term timetable for industrial policy reforms were developed by the Government jointly with the Bank and are outlined in the Letters of Intent submitted to the Bank by the Hungarian authorities in May 1986 and 1987, which formed the basis for the first two industrial restructuring projects. Details were presented in the Staff Appraisal Report for the First Industrial Restructuring Project (Report No. 6069-HU, dated May 7, 1986), and updated in the Staff Appraisal Report for the Second Industrial Restructuring Project (Report No. 6643-HU, dated May 15, 1987). 41. Progress since 1985. The industrial policy reforms across all the 11 areas form an integrated package of structural changes in the industrial sector. While coordinated action on all areas is essential for the reform to produce its full effect, the emphasis given to individual areas has changed - 13 - from year to year according to evolving circumstances. During 1985-87, the highest priority was given to: (a) reform of the enterprise management system, (b) enactment of the liquidation framework, (c) increased competition in international trade activity, (d) setting up a two tier banking system, (e) reform of the system of enterprise accounting and information disclosure practices, and (f) preparation of the tax reform. A Restructuring Council headed by the Deputy President of NPO and including representatives of various Government agencies and NBH was set up under the First Industrial Restructuring Project to monitor the timely introduction of the agreed reform measures. The Council is supported by a Policy Task Force. Since 1985, measures have been implemented in all of these areas according to the commitments agreed under the first two projects. 42. Assessment of the Reforms. The reforms as reflected in the Government's Letters of Intent are intrinsically sound and remain adequate in the current economic environment. The implementation of the reforms, and consequently, their results have clearly fallen short especially during 1985-86. However, the Hungarian reform process has surmounted, in the last two years, some major ideological and political barriers that appeared insurmountable only a short time ago, and which remain serious obstacles to reform in some neighboring socialist countries. These include 'hr rtsistance to recognizing the possibility of open unemployment and of liquidation of state enterprises; existence of wage differentials; legalizing private entrepreneurship and ownership of means of production; taxation of private incomes; and even to considering mixed ownership of enterprises. Widespread systemic reforms such as those underway in Hungary will take several years to produce the desired changes in managerial attitudes and behavior, and ultimately, stronger economic growth. The focus of the proposed operation is to ensure that the necessary framework of incentives and supportive measures is put in place in an accelerated and consistent manner to increase the prospect of success. 43. The 1988-90 Industrial Policy Reforms. As in the earlier operations, the industrial policy reforms to be implemented during 1988-90 will address all 11 policy areas. The objectives continue to be to tighten financial discipline in the enterprise sector, increase competition and improve resource mobility. Unlike in the 1985-86 period, industrial policy reforms will proceed under a much more supportive macroeconomic policy framework. The highest priority will be accorded to those areas which are likely to have immediate impact on Hungary's macroeconomic problems. These are: (a) further reduction in budgetary support to inefficient enterprises and subsectors and stringent application of the liquidation framework; (b) strengthened incentives for convertible currency exports, with necessary changes in regulations; (c) facilitation of entry of new enterprises and private entrepreneurship; (d) further reform of taxation, pricing and wage systems; and (e) reduction in producer and consumer subsidies. The policy industrial reforms for 1988-90 agreed with the Government are contained in the Government's Letter of Sector Development Policies, dated May 26, 1988 attached as Annex 6 and discussed below. 1. Entry of Enterprises 44. Increased competition is one of the most important facets of the reform. The Government will therefore liberalize regulations to facilitate - 14 - the establishment of different forms of economic associations and conversion to other forms. Currently, legislation is being finalized permitting: (i) state enterprises to convert themselves into joint-stock companies, (ii) individuals to own negotiable and transferable shares in joint-stock companies, and (iii) individuals to form limited liability and joint-stock companies. The draft legislation will be approved by the Council of Ministers in mid-1988, and the Law of Association introduced in Parliament in its autumn session. Following Parliament's approval, the legislation is expected to become effective from January 1, 1989. 45. The Government will continue to encourage the small scale, essentially private, sector which has proved to be dynamic. The maximum number of employees permitted in private businesses has been doubled from 15 to 30. Amendments have been made to the current legislation to permit individuals to form limited liability associations together with legal entities. Incentives are being continued for enterprises to set up subsidiaries or autonomous profit centers, and to promote small and medium enterprises. Building on significant past progress in this direction, a further 24 new enterprises have been established by breaking up State enterprises. This process is planned to continue during 1988-90. 2. Liquidation and Restructuring of Inefficient Enterprises 46. The Government has recognized the critical importance of tightening financial discipline among enterprises to bring about greater efficiency and market orientation. Accordingly, bankruptcy legislation was given high priority and enacted in 1986. The legislation has generally deterred companies from taking imprudent financial decisions, though the number of actual liquidations of State enterprises has been limited. The Government will implement the bankruptcy legislation more forcefully in 1988, including initiation by the State of liquidation proceedings against enterprises in arrears of Government dues. Commercial banks are now required to set up additional provisions for doubtful debts in addition to normal risk reserves. These provisions will be equivalent to 201 of those debts classified as non-performing according to the criteria established by the Bank Supervisory Board. This, together with strict credit policies, will tighten financial discipline in the economy. 47. Along with the enactment of the bankruptcy legislation, a Refloatation Organization was set up to coordinate and monitor financial workouts of enterprises in financial difficulty. The Government has decided to limit enterprise and subsector specific financial support designed to alleviate financial difficulties of enterprises to that provided under the liquidation/refloatation framework, with the exception of coal mining (para. 49), and of a Ft600 million Government guarantee for bank loans to enterprises that are unable to "gross up" their wage bills in 1988 following the tax reform. To prevent excessive recourse to the Refloatation Organization, the 1988 budget allocation to the Refloatation Fund was reduced to Ftl.5 billion, 251 below 1987 nominal levels. State guarantees for the issue of bonds to finance the Refloatation Fund have been eliminated. Further, the Government is developing programs for the resolution of problems in crisis subsectors (coal mining and ferrous metallurgy), and some major - 15 - enterprises known to be in chronic financial difficulties. Major among these is Ganz-Mavag, one of the largest engineering units in Hungary. Some of these programs are now being implemented, while the others are being reviewed prior to a final decision. The programs aim at restructuring of enterprises in these subsectors, closure of non-viable units, reductions in labor force, and shifting production to more profitable and competitive activities permitting the reduction and elimination of Government support. 48. In the ferrous metallurgy subsector, current subsidies other than CMEA Price Equalization (Ft5 billion in 1988), have been eliminated. Plans to reduce capacity and rationalize the product mix across two of the three steel plants, which are loss-making, to enable the units to become financially self-sufficient have been approved. As part of these plans, Government investment support will be limited to restructuring existing capacities and will not exceed Ft2.0 billion during 1988-90. 49. In the coal mining subsector, the Government is developing a restructuring plan, which will be reviewed by the Bank and then finalized by the end of 1988. The plan will include: a substantial reduction in the level of coal production from underground mines; review of the feasibility of import of energy to substitute coal from underground mines; identification of pits whose coal production cost are higher than those for comparable energy source imports, a timetable for closure of uneconomic pits and implementing concurrent reductions in labor, especially administrative staff. The plan will be implemented from 1989 to progressively reduce subsidies to coal mining starting with a substantial reduction from the 1988 budget allocation of FtlO.6 billion. 3. International Trade 50. The Government recognizes that external competition and a liberal import policy is an essential ingredient of the policy to increase competitive pressure on domestic enterprises to improve efficiency. The Government intends to maintain the incentives currently provided to investments for export to convertible currency areas under the export promotion program introduced in 1986. The Government is taking steps to increase the relative profitability of exports to convertible currency markets by eliminating the guaranteed profitability of exports to CMEA. The Government is streamlining the procedures for import licensing to ensure that licenses are issued to exporters in an expeditious way to avoid export constraints. 51. To achieve the needed improvement in the convertible currency trade balance, the Government will rely on market based instruments and tight demand management. The Government will maintain the import regime free of quantitative restrictions in line with Hungary's protocol with the GATT. The average level of import tariffs was reduced from 23% in 1980 to 16% in 1987 in eight annual steps as agreed by the Government with the GATT in 1980. To foster greater impcrt competition, the Government will encourage more widespread use of international competitive bidding for goods and services in invest.nents financed from the Government budget or from the commercial banks. 52. The Government has already liberalized access to foreign trading rights, thus promoting a closer link between production and trade, and - 16 - increased competition in foreign trading activities. As of January 1, 1988 all legal entities may register automatically to conduct foreign trade in convertible currencies subject only to prescribed criteria of staff capability and financial viability. 350 enterprises have already been registered, while a further 83 applications are being processed. 53. Finally, with the establishment of the new Ministry of Trade, the Government has reorganized the responsibilities related to foreign trade. In this context, the Government has agreed to review the regulatory framework influencing convertible currency foreign trade, particularly imports, under terms of reference agreed with the Bank, by the end of 1988. In light of the outcome of the review, the Government will identify necessary changes to make the framework more efficient in line with the Government's policy objectives. Thereafter the Government w-ll develop a timetable for implementing the necessary changes beginning in 1989. 4. Pricing 54. The Government recognizes that prices should respond to demand and supply and changes in the structure of relative prices are crucial for efficient resource allocation. The Government will increasingly replace administrative price determination by market mechanisms which will help develop a flexible and dynamic economy integrated more effectively into world markets. For inflation control, the Government will rely on appropriate monetary and fiscal policies. The system of price determination has been very considerably simplified and liberalized since 1985. In 1986, the Export Pricing Rule, which set prices for domestic sales in line with those of export sales was abolished. The basic limitation of prices in the domestic market is now the remaining rule that such prices should not exceed the landed cost of comparable imports (The Import Pricing Rule). In order to monitor expected price developments, the Government can require advance reporting of price increases by producers. In cases where markets are dominated by a small number of firms or where other major market imperfections exist, there is a mechanism for the price authorities to arrange consultations regarding price levels between producers and consumers. This is supplemented by the provisions of the Law of Unfair Economic Practices, which is basically legislation designed to prevernt speculative and exploitative behavior by producers operating in imperfect markets. 55. In the context of the introduction of the VAT, the Government found it necessary to impose temporary administrative control of price movements from August 1987, requiring prior reporting of all intended price increases to the Government. This requirement was abolished on April 1, 1988, after which enterprises are free to change most prices. 56. Since January 1, 1988, administratively determined consumer prices are limited mainly to energy, passenger and city transport, milk and some items of basic foods and pharmaceuticals, which amount to no more than 202 of consumer goods. Prices of the remaining 80% of consumer goods are classified as belonging to the free pricing category, of which 22% are subject to advance reporting of price increases to the Government, 5b to procedures under which producers and buyers can be brought together for consultations, and the - 17 - remaining 53% are subject only to the Import Pricing Rule and the Law of Unfair Economic Practices. The Government has agreed to increase the last proportion to at least 62.5% by January 1, 1989. 57. Prices of 257 of the value of producer goods turnover remain administratively set, mainly for energy, transport, some agricultural products and chemicals. Out of the remaining 75%, price increases have to be reported in advance to the Government in respect of 15% of turnover, and consultations can be required in respect of another 3%. Prices of the remaining 57% of the value of producer goods turnover are subject only to the general pricing rule. 58. The Government has agreed to carry out a study, by end of 1988, under terms of reference agreed with the Bank, of the scope of administrative price setting, advance reporting requirements and consultation procedures with a view to limiting their coverage and improving the effectiveness of market forces in the economy. The Government plans to review the level of administratively determined consumer and producer prices and the process for setting them to identify possible improvements and reductions in their scope. The Government intends to implement the results of the review during 1989 after consultations with the Bank. In 1989 and 1990 The Government intends to reduce the number of goods covered by advance reporting requirements. Where advance reporting requirements are designed to enable monitoring of expected price developments, the Government will replace them by ex-post reporting of price levels. 59. The Government is taking steps to develop legislation to prevent monopolistic behavior for enactment in 1989. Meanwhile, the pricing authorities will limit their consultations with producers and consumers to markets dominated by a small number of firms or where other major market imperfections exist. The Government will review the experience with these consultations, and also consider the use of imports to enforce market discipline in cases of unfair market practices, or other market imperfections. Based on such reviews, the Government expects to be able to increase the share of consumer prices subject only to the Import Pricing Rule and the Law of Unfair Economic Practices to about 70% by January 1, 1990, with this percentage being determined finally after the reviews have been completed. 5. Taxation and Subsidies 60. A major achievement of the Government in 1987 was the enactment of the tax reform, comprising the introduction of a value added tax and personal income tax, and the elimination of a large number of existing taxes on enterprises. The tax reform was implemented effective from January 1, 1988. The tax reform eliminated many distortions to enterprise decision-making and will enable efficient enterprises to retain a greater proportion of their profits which should lead to long-run efficiency gains. Aggregate corporate profit taxes are projected to decrease by Ft44 billion and indirect taxes to increase by FtllO billion (8% of GDP). 61. The Government intends to make further reforms in the tax system to make it neutral with respect to form of association. By January 1, 1989, the Countervalue Tax (which is a tax applied to turnover of private enterprises) - 18 - will be eliminated and the Entrepreneurial Tax (which is a tax equal to 20% of the profit of a private entrepreneur) will be integrated into the personal and corporate profit taxes including a provision for the deduction of the cost of he entrepreneur's labor income for tax purposes. The Government will undertake a further streamlining of the legal framework of enterprise taxation and introduce a new unified law for the taxation of business profits not later than January 1, 1990. 62. In view of the need for strict demand management in 1988, the Government will initially rebate only 20% of the value added tax paid on goods used for investment. The proportion will increase to 40% from 1989, 60% from 1990, 80% from 1991, and 100% from 1992. 63. In addition to the tax reform, a subsidy reduction program will further restructure the role of the Government budget in the economy. In 1988 total current producer and consumer subsidies from the State budget, the budget of the Local Councils and Extrabudgetary Funds were reduced by about 15%, i.e. by Ft37.1 billion to Ft204.9 billion. This represents a reduction of about 25-30% in real terms as the inflation rate is expected to be about 15% in 1988. The Government is committed to continue reducing subsidies and financial support. The Government will develop a program by October 1988 to reduce these subsidies and financial support from the 1988 Plan level of Ft204.9 billion by at least 10% per year in 1989 and 1990, which will be a much larger reduction in real terms, given the expected inflation rate. 6. Wage Differentiation and Worker Mobility 64. The Government supports the principle of free determination of individual earnings based on performance. However, given the necessity of very tight demand management policies in 1988, the Government fourd it necessary to enforce a general ceiling on increases in enterprises' wage bill. During 1988, enterprises will be subject to a 2.5% nominal ceiling on the growth of their total wage bill. Within the aggregate ceiling, enterprises could generate savings by releasing excess labor and apply such savings to increase wages for the remaining work force by more than 2.5%. The mandatory upper limits of wage scales have been removed from 1988 to enlarge the scope for such wage differentiation. The only exception to the general ceiling on wage increases will be in respect of a small group of enterprises (employing at present 6% of the labor force) meeting stringent objective criteria of profitability, creditworthiness, and non-reliance on budgetary subsidies. 65. The Government intends to elaborate a reform of the wage system during 1988, to be implemented beginning from January 1, 1989. The reform will enable enterprises, in the productive sectors (i.e., only excluding services) to determine individual worker's earnings freely, subject to an overall ceiling on the wage bill of the enterprise related to performance, permitting sufficieilt scope for wage differentiation. This is designed to address the need for major shifts in employment patterns likely to arise over the next few years as a result of industrial restructuring. 66. A significant step has been taken in 1988 with the establishment of the Employment Fund with a budget of Ftl.2 billion to strengthen measures for - 19 - retraining and facilitate labor mobility. The Government will continue to modify the conditions for use of the Fund based on experience. 7. Capital Markets 67. Further development of the capital markets for efficient mobilization and allocation of capital will continue. The new Law of Association, the conversion of some state enterprises into joint-stock companies, and proposals for establishment of securities market regulation, will help to develop the capital market. As a first step, the Government has already enabled introduction of "capital tickets", which are a redeemable, non-voting, profit sharing instrument to be issued to employees by their enterprises in 1988. The enterprise and household bond markets have been integrated with the removal of the requirement of a State guarantee for bonds sold to the population. The Government will further modify the regulatory environment to promote development of insurance, and develop plans to operate the social security system on a self-sustaining basis. These measures should also help to strengthen the development of the capital market. 68. To ensure adequate recognition of profits and equity capital as well as the availability of timely and reliable information about the financial position of enterprises and potential borrowers to the banks and investors, new accounting standards, auditing and di3closure requirements were introduced in January 1988. 69. During 1987, several financial institutions, including insurance companies, commercial and specialized banks, joined together to develop a credit information system and to share information on bond issues and trading. The Government will support this initiative to develop a stock exchange that can serve the needs of an active and diversified financial market. 8. Banking System 70. In 1987, credit functions of NBH were separated from its central banking functions and entrusted to competitive, full service domestic commercial banks set up for the purpose. As a further step to promote competition among banks, enterprises will be permitted to open current accounts with more than one commercial bank of their choice from January 1, 1989. A study of the policies and measures needed for the development and reform of the financial sector was carried out collaboratively by the Bank and the Government in 1987. The study concluded that the most important step to be taken is to integrate the interest rates for enterprises and households in order to unify the flow of savings among all sources and uses through the banking system. The main obstacle to this integration has been the system of subsidized housing loans financed out of low interest rate household deposits. To rectify this siluation, the Government has agreed to develop comprehensive proposals for a new housing finance system and review the proposals with the Bank by the end of 1988. 71. As a preliminary step towards the integration of banking services, commercial banks have been permitted during 1988 to issue bonds to households to mobilize resources and to provide banking services to entrepreneurs. - 20 - Concurrently with the development and introduction of the new system of housing finance, the Government would be able to gradually integrate interest rates in the two banking systems and integrate the banking system fully. By January 1, 1989 the Government will initiate implementation of the integration of banking services for households and enterprises and continue the process, with full integration planned in 1989-90. 72. New instruments such as treasury bills were introduced in 1988 to strengthen the effectiveness of monetary policy. Graduated interest rates have been introduced to improve the refinancing mechanism to reduce excess liquidity in the banking system and facilitate better management of monetary policy. The Government will continue to review the interest rate structure, refinancing criteria and reserve requirements to improve the effectiveness of monetary policy, resource mobilization and allocation. 73. By June 1988, the newly established commercial banks will carry out a portfolio review by independent auditors to determine the extent of non-performing loans and set up provisions as necessary in accordance with the regulations issued by the State Bank Supervision Board. Steps will be taken to strengthen and systematize the inter-bank market. A clearing center for checks and payments is being established with Bank funding and technical assistance. 74. The Government intends to introduce foreign exchange operations by commercial banks gradually, commencing in 1988. For the time being, borrowing in international financial markets will be carried out exclusively by NBH in view of the need for very careful management of the country's external debt. 9. Enterprise Management System 75. The Government intends to extend the system of autonomous enterprise management, which is currently based on management by partly elected enterprise councils or by enterprise assemblies. While the experience with the present system is too short to draw any definite conclusions at present, modifications will be made as required in the light of experience in the next two years, especially as deregulation of prices and wages is progressively implemented. 76. As mentioned earlier (para. 44), the new Law of Association will permit State enterprises to convert themselves into joint stock companies. The Government believes that the decision for such conversion should be taken at the initiative of the enterprise managements themselves. To encourage the conversion process, the Government will identify an initial group of enterprises and facilitate their conversion commencing in l989. 10. Direct Foreign Investment 77. The Government recognizes the contribution direct foreign investment could make to improving the structure and performance of the Hungarian economy by enabling infusion of foreign capital, technology and management know-how. Besides intensifying promotional campaigns to attract foreign capital and continuing to enter into investment protection agreements with other countries, the Government will continue to assess the effectiveness of the incentives framework, rules, regulations and operating environment for direct - 21 - foreign investment and implement modifications as necessary in the context of the newly introduced tax reform and the proposed law of association. Hungary deposited its instruments of ratification of the Convention establishing the Multilateral Investment Guarantee Agency on April 21, 1988. 11. Technology Development 78. Technology development is one of the major objectives of the program. The reform of the tax system and other policy areas radically improves the prospects for technology development. The Government also introduced measures for improving the accounting treatment of intangible assets sucb as intellectual property, e.g. patents and copyrights, and is continuing to develop measures for the accounting treatment of disembodied technology, which will provide necessary incentives for R&D. The Government intends to review the 12 national R&D programs with a view to concentrating resources on a few selected priority areas, instead of diffusing them thinly and widely. The Government will streamline the procedure for approval of licensing, leading to a registration mechanism instead of individual approvals by January 1, 1989. Finally, the Government will continue the effort to make R&D by enterprises more market oriented, and increase the proportion of R&D resources available to enterprises for market oriented R&D activities. PART IV - THE PROPOSED LOAN A. Loan Features and Implementation 79. Loan Design. The proposed sector adjustment loan would support the Government's Economic Stabilization and Structural Reform Program. The program will ensure a supportive macroeconomic environment for consistent implementation of industrial policy reforms. The industrial reforms will address all the eleven industrial policy reform areas (para. 39). However, at the present stage, the highest priority must be accorded to those areas which are most likely to have an immediate macroeconomic impact and on the realization of the main reform objectives (financial discipline, enhancement of competition, and resource mobility). The agreed program, as well as conditionality for the release of the second tranche of the loan, is designed to address these areas in particular. 80. Loan Amount and Borrower. The loan in the amount of US$200 million will be made to the Government of Hungary, which will make the proceeds available to NBH, which will administer and disburse the funds. NBH will: (a) maintain separate accounts to record and monitor disbursements and repayments; and (b) arrange for an audit of such accounts by auditors acceptable to the Bank and submit certified copies of the relevant accounts to the Bank within six months of the loan's effectiveness and then on an annual basis. The auditor's report will include an opinion on whether satisfactory procedures are in operation at NBH regarding the use of Statements of Expenditure (SOE). 81. Utilization. The proposed loan would finance about 52 of Hungary's convertible currency imports over the disbursement period (July 1988-June 1989). The proposed loan would finance all goods to be imported into Hungary - 22 - except those financed by other sources and a specific list of excluded goods such as military or para-military items, luxury goods, nuclear reactors and parts, and uranium. The foreign exchange made available would be finally used mostly by enterprises. They would raise the local currency equivalent of their foreign currency needs either out of their own resources, or by borrowing from commercial banks. The banks would certify the availability of local currency to NBH after satisfying themselves of the financial viability of the enterprises in cases where the local currency resources are being provided through additional credits. NBH would then open the letter of credit, and on delivery of the imported goods, make the necessary payment in foreign currency and debit the enterprise's account. 82. Procurement. Procurement of goods costing more than US$5 million will be through international competitive bidding in accordance with the Bank's Guidelines for Procurement. Certain commonly traded commodities may be purchased through price quotations from organized international commodity markets. All contracts of lesser value would be awarded through normal channels on the basis of normal procurement procedures of the agencies concerned, which are judged to be satisfactory. 83. Disbursement. The loan will be disbursed in two equal tranches. The first tranche of US$100 million will be available on effectiveness, while the second tranche of US$100 million will be released on fulfillment of tranche release conditions (para. 86). To simplify disbursement, only invoices with a minimum value of US$50,000 will be eligible for disbursement. The loan would be disbursed only against foreign expenditures. In order to ensure that Hungary will have ready access to foreign exchange, a special account would be established in NBH to which the Bank would make an initial deposit of up to US$40 million, which would approximately equal estimated disbursements for three months. Payment requests would be made against full documentation except for contracts valued up to US$3 million equivalent, where SOEs would be autnorized. The special account would be replenished against withdrawal requests at monthly intervals or as appropriate when the undisbursed balance of the account falls below US$25 million and until only US$40 million of the loan remains undisbursed. The closing date for disbursements will be June 30, 1990. 84. Implementation. Impleraentation arrangements set up during the two industrial restructuring projects will remain in force. The Restructuring Council set up to monitor the implementation of the reform actions will continue to be responsible for the development and implementation of the industrial policy reforms. NBH and NPO will be responsible for monitoring and overal. coordination. B. Monitoring and Tranche Release 85. Monitoring of performance involves essentially three complementary activities. The first is the monitoring of the implementation of the Government's macroeconomic program which is an ongoing activity as part of the Bank's economic dialogue and reporting arrangements to be agreed during loan negotiations. The second activity is monitoring of the implementation of agreed industrial policy reform actions on a semiannual basis by the Bank. Progress in carrying out agreed studies of (a) the investment program (para. 15), (b) the regulatory framework of convertible currency foreign trade - 23 - (para. 53) and (c) the price setting system (para. 58) under agreed terms of reference ill be reviewed. The third activity will be monitoring of progress on specific reform actions and meeting macroeconomic targets as a condition for the release of the second tranche of the loan. 86. Conditions for Tranche Release. The release of the second tranche of the loan will be based on completion, in a manner satisfactory to the Bank, of the following actions: (i) Adoption of the 1989 Annual Plan and Central State Budget, inc'luding a public investment plan, which: (a) further reduces the Central State Budget deficit and results in halting the growth of Hungary's external debt in convertible currency by the end of 1990 (para. 36); and, (b) further reduces the total producer and consumer subsidies and other financial support from the 1988 plan level of Ft2O4.9 billion by at least 102 (para. 63). (ii) Enactment of a Law of Association and related legislation which would permit: (a) State enterprises to convert themselves into joint stock companies; (b) individuals to hold negotiable shares in joint stock companies; and (c) individuals to form limited liability and joint stock companies (para. 44). (iii) Adoption and commencement of implementation of programs to restructure the ferrous metallurgy and coal mining suosectors (para. 48-49). iv) Enactment of legislation which would eliminate the Countervalue Tax and integrate the Entrepreneurial Tax as part of the corporate profit and personal income taxes (para. 61). (v) Enactment of legislation which would allow enterprises to determine independently the level and scope of compensation for individual workers, within overall ceilings on the wage bill of the enterprise based on performance (para. 65). (vi) Integration of banking services for enterprises and households, with full integration of the two barXing systems planned for 1990 (para. 71). C. Coordination with the IMF 87. The Hungarian authorities reached agreement on most issues regarding the Standby Arrangement, as mentioned earlier, with the IMF in January 1988. The appraisal of the proposed loan was underway at about the same time. Bank staff assigned to the proposed loan have coordinated their work with that of IMF staff, and the two institutions have taken mutually consistent positions on the 1988 plan and on critical areas of the program. Bank and IMF staff will continue to work together in providing advice to the Government in managing the stabilization/reform effort. The staffs of the two institutions will coordinate actions and recommendations during the period of the loan. - 24 - D. Social Costs 88. There will be social costs to implementation of the program. The most significant will be the appearance of open unemployment, previously unseen in Hungary. Most of the displaced workers are expected to be able to find new jobs within a short period. Unemployment compensation is available for one year (up to six months at full pay, followed by three months at 75% pay and another three months at 60% pay). Retraining programs are being expanded, a nationwide network of more than 400 employment offices has been set up, and a program of public works has been launched to give temporary employment to workers while they wait for other prospective jobs. An Employment Policy Fund, with an initial allocation of Ftl.2 billion (US$25 million) has been included in the 1988 fiscal budget to finance employment related central assistance in a coordinated manner. In addition to covering the costs for unemployment compensation and the retraining program, the fund will provide grants to help finance employment-creating investments and relocation assistance (mainly for housing), and will provide seed capital to unemployed workers wishing to start their own small businesses. To date, instances of labor redundancy as a result of enterprise restructuring have been readily resolved in most cases by the transfer of workers to other firms, by retraining within the original firm, or by early retirement. 89. The condition of pensioners and families with small children also is a matter of concern, particularly because of the price increases that will accompany the introduction of the Value Added Tax. A Social Benefits Package has been introduced in January 1988 to compensate partially for the planned reduction in real wages, while simultaneously decreasing the budget deficit. The package aims at shifting from price subsidies to targetted assistance which should have a net positive resource allocation effect. The package includes a 10% increase in pensions (Ftl2.1 billion). To compensate families partially for the removal of price subsidies on food, children's clothing, and construction materials used in housing construction, the Social Benefit Package also includes a 40% increase in family allowances, an increase in the size and duration of child support payments, and an increase in family grants for housing purchase estimated to amount to Ftl4 billion. E. Risks 90. The principal risk associated with the loan and the program it supports is its far reaching nature, and the difficult economic environment in which it is being implemented. Despite the turnaround in the economy in 1987, the high level of debt has left Hungary with little potential for further borrowing. In this situation, tight financial discipline will have to be enforced on the enterprise sector, which has not always acted with sufficient financial prudence in its investment choices. The Government would need to implement its macroeconomic program, which calls for severe austerity after thirty years of rising consumption, with determination until a supply response emerges, necessarily after a time-lag. Finally, Hungary, being a highly trade-dependent country, is subject to adverse external changes. 91. On the other hand, there is a broad consensus in Hungary that adjustment in the domestic economy can no longer be postponed by resort to continued external borrowing, even if it means a decline in living standards - 25 - in the short term, to return to a sustainable growth path. The need for the proposed steps has been openly debated in the media. Trade unions were consulted before the stabilization program was presented to the Parliament. The maintenance of the consensus dLring the implementation of the program, which does change the existing social compact, will be a challenge, but the risk is reduced by the fact that a new leadership, committed to the reform, has been put in place. 92. Finally, Bank support coupled with an agreement with the IMF would reduce the overall risk, as it would ease the country's access to international financial markets to roll over maturing debt until at least 1990, when Hungary is expected to reach current account balance. Overall, the assessment is that while the risks are considerable, the Government's commitment, the openness of its approach, and the relatively open conditions of Hungarian society make the risks manageable. PART V - RECOMMENDATION 93. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directers approve the loan. Barber B. Conable President Attachments Washington, D.C. May 27, 1988 - 26 - ANNEX 1 Page 1 of 4 1987 SOCIAL INDICATOR DATA SHEET HUNGARY ROforenco Greuo, 4.wPE) Qocent Joeor mid t"dustr'al '96o 1973 Estimate InCOmO ¶Kt econ A~~~~~~~~~~~~~~~~~~ Total land aroa (tnou so AM) 93.0 93.0 93.0 AgrlcuItural (%. of total) 74 8 73.5 70.9 W PER CAPIrA (current USS) * * 2.020 1.830 '.20 PaPuwtaw AaI VITAL STATISTICS Total ocoulation (tnmu) '0.153 10,436 t0.633 Urbom 000. (% of total) 43 49 55 Go Populatton growth ratel%). Total 0.3 0.2 2.' 0.7 Urion 2.2 1 5 3.6 .5 Life 0xpQct. at 0irtn (yr9) '0 70 71 66 76 Population projoctions: Poo. in 2000 (tmou) 10.506 stationary ooo. (thou) t2.000 Pooulatton donfoty per Sq kM of agricultural land 146 tS3 162 230 534 Por. ago structuro (%): 0-i4 yr$ 23 21 22 36 21 iS-64 yrs so 67 s6 59 67 69 and aoovo '0 12 13 0 i2 Crudo aortn roto (por trou) '3 1s 12 20 13 Crude oeatm rato (per thou) I 1t2 14 8 9 Total fortiity rate 1.8 2.0 1.7 3.? 1.8 infant mort. rato (per thou) 39 34 20 s2 9 Child death rate (par trou) 3 2 4 0 Family olanning: Acceptors. annual (trou) .. 149 712 Users (% of iarr'oa woman) 67 ?4 FOOD FaALrTN A9kD riQITIaN Inmex of face orroductiof per capita (1979-51 a 100) .. 90 104 106 '02 Per caDita 9u0ply of: calorlo£ (per day) 3.116 3.371 3.544 2.90? 341t? Protoins (grams oar day) 66 91 94 7S 92 Pop. oor physician (thou) .. 0.9 0.4 2.4 1.5 Poe. por nurse (thou) 0.3 0.2 0.2 0.7 0.; Poe. oar hoSeitat oad (thou) .. O.1 0.1 0.4 0.1 AeQss to avfo wa2tor (% of population): Total .. 3. Uroen .. 6S 84 Rural .11 43 Population Growth Infant Mortality Primary School Enroilmont 4 ZN2011 - >-O^ G-§ to Ifulles - na age,ov°'.'i I - 27 - ANNEX 1 Page 2 of 4 1987 SOCIAL INDICATOR DATA SHEET HUNGARY Rofoerorco Groupn (URI) Recant Uooor MI Csd tnusetrial 1996 1973 Estimteo incomo mkt ocon. LABOR FORCE 'otal tabor Forco (tneu) 1.138 5.464 5.227 Fomalo (%) 38 41 44 34 37 Agriculture (M%) 32 23 18 29 7 tucTry ( 40 44 44 31 3% Paret'cipOtion rate (%): Total g1 52 49 38 47 ma0o es 62 of so 60 Formal( 37 42 42 26 35 Ago OGPondonCy ratio 0.5 O.5 O.S 0.7 O.5 H4OUSING Avorago SiO Of MouQofol@t: Totalt 3 3 Uroan 3 3 Rural 3 3 Pereontage of etwolltgg wstr eloctricity: Total .. 94 98 Rural .. 91 97 EDUCAT IO4 Enroalmonrt ratee: Primary: Total IQI 99 90 soo 102 Maio 102 99 98 103 102 penalso oo 9g 99 101 10t Soconcary: Total .. 63 73 63 90 ato1 .. 67 73 44 al Fomalo .. 58 73 61 9t Pl,pil-Teacmar ratio: Primary 23 16 1 28 20 Soconcteey 21 20 .. 19 14 upitls roecning raOO 6 (%) .. 93 96 a9 IPCWIE. CO4SU4PTIC6, AK9 POVERTY Erorgy consumot oI oar Cap. (kg of oil oquivalor"t) 1.825 2.259 2.a74 1,9f0 4.083 Preermiago of private Inmeom raco* va Oy: mignestt 10% of nouso'olod .. ... -"gnost 20% 33 34 32Ja Louast 20% 10 10 11 8 L0foiat 40% 25 29 26 a Est. aOboluto oovorty iecome level (US$ par capita): Q_.ral . .. .. Est. ooo. oblOouw oluto Povoety Income level (%) Rural 0assoinger cars/triou poo. 10.0 39.1 ¶07.2 SO.4 323.7 Nowsoaoor cirCulatIon (por tnousgand ooDulatlnl) 178.2 225.7 249.8 80.0 300.0 :ECS9 Augtt i957 Not avale-lb "*te tost rosoetti BOIImBIO of Po"141I* and GtMP Ot tBo'B ate Igi *0 ieIGu eothalmte A." Groms avoaresdoo atB 0"agt.4n ,Oeptea Ce,v"e cevo.Bg, isBasd a*n data OveBl*jistI Bito ekes Aolftdotm UA'OBO gt"0B fot@tooe *109 010fGl to say year ootbowo IO *03 BI. 1913 botwoi 1970s IoME 106 0*10 'oU tuout oOtiuAto ooofi l an3^eiE Iwo B i071 28 - ANNEX I Definitions of Social Indicators e 3 of 4 The definition of a particular social indicator may Total teruhlzt rate- A%erage number of children that vary among countines or within one country over would be born aJlve to a woman dunng her lifetime. time. For instance. different countnes define "urban if during her childbearing sears she were to bear Area or -safe water" in different ways. For more children at each ge in Accordance with pre%ailing detailed definitions. see the tec'hnical notes to the age-specific fertilitv rates. World Development Indicators. Infant 'ugedfI-l, mortality rate - Number of infants per thousand itve births. in a gven year. who die AREA (thousand square kilometers) before reaching one year of age. Total. Total surface area compnsing land area And ClitId laged 1-4: mortalit' ratu - Number of deaths inland waters. of children. aged 1-4. per thousand children in the .4rtwultutal 'percentage of total, - Estimate of agn- same age group. in a given vear. cultural area used for crops. pastures. market and FamiY planning utce'ptors. thousands, - Annual kitchen prdens or lying fallow. as a percentage of number of acceptors of birth-control measures re- total. ceived under the auspices of a national family plan. ning program. GNP PER CAPITA (USS) - 1986 GNP per capita Famd l planntng. users 'percentage of married stom- estimates at current market pnces. calculated by the enl X Percentage of mamed women of child-bearing conversion method used for the World Bank .4tlas. age who are practicing. or whose husbands are practicing. any form of contraception. Child-bearing POPt;LATION AND VITAL STATITICS age is generally IS to 44. although for some coun- Total population - mid-year (millions). 1986 data. tries contraceptive usage is measured for other age .'rhan population (percentage ot total, - Difrerent groups. countnes follow different definitions of urban pop- ulation which may affect comparability of data FOOD. HEALTH AND INUTRITION 4mong countries. Index offood production per capita ( 1979 - 81 - 100) A'pulaton grouwth rate ipercent) - total and urban - - Index of per capita annual production of all food Annual growth rates of total and of urban popula- commodities. Production excludes animal feed and tions. seed for agriculture. Food commodities include pn- Liti. expectancY at birth t'rearsi - Number of years a mary commodities I for exampl. suprcane instead newborn infant would live if prevailing patterns of of sugar) which are edible and which contain nu- mortality at the time of its birth were to stay the tnents (for example. tea and coffee are excluded). same throughout its life. They include nuts. fruits. pulses. cereals. vegetables. Population projections oil seeds. sugarcane and sugar beets. livestock. and Population mn 2000 - Projections of population lhvestock products. Aggregate production of each given total population by age and sex. fertility and countrv is based on national average producer pnce the demographic parameters of mortality rates. and weight,. migration in the base year 1980. Per capitasup7,v of calories Computed from energy Stationary population - Projected population level equivalent of net food supplies available in a coun- when zero population growth is achieved: i.e.. the try. per capita, per day. Available supplies compnse birth rat is constant and is equal to the death rate. domestic production. imports less exports. and the age structure is stable. and the growth rate is changes in stock. Net supplies exclude animal feed. zero. seeds for use in agriculture. quantities used in food Population density. agricultural land - Population per processing. and losses in distnbution. square kilometer (100 hectares) of agricultural area. Per capita supply at protein grams per dayi - Protein Population age structure 'percent / - Children 0-14 content of per canica net supply ot food per day. Net years. working age group 15-64 years. and people of supply of food is defined as above. Requirements for 65 years and over as percentages of population. all countnes. established by United States Depart. Crude birth rate- Annual live births per ti ousand ment of Agriculture. provide for minimum allow- population. ances of 60 grams of total protein per day and 20 Crude death rate - Annual deaths per thousand grams of animal or pulse protein. population. Pbpulation per physician - Population divided by the - 29 - ANNEX 1 Page 4 of 4 number of practicing physicans qualified from a and rural- Conventional dwellings with electricity In medical school at university level. living quarters. as a percentage of all dwellings. Population per nin peson- Population divided by the number of practcing graduate nurses. aistant EDUCATION nurses, practical nurses and numng auxilianes. Enrollment rates Population per hospital bed - Population divided by Przwari school enrollment- total. male andfemale the number of hospital beds available in public and - Gross enrollment of all ages at pnmarv level as a pnvate. general and specialized hospitals. and reha- percentage of school-age children as defined by each bilication centers. Hospitals are establishments per- country. and reported to Unexo. While many coun- manently staffed by at least one physician. tcres consider primary school age to be 6-1 1 years. Access to safe water (percentage of population} - othes use different age groups. For some countnes total. urban. and mral - People (total. urban. and with universal education. gross enrollment may ex- rural) with reasonable access to safe water supply ceed 100 percent since some pupils are younger (includes treated surface waters or untreated but or older than the country's own standard pnmary uncontaminated water such as that from sprngs. school age. sanitary wells. and protected boreholesl. In an urban Secondary school nrollmnt - total. male andfem. area this may be a public fountain or standpost ale Computed in a similar manner. but including located not more than 200 meters away. In rural pupils enrolled in vocational. or teacher tramining areas this imr"ies that members of the household do secondary schools. The age group is usually 12 to 17. not have to spend a disproportionate part of the day Pupil-teacher ratio - primary, and secondary - T otal fetching water. students enrolied in school divided by the total number of teachen. LABOR FORCE Percentage puils reachig gade six - The percent. Total labor force (millionsj - Economically active. age of children starting prinmary school. that contin- including armed forces and unemployed but exciud- ue until gade six. ing houswives and students. Femae (percent) - Female labor force as a percent- INCOME, CONSUMPTION, AND POVERTY age of total labor force. Energy consumption per capita (kilograms of oil Agriulture (percent) - Labor force in farming, eqiwvlent - Annual conswnption of commercial forestry. hunting and fishing as a percentage of total primary enery (coal lignte, petroleum. natural gas. labor force. and hydro, nuclear and gothemal electricity). Industry (percent) - Labor force in mining, construc. Incomw distribution - Income (both in cash and kind) tion. manufacturing and electarity. water and gas as accnuing to percentile groups of households ranked a percentape of total labor force. by total household income. Participation rate (percent) . total. male. andfemae Passnger cars (per thousand population) - Includes - Participation rates are the paentage of population motor can seating fewer than eight persons. of all ages in the labor force. These are based on ILO Newspapr circulation (per thosand population- data on the age-sex structure of the population. Average circulation of a 'daily, general interest Age dependency ratio - Ratio of population under IS, newspaper." defined as a news periodical published and 65 and over, to the working age population (ape at least four times a week. 5-64). Estimated absolute poverty income level USS per capita) - urban and rural- Absolute poverty income HOUSING level is that below which a minimal nutitionally Average sit of hoehold (persons per household) - adequate diet plus essential nonfood requirements total, urban, and ruwal A household consists of a are not affordable. group of individuals who share living quarters and Estimated population below absolute poverty income main meals. lvel percent) - Pervzntage of urban and rural pop- Percentage of dwellings with electrcn s. total, urban. ulations who live in "absolute poverty." - 30 - ANNEX 2 HUNGARY INDUSTRIAL SECTOR ADJUSTMENT LOAN 6Et EMIWC IC IkICAtORS ._ _-._-.--------Proiected.--.------'-------------- -.-- 1982 1983 194 1785 IIt 19D7/p lt8 1989 10 1991 199? 199 194 1995 60P 6ro th Rate 2.8n o.n 2.tl -o.n 1.5t i.4% I. 4 I.7t 2.n .i s.2 3.37 3.n i.5 s.5 6UP 6roth Rate t.n1 -0.1 2.61 -0. n 1.51 3.42 1.61 1.a1 2.1 3.12 3.3 3.41 3.5 1.51 609rapith 6ro*th Rate 1.81 -0.52 I.6t -0.7t 0.lt 3.t l.t2 I.U 2.n 3.11 3.31 3.41 3.52 3.51 Private tConsoaptin/Capita Iroath Rate 1.31 0.51 1.22 1.41 2.02 2.81 -2.31 1.01 2.11 3.01 3.31 3.41 3.42 3.52 Total 008 lin fuil. USti I/ 7715 8250 88rA 11760 15086 17739 11878 '8250 18369 1853 18483 18704 18920 19075 I8IRD8OD 1/ O.02 o.ot 0.02 2.9t 3.52 4.21 6.62 8.U% 10.t 12.6U (3.7t I(.5 15.02 15.51 D00/165 1/ 120.02 132.61 143.12 191.41 227.n 246.92 237.01 23.81 21(.62 206.11 196.62 10.51 180.61 172.52 P0at8GO 1/ 33.32 39.32 43.42 57.0t 63.51 t8.01 65.71 t3.81 60.52 56.6 53.4 50.51 47.72 44.92 Debt Srvire (to ill. USS) 13/ 1995 190 2580 3155 375 3416 3107 294 3210 3705 4066 4258 4140 4438 Debt Swevic*/IS I/ 2/131 31.01 32.01 41.81 51.32 56.41 47.51 41.22 37.02 38.01 41.61 43.22 42.91 39.51 40.11 Debt Service 6W 1/ / 8.62 9.5t 12.n 15.3t 5.7n 13.12t (1.42 1O.3 1O.t 11.41 1i.n 11.51 1o.41 10.5t IIRD Det Service/Debt Sevtce 1/ 3/ 0.01 0.0 0.02 0.1n 1.11 2.22 3.82 6.3 8.7n 9.Ot 9.4t 9.n 8 I.1t 11.42 Gross Investanta/6P 28.52 26.52 25.72 25.02 26.n 26.82 26.8 26.31 26.52 26.82 26.n1 27.1t 2.It 27.22 Doetsc SavianIS'If 27.72 26.n 26.71 24.n 22.92 23.n 26.52 26.8 27.22 27.22 27.32 27.42 27.42 27.52 11ational Saviaqs'49 274.2 26.62 27.11 24.7n 21.5S 24.6U 26.11 26.61 27.31 27.4t 27.81 27.52 28.02 28.3t Rarpolal aitsonal Zavaop Rate 38.0t 17.41 21.81 -17.31 -38.n9 49.91 35.61 30.81 34.02 29.22 32.52 27.4n 30.02 31.41 Public Ioveatnt/SDP 41 25.22 22.92 22.0t 21.22 21.51 22.22 22.22 21.81 21.92 21.9t 22.81 21.n 2t.2 21.52 Household Savingo/SP 3.52 4.02 4.3 4.31 4.62 3.7% 3.22 3.52 4.11 4.72 5.22 5. 6 5.92 6.11 Ratio nof Pnblic/ibuehold Savtns 41 6.8 5.7 5.3 4.7 3.7 5.7 7.2 6.6 5.7 4.8 4.3 4.0 3.8 3.6 Governent RimenolGPt 5t 63.52 65.22 65, 64.91 71.32 65.92 4.2 4.02t 61.7n 6.42 61.O0 6O.72 6O.32. 6o.o 6overfnest ExpendituroelW 5/ 67.52 68.91 66.42 67.U 74.42 68.21 64.21 63.12 6O.92 60.61 60.21 59.92 59.Ul 59.32 Deficit 1-) or Surplus (+ 5 -4.01 -3a.6 -0.81 -2.n1 -3.12 -2.n 0.1t 0.81 0.1 0 .71 o.8 o.m o.7 Export Voloe Grokth Rate 7.2 9.62 5.91 -0.81 -0.81 3.52 3.92 2.92 2.82 2.81 3.12 3.11 S.3t 3.12 Ruble 3.31 7.71 7.02 8.31 -0.11 2.52 2.01 0.41 0.52 1.62 2.52 2.5t 2.51 2.52 Nooroble 10.61 10.82 4.72 -6.61 -3.82 5.0 5. 5.02 4.62 3.72 3.62 3.52 3.51 3.52 Exports/60P 37.92 40.22 41.12 42.22 39.61 37.n 37.42 38.02 38.11 38.02 38.01 37.82 37. U17.61 lepart Voluav 6rovthb Rate 0.6 5.62 1.11 1.82 1.57 4.02 -1.61 1.61 2.42 3.32 3.52 3. 3 3.3S 1.31 Rubl1 2.81 1.St -O.52 -o.42 3.n 3.7n 3.82 2.2 3.41 3.5. 3.0 i.61 3.0o 3.0t Konruble -2.32 6.41 0.42 2.U 0.82 2.62 -6. Ot 1.0 1.51 3.22 3.5 3.52 3.52 3.52 laports/60P 37.11 38.3n 37.9n 40.1t 41.12 38.42 35.61 35.72 35.62 35.2 3S81 35.72 35.72 35.63 Current kIcont lit sil. USt1 -313 37 270 -56 -1286 -573 -(66 89 229 209 290 312 335 438 of hich, Convertible Currency -92 27' 329 -457 -1419 -847 -504 -252 -52 38 78 87 122 191 Cov. Currency Current kcount/lOP -0.41 1.42 1.62 -2.21 -6.02 -3.22 -1.9 -o.91 -0.1t 0.11 0.21 0.22 0.32 0.51 p Preliinary Sources: Central Statistical 0ffIco, National lank of unary, ational Plenaing Office, Goveroment Fivnacial Statistics (varios issusl, nd lkrld Oak staff itiitss. 1/ Coovertable currency. 2/ Exports of goods and wrvice are adjasthd to inclide rstble spor correspondimg to ruble aipwrts of energy and raw materials, and to suclde estisted re-aports. 3/ taurtatatian includes prepayet of eedaue- end lon-tare debt. The ainuts are U457 million to ISS, s523 millio an 1986, and approximately $420 allion t 1987. Kta further prepayets ae projected. If prepymsnts are eoclude, the Debt Srvice ltit tni thou tears becom 43.9, 48.5t, and 42.42. 4/ Public sectov includa the mOCilst enterprise sector. 5/ Data on the Public Sector refer to the C lte Indated Central and Local Sowrsats. ference in the test ire to the Central Boverseant in the State Bu40t format. - 31 - ANNEX 3 HUNGARY INDUSTRIAL SECTOR ADJUSTNENT LOAN MAW OF P69837 1i ct9f16 £UIW (11S llstims it cvrmut prncsl - ----PrjKctod------ --~- - ~---------~ - --- 2m2 93 1984 2935 196 19737p M988 1989 IM0 99 1992 1993 1994 9 * - _4 _4 ... . . .,,. ... . ... *.*. . . A. Expots of S" I t5 S516 514 529 48 453 3692 5997 6454 6929 73 782 O0 8 425 1. brehandta (FOB) 81 484? 4965 4475 4136 u078 539 5803 6243 65 170 52 014 8o5r 2. If4ct@r Srvinc 29 298 332 3 416 614 U18 651 8£ 722 n59 798 840 8 8. Isports of Scad & IF5 4447 427 4053 4547 510 5629 5447 50 5l 62 64 1131 7622 8145 1. Nerchdwdnae 1708) 4110 3970 1729 41BO44676 5075 474 5013 5212 5 5 625 6669 7107 2. oma-Factor Srvic 37 308 324 367 45 554 72 617 669 no 799 4 9 1037 C. RnQus Sleac 722 867 1244 2 -577 S3 551 824 108 1142 1137 118 1231 1276 O. Net Factor I.. -97 -62 -744 -25 -429 -92 -1072 -109 -1104 -2131 -1128 -138 -1150 -1124 1. Factor gcipts 125 112 153 220 256 206 224 226 Va 222 229 241 255 269 2. Factor P hwte 1101 n 8S9 94 1085 J110 1296 1321 133 1353 1357 137 1405 139I E. et Carrat Traonsas 2t2 92 -171 -20 -13 14 17 20 23 27 31 36 41 4k 1. Carrat i te 550 492 449 443 644 722 758 795 833 72 912 953 995 1039 2. Carrat Paynts 388 400 620 463 t57 708 741 m 81o o4 Got 917 9n4 99 F. Cwrrat kccout blance -92 297 329 -457 -I419 -847 -504 -252 -32 8 78 87 122 I" s. Long-Tor Capital toflo 174 t0 964 199 1152 82 229 m 119 -27 10 222 215 155 1. t LT Los" 174 60 644 I90 1152 822 13 372 119 7 140 222 215 155 a. Disaour ts 1068 1276 2645 4119 SS02 3108 1950 2000 2000 2325 2850 3100 2950 ro00 i. epayeofts 804 1216 1681 2210 2t50 228 1811 1628 1.2 2352 2710 2878 2735 3045 M. total other itas (at) -1236 9 -9 -551 121 -I225 -200 -I10 -170 -170 -170 -I70 -10 -170 I. Rwt Sht-Twa Coital -1044 154 -864 -267 432 -1156 -150 -120 -120 -120 -120 -120 -120 -120 2. Capital Flm EI -192 -5 -125 -284 -311 -97 -50 -50 -50 -50 -5 -50 -50 -50 1. Chapn to Mt bR sv -1154 446 304 90 -246 -1278 -566 -49 -82 -158 49 138 247 183 1. Mat Credit fOro tke 11 237 336 38 la 68 -300 5 In 268 -30 -300 -300 -300 -120 2. Other Rewre OhM" -1391 110 -76 M88 -20 -978 -571 -228 -350 -108 349 435 47 103 Sham of SOP 1. Reorce Balnce 3.11 4.21 6.1 1.41 -2.41 0.2n 2.02 2.91 3.51 3.51 3.41 3.21 3.1 3.01 2. Total latest Payuent 4.8 32 4.41 4.u 4.62 4.32 4.81 4.6 4.41 4.21 3.92 3.72 3.51 3.n 3. Cerat at Balance -0.41 1.42 1.62 -9 a2 -6.0e -3.22 -1.92 -0.92 -9.12 0.12 0.2a 0.2 0.32 0.51 4. LT Capital bnfo 4.6 6tt 1 3.02 20.01 16.02 21.92 7.22 7.0 6.62 .7.2t 8.21 8.42 7.41 7.57 . bt Credit fro the 1iF 1.01 1.61 1.91 0.12 0.32 -1.22 0.01 0. 0.92 -o.2a -4.9n -0.6 -0.81 -o0.n Mard Itn:i SOP (laltian of arreat U5$) 23159 21005 20345 20625 2357 26085 21227 28603 30370 323 341t7 37o42 958 4246l Fuaidg Erch&W RBwe (10S3 call.) 1. tat'l. Rsrv 767 1222 1805 2792 2088 1953 1387 1338 2255 1097 1146 1284 2451 1634 2.6014 4 40 71 751 m1 sa 525 525 5 525 525 52S 525 525 S3 srs k rsninCl. BoId 1233 162 255 3543 3639 2478 1912 286 1780 1622 2671 280 1976 :159 Br. Rrny is Naths Iports 3.3 5.2 7.6 9.4 8.5 5.3 4.2 4.0 3.6 3.1 3.0 3.0 3.1 3.2 Eznqe Riata 1. Ios. off. I-Rate 36.6 42.7 48.0 50.1 45.8 47.0 52.3 55.5 57.4 58.2 58.5 5.8 59.0 59.3 2. R"l (i4. i-ate 8 9n80 I/ 78.7 84.7 84.0 85.6 101.2 121.2 135.0 143.2 148.1 150.2 ISI.0 2S5.7 152.4 153.l P Preltiaarv Sorcnl Cutra Statistical Office, btirlel Btk of Reoery, ktional Plaanani 014ico ed 1ld BNO staff astoastas. I/ tie idicate a Eprciatia. - 32 - ANNEX 4 Page 1 of 2 HUNGARY INDUSTRIAL SECTOR ADJUSTMENT LOAN Status of Bank Group Operations in Hungary A. STATEMENT OF BANK LOANS /a (As of March 31, 1988) US$ Million Loan Fiscal (Less Cancellations) No. Year Borrower Purpose Loan Undisbursed One loan and six B-loans loans fully disbursed 266.5 - 2317 1983 HPR /b Industrial Energy Conservation 109.0 20.3 2397 1984 NBH /c Indus. Exports & Restructuring 110.0 16.2 2398 1984 OKGT /d Petroleum 90.0 7.8 2510 1985 NBH Integrated Livestock 80.0 60.5 2511 1985 NBH Fine Chemicals 73.0 25.9 2557 1985 HPR Transport (Rail/Road) 75.0 27.2 2697 1986 HPR Power 64.0 58.5 2700 1986 NBH Industrial Restructuring 100.0 50.0 2709 1986 NBH Industrial Energy Conservation II 25.0 18.9 2738 1987 NBH Crop Production Improvement 100.0 43.6 2834 1987 NBH Industrial Restructuring II 150.0 99.8 2847 1987 NBH Telecommunications 70.0 63.4 Total 1,312.5 Of which Repaid 28.3 Total Now Held by the Bank 1,284.2 Total Undisbursed 492.1 /a The status of these projects is described in a separate report on all Bank/IDA-financed projects in execution, which is updated twice yearly and circulated to the Execative Directors on April 30 and October 31. /b Hungarian People's Republic. /c National Bank of Hungary. /d National Oil and Gas Trust. 2673G - 33 - ANNEX 4 Page 2 of 2 B. STATEMENT OF IFC INVESTMENTS (as of March 31, 1988) Fiscal Type of US$ Million Year Obligor Business Loan Equity Total 1988 Salgotarjan Glass Wool Glasswool 3.44 1.39 4.83 1987 UNIC Bank Banking - 3.21 3.21 1987 Huni Fermentation Limited Lysine Manufacturing 8.55 2.70 11.25 Total Gross Commitments 11.99 7.30 19.29 Less cancellations, terminations, repayments and sales - - - Total Commitments now held by IFC 11.99 7.30 19.29 Total Undisbursed 11.29 0.33 11.62 2673G 34 ANNEX 5 HUNGARY Macro-EconomiC Prooram 198a-1990 Policy area/Actions Pre Board Presentations Mid 1988 - end 1988 1989 1990 1. FIscal lTeficitt Adopt 1988 Central State Formul-ate 1989 Central State Implement 1990 State budget Implement 1989 State Budget with deficit not budget to further reduce in accordance with agreed budget in accordance with exceeding FT10.4 billion. budget deficit in order to targets. Formulate 1990 agreed targets. reduce current account Central State budget to deficit and reach current further reduce budget account balance in 1990. deficit in order to reduce current account deficit and achieve near balance in the current account in 1990. 2. Current Account Deficit Adopt demand management Develop current account Develop current account Achieve near balance in measures to limit current deficit target consistent deficit target consistent the current Account account deficit in with budget deficit. with budget deficit. Adopt balance in convertible convertible currencies to demand management measures currencies. $500 million to limit current account deficit to target. 3. Ex_anston of Credit Adopt measures to restrict Oevelop credit expansion Continue to implement Continue to implement expansion of credit of target consistent with the monetary program con monetary program con monetary institutions to the budget deficit, subsidy sistent with maintenance sistent with maintenance State and the State reduction program and of macroeconomic of macroeconomic Development Institute mainterince of macro- equilibrium. equilibrium. to Ft390.6 billion. economic equilibrium. 4. Household Savinos Implement flexible interest Review household interest Implement interest rate Implement interest rate rate polic) to stimulate rates in light of changes as nec sary. changes as necessary. savings and prevent developments in the savings Review household interest Review household disintermediation. rate in 1988. For wilate rates in light of interest rates in light Raise interest rates interest rate changes developments in the savings of developments in the on long term savings to necessary. rate in 1989. Formulate savings rate in 1990. positive levels in real interest rate changes Formulate interest rate terms. as necessary. changes as necessary. S. Exchanae Rate Policy Continue active exchange rate policy to promote external equilibrium, curb domestic demand. and increase relative profitability of convertible currency exports to promote such exports. 6. Public Investment Prooram Reduce State Peview 1989-9V public Implement revised public investment plan. investm,. by 15X from plan investment to plan to tmprove 1987 level. Reduce financial efficiency of investment. support from SDI for Assess the role and scope of preferred activities of SDI to improve its efficiency enterprises from Ftl6.4 and its integration into the billion to FtlS.4 billion in financial system. 1988. 061Tf - 35 - ANNEX 6 HUNGARY INDUSTRIAL SECTOR ADJUTrMENT LOAN Letter of Sector Development Policies Budapest, Dated, May 26, 1983. Mr. Barber B. Conable, President, The World Bank Washington D.C. Dear Mr. Conable, I am writing this letter in reference to the proposed Industrial Sector Adjustment Loan. This letter and its attachment update the Hungarian Government's Letters of Intent on the Development of Economic Conditions Concerning Industrial Restructuring in Hungary of May 6, 1986, and May 8, 1987 submitted in connection with the First and Second Industrial Restructuring Projects, respectively. Background As you are aware, Hungary has a highly trade dependent economy with over 40 percent of GDP being internationally traded. Such high trade dependence requires continuous increases in the efficiency and international competitiveness of Hungary's industry, especially as over half of our trade is with convertible currency markets. Accordingly, it has been the Government's endeavour to reform the economy and to make it more efficient and internationally competitive. The Government is continuously taking steps to enlarge the role of market forces in the economy, introduce entrepreneurial attitudes in enterprises, and expand the role of market-based instruments for macro-economic management. The Government has already taken a number of actions to advance the reform supported by the two World Bank-financed Industrial Restructuring Projects. These include among others: (i) reform of the enterprise management system in 1985; (ii) enactment of a bankruptcy law in 1986; (iii) the liberalization of international trading activity, following the removal of quantitative import restrictions in 1984; (iv) introduction of a two-tier competitive banking system in 1987; and (v) a comprehensive tax reform, comprising the introduction of a personal income tax and a value added tax from January 1, 1988. The supply response to these actions is beginning to emerge, but has not met our expectations, partly because of external factors, and also because the full range of reform measures has not yet been introduced. In addition, during the last two years, the macroeconomic environment created more domestic - 36 - demand than anticipated, reducing incentives for enterprises to increase efficiency and compete more effectively in export markets. Even when all the reform elements are introduced, it will take considerable time fo, the structural change in the economy to produce the changes in attitudes and behavior necessary for the full impact to be felt. After a particularly disappointing performance in 1985-86, the economy continued to deteriorate at the beginning of 1987. The Government therefore took corrective measures to reduce the budget deficit by reducing subsidies and increasing administered prices of some commodities. The Forint was devalued by 5% in November 1987 in addition to a devaluation of 8% in March 1987. The budget deficit was reduced from Ft46.9 billion in 1986 to Ft34.8 billion, and the current account deficit in convertible currency decreased from US$1.4 billion in 1986 to US$846 million in 1987. At the same time, there was evidence of the initial emergence of a supply response to the policy measures introduced in 1985-87. In 1987, industrial growth reached 3.7%, and the volume of nonruble exports rose by 5%. Exports to the highly competitive western markets grew much faster (12%). In 1987, GDP grew by 3.4%. The economy achieved a partial turnaround in 1987, establishing that the design of the reform program remains fundamentally sound, and will produce the desired results if implemented consistently and forcefully within a sufficiently tight macroeconomic environment. The Government's Medium Term Program The Government is aware that the recovery has to be strengthened and sustained. Accordingly, we have prepared a three year (1988-90) program of economic stabilization and structural reform, which incorporates the ongoing industrial sector policy reform program. The overriding objective of the program is initially to restrain, and then to halt the growth of external debt by the end of 1990 by progressively reducing the convertible currency current account deficit. Through the program, we expect to restore sustainable growth of the economy allowing long term improvement in the living standards of the people. The program promotes structural change through accelerated systemic reforms, along with stabilization, to raise productivity and international competitiveness. The Government intends to implement the program in a consistent manner over the 1988-90 period. The targets for 1988 are outlined below. The current account deficit in convertible currencies will not be allowed to exceed US$500 million. The targeted reduction in the current account deficit will be achieved by implementing a restrictive demand management policy, including a reduction in the budget deficit and tight credit policy; an active exchange rate policy; and measures to enhance supply, especially exports. The budget deficit will not be allowed to exceed FtlO.4 billion. The reduction in the deficit will occur, despite a lower overall tax burden in - 37 - relation to GDP, largely through a substantial reduction in producer and consumer subsidies. Household consumption will be reduced by 2-2.5% in real terms through a 9-10% reduction in real wages. Credit of monetary institutions to the State budget and the refinancing of the State Development Institute will together be limited to Ft390.6 billion. Credit expansion will be restrained through higher interest rates and lower limits on the refinancing of commercial banks by the National Bank of Hungary. Besides the increase in interest rates on short-term refinancing credits from 11% to 16% at the beginning of the year, the interest rate on installment credit, which was raised by three percentage points in November, were raised further by one percentage point to reach 14% by April 30, 1988. Use of such credit has been restricted and interest rates on personal loans have been raised by an additional two percentage points to 15-17%. Interest charges on nonpreferential bank loans for housing have also been raised to 12-15%. Further significant measures to stimulate household savings and to prevent disintermediation have been decided. Interest rates on term deposits of households will be raised to 13.5-15% from June 1, 1988. Interest rates on long term savings notes will also be raised to 14.0-16.5% from the same date. With these increases, interest rates on long term household savings are expected to be positive in real terms. The Government will continue to monitor household savings and take measures to maintain the attractiveness of savings instruments if necessary to generate the required volume of savings. Net domestic assets of monetary institutions will not be allowed to increase beyond Ftl,284.8 billion. We will continue to pursue an active exchange rate policy to promote external equilibrium. The cumulative devaluation of the forint by 25% between 1986-1987 has had some impact in promoting exports and reducing the trade deficit. The stabilization program should provide a significant incentive to increase exports by curbing domestic demand. We will continue to take actions to increase the relative profitability of exports to convertible currency markets, and continue to provide incentives to stimulate exports. External borrowings in 1988 will be limited to ensure that the total external liabilities in convertible currencies will not exceed US$16 billion, (excluding net purchases from IMF), including short-term liabilities of no more than US$2.3 billion during 1988. Over the past 3 years, we have attempted to improve the effectiveness of the investment program by enco::raging a shift of investment resources out of energy and basic materials into the manufacturing subsectors. Tight resource constraints anticipated during the program period have led us to intensify this effort. As a result of an intensive review of Plan priorities undertaken last year, expenditures on large State investments will be reduced by 15% in 1988. In 1988, no new large central projects will be started, and resources will be concentrated on completing ongoing projects. - 38 - We intend to reduce investment in coal mining, electric energy and metallurgy, and increase investment in manufacturing industry. Investments by Local Councils, which had exceeded planned levels in recent years, will be reduced by at least 20% to a level that permits them to provide for essential health and education investments. Equity allocations (a form of low-cost credit) and other forms of financial support from the State Development Institute (SDI) for preferred investment activities of enterprises will be reduced from Ftl6.4 billion in 1987 to Ftl5.4 billion in 1988. Most of the structural measures outlined below, combined with tight monetary policy, will increase enterprise financial discipline and improve the quality of enterprise investment, which forms the largest single share of socialist sector investment (62%) as well as of investment in industry (78%). We are also taking steps to facilitate investment financing for the rapidly growing small business sector, which we expect will expand vigorously following the implementation of the new Law of Association in January 1989. Finally, before the end of 1988, we will undertake a further review of the investment plans for 1989-90 in an effort to ensure the greatest possible returns from the scarce resources available. We will also assess the role and size of the SDI to determine the scope for improving its efficiency and its integration into the financial system. The reduction in household real incomes which the program implies will have social costs. The Government has taken steps to protect the vulnerable sections of the society. The budget for 1988 includes a Ft26.1 billion social benefits package containing increases in pensions and family allowances to compensate partially for the removal of subsidies on food, children's clothing, and construction materials used in housing. Increases in the size and duration of child support payments, and an increase in family grants for housing purchase are also included. Unemployment compensation and retraining opportunities are being expanded for those who might be temporarily displaced as a result of the closing down of inefficient productive activities. Measures to promote growth of new small businesses will provide increased opportunities to such workers. An Employment Fund has been established with an initial allocation of Ftl.2 billion to finance and coordinate employment-related assistance. These additional programs have been funded out of savings in Government expenditure, while reducing the budget deficit at the same time. We will monitor the performance of the economy closely, and if it appears that the actions already taken are inadequate to reach the targets, the Government will undertake additional measures promptly. The Government also reached agreement with the IMF on a Standby Arrangement for SDR265 million to support the implementation of the economic stabilization and structrual reform program. Structural Reforms We are strongly committed to accelerate systemic reform and promote the needed structural changes in the economy. While implementation of reforms and achievement of structural change is difficult at any time, it is more so - 39 - during a stabilization period. The high level of Hungary's convertible currency debt and the high proportion of debt service to exports limits the room for resorting to further commercial borrowing in support of the reform program. Our problem is further compounded by the uncertain prospects for world economic growth and trade. We are nevertheless determined to press ahead with the policy reform program, as we firmly believe it is the only way to achieve sustainable growth and the longer-term goal of improved living standards. Industry is the single largest sector in the Hungarian economy, contributing about a third of GDP, employment and gross domestic fixed investment. It accounts for 75-802 of the total imports and exports. Industrial sector policy reform is therefore the centerpiece of our economic reform. In 1985, the Government undertook, jointly with the Bank, an extensive analysis of the structure, performance, constraints and potential of the industrial sector and of the sector policy and institutional framework. The principal constraints on improved industrial performance were identified as the lack of financial discipline and weak autonomy of enterprises, the lack of domestic and international competition, and the low mobility of resources. Drawing upon this analysis, the Government launched a five-year industrial sector restructuring program in 1985 to address these constraints. The program aims at increasing reliance on competitive market mechanisms and signals in order to promote efficiency, innovation, and financial discipline at the enterprise level. The program consists of reform actions covering eleven policy areas, which are central to the objectives of the reform. These areas are: entry of enterprises; liquidation and restructuring of inefficient enterprises; international trade; pricing; taxation and subsidies; wage differentiation and worker mobility; capital markets; the banking system; the enterprise management system; direct foreign investment; and technology development. As mentioned above, between 1985-87 we have taken a number of significant actions in support of the program, fully in line with our earlier agreements. The policy actions the Government is committed to take during 1988-90 in respect of the eleven policy areas are elaborated in the following paragraphs. A policy matrix is annexed indicating the specific actions recently taken and those planned to be taken. We recognize the importance of providing a stable environment for enterprise decision-making as quickly as possible. We will therefore accelerate the implementation of the program so that all major systemic changes are implemented during 1988-89. 1. Entry of Enterprises Increase in competition is one of the most important facets of the reform. The Government will therefore liberalize regulations to facilitate the establishment of different forms of economic associations and conversion to other forms. - 40 - We are currently drafting legislation permitting: (i) State enterprises to convert themselves into joint-stock companies, (ii) individuals to own negotiable and transferable shares in joint-stock companies, (iii) individuals to form limited liability companies and joint-stock companies. The draft legislation will be approved by the Council of Ministers in mid-1988, and the Law of Association introduced in Parliament in its autumn session. Following Parliament's approval, the legislation will be implemented from January 1, 1989. The Government will continue to encourage the small scale, essentially private, sector which has proved to be dynamic. The maximum number of employees permitted in private businesses has been doubled from 15 to 30. Amendments have been made to the current legislation to permit individuals to form limited liability associations together with legal entities. We have already designed incentives for enterprises to set up subsidiaries or autonomous profit centers, and to promote small and medium enterprises. During the last year 24 new enterprises have been established by breaking up large State enterprises. We expect this process to continue during 1988-90. 2. Liquidation and Restructuring of Inefficient Enterprises. The Government has recognized the critical importance of tightening financial discipline among enterprises to bring about greater efficiency and market orientation. Accordingly, bankruptcy legislation was given high priority and enacted in 1986. The legislation has generally deterred companies from taking imprudent financial decisions, though the number of actual liquidations of State enterprises has been limited. The Government will implement the bankruptcy legislation more forcefully in 1988. It has been decided that the State itself will initiate liquidation proceedings against enterprises in arrears of Government dues. Commercial banks are now required to set up additional provisions for doubtful debts in addition to normal risk reserves. These provisions will be equivalent to 20% of those debts classified as non-performing according to the criteria established by the Bank Supervisory Board. This, together with tight credit monetary policies, will tighten financial discipline in the economy. We will limit enterprise and subsector specific financial support designed to alleviate financial difficulties of enterprises to that provided under the liquidation/refloatation framework, with the exception of coal mining (discussed below), and a Ft600 million Government guarantee for bank loans to enterprises that are unable to gross up their wage bills in 1988 following the tax reform. The 1988 budget allocation to the Refloatation Fund was reduced to Ftl.5 billion, 25% below 1987 nominal levels. State guarantees for issue of bonds to finance the Refloatation Fund have been eliminated. Further, the Government has elaborated programs for the resolution of problems in crisis sub-sectors, and some major enterprises known to be in chronic - 41 - financial difficulties. Some of these programs are now being implemented, while the others are being reviewed. The programs aim at restructuring of enterprises in these subsectors, closure of non-viable units, reductions in labor force, and shifting production to more profitable and competitive activities permitting the reductioii and elimination of governmental support. In the ferrous metallurgy subsector, we have eliminated current subsidies other than CMEA Price Equalization (Ft5 billion in 1988), and intend to continue this limitation. We have developed plans to restructure capacity to enable the units to operate with financial self-sufficiency. As part of these plans, further investments are limited to those for restructuring existing capacities, support to which during 1988-90, will not exceed Ft2.0 billion. We are currently developing a restructuring plan for the coal mining subsector. The plan, which we will review with the Bank and finalize by November 1988, will include: a substantial reduction in the level of coal production from underground mines; a review of the feasibility of import of energy to substitute coal from underground mines; the identification of uneconomic pits (pits whose coal production costs are higher than those for comparable energy source imports) and a timetable for taking necessary measures, including closure of the uneconomic pits and a concurrent reduction in the labor force, especially administrative staff. We will implement the plan from 1989 and progressively reduce subsidies to coal mining commencing with a substantial reduction from the 1988 budget allocation of FtlO.6 billion (including those for grossing-up of wage bills of coal mining enterprises which were provided in 1988). 3. International Trade The Government recognizes that external competition through export promotion and a liberal import policy is an essential ingredient of our policy to increase the pressure on domestic enterprises to improve efficiency. We intend to maintain the incentives currently provided to export related investments under the export promotion program introduced in 1986. We are continuously taking steps to increase the relative profitability of exports to convertible currency markets. We are streamlining the procedures for import licensing to ensure licenses are issued to exporters in an expeditious way to avoid export constraints. To achieve the needed improvement in the convertible currency trade balance, the Government will rely on market based instruments and tight demand management. The Government will maintain the import regime free of quantitative restrictions in line with Hungary's protocol with the GATT. We recognize the need to foster greater import competition. Toward this end, we will encourage more widespread use of international competitive bidding for goods and services in investments financed from the Government budget. We will also encourage the commercial banks to promote the increased use of international competitive bidding by their borrowers. - 42 - We have already liberalized access to foreign trading rights, thus promoting greater links between production and trade, and increased competition in foreign trading activities. As of January 1, 1988 all legal entities may register automatically to conduct foreign trade in convertible currencies subject only to prescribed criteria of staff capability and financial viability. Finally, with the establishment of the new Ministry of Trade, we have reorganized the responsibilities related to foreign trade. In this context, we will review the regulatory framework influencing convertible currency foreign trade. In light of the outcome of the review, we will identify necessary changes to make the framework more efficient in line with the Government's policy objectives. Thereafter, by the end of 1988, we will develop a timetable for implementing necessary changes and implement them beginning in 1989. 4. Pricing The Government recognizes thaL prices should respond to demand and supply, and changes in the structure of relative prices are crucial to efficient resource allocation. We will increasingly replace administrative price determination by market mechanisms which will help develop a flexible and dynamic economy integrated more effectively into world markets. For inflation control, the Government will rely on appropriate monetary and fiscal policies. In the context of the introduction of the VAT, we found it necessary to impose a temporary administrative control of price movements from August 1987, requiring prior reporting of all intended price increases to the Government. This requirement was abolished on April 1, 1988. Enterprises are now free to change most prices. Prices of 25% of the value of producer goods turnover remain administratively set, mainly for energy, transport, some agricultural products and chemicals. Since January 1, 1988, price of at least 80% of consumer goods are classified as belonging to the free pricing category. Of this, 22% are subject to advance reporting, 5% to price consultation procedures, and the remaining 53% are subject only to the Import Pricing Rule and the Law of Unfair Economic Practices. This proportion will be increased to at least 62.5% by January 1, 1989. Beginning April 1, 1988, administratively determined maximum consumer prices have been limited mainly to energy, passenger and city transport, milk and some items of basic foods, pharmaceuticals, amounting to no more than 20% of consumer goods. We will examine the scope of administrative price setting, consultations and advance reporting by the end of 1988 with a view to limiting their coverage and improving the effectiveness of market forces in the economy. We plan to review tne level of administratively determined maximum consumer and producer prices and the process for setting them to identify possible improvements and reductions in their scope. We intend to implement the results of the review during 1989. In 1989 and 1990 we intend to reduce - 43 - the number of goods covered by advance reporting. Where advance reporting is designed to permit monitoring of expected price developments, we will replace it by by ex-post reporting. We are taking steps to develop legislation to prevent monopolistic behavior for enactment in 1989. Meanwhile, the pricing authorities will limit their consultations with producers and coisumers to markets dominated by a small number of firms or where other major market imperfections exist. We will continuously review our experience with these consultations, and we will also consider the use of imports to enforce market discipline in cases of unfair market practices, or other market imperfections. Based on such reviews, we expect to be able to increase the share of consumer prices subject only to the Import Pricing Rule and the Law of Unfair Economic Practices to about 70% by January 1, 1990, though this percentage can only be determined finally after the reviews have been completed. 5. Taxation and Subsidies A major achievement of the Government in 1987 was the enactment of the tax ref rm, comprising the introduction of a value added tax and personal income-tax. and the elimination of a large number of the existing taxes on enterprise . The tax reform has been implemented effective from January 1, 1988. - tax reform eliminated a great many distortions to enterprise decision-making and will enable efficient enterprises to retain a greater proportion of their profits which will lead to long-run efficiency gains. Aggregate corporate profit taxes are projected to decrease by Ft44 billion and indirect taxes to increase by FtllO billion (8% of GDP). By January 1, 1989, the Countervalue Tax will be eliminated and the Entrepreneurial Tax will be integrated into the personal and corporate profit taxes including a provision for the deduction of the cost of the entrepreneur's labor income for tax purposes. We will undertake a further streamlining of the legal framework of enterprise taxation and introduce a new unified law for the taxation of business profits not later than January 1, 1990. The new system will aim to make the tax system neutral with reference to form of association. In view of the need for strict demand management in 1988, the Government will rebate only 20% of the value added tax paid on goods used for investment. This is a purely transitory measure: 40% will be rebated from 1989, 60% f:om 1990, 80% from 1991, and full rebates are planned from 1992. In addition to the tax reform, a subsidy reduction program will further restructure the role of the State budget in the economy. The 1988 annual plan contains a reduction in the total current producer and consumer support from the State budget, the budget of Local Councils, and Extrabudgetary Funds of Ft37.1 billion to Ft204.9 billion. The Government is strongly committed to taking the needed measures to meet the 1988 plan target - 44 - for reducing subsidies. We will endeavor to continue the phase-out of subsidies as rapidly as possible to improve fiscal balance, tighten financial discipline and promote structural adjustment at both the macroeconomic and enterprise levels. Toward this end, by October 1988 we will develop and thereafter review with the Bank, a program to reduce subsidies and financial support from the 1988 Plan level of Ft2O4.9 billion by at least 10% per year in 1989 and 1990. 6. Wage Differentiation and Worker Mobility The Government supports the principle of free determination of individual earnings based on performance. However, given the necessity of very strict demand management policies in 1988, the Government has been obliged to enforce a general ceiling on increases in enterprises wage bill. During 1988, enterprises will be subject to a 2.5% ceiling on the growth of titeir total earnings bill. Within the aggregate ceiling, enterprises could generate savings by releasing excess labor and apply such savings to increase wages for the remaining work force by more than 2.5X. The mandatory upper limits of wage scales have been removed from 1988 to enlarge the scope for such wage differentiation. The only exception to the general ceiling on wage increases will be made in respect of a small group of enterprises (employing at present 6% of the labor force) meeting objective criteria of profitability, creditworthiness, and non-reliance on budgetary subsidies. The Government intends to elaborate a reform of the wage system during 1988, to be implemented beginning from January 1, 1989. The reform will enable productive enterprises freely to determine individual earnings, subject to an overall ceiling on their wage bill related to performance, permitting sufficient scope for wage differentiation. This will address the need for major shifts in employment patterns likely to arise over the next few years as a result of industrial restructuring. A significant step has been taken in 1988 with the establishment of the Employment Fund with a budget of Ftl.2 billion, to strengthen measures for retraining and facilitate labor mobility. We will continue to modify the conditions for use of the Fund based on experience. 7. Capital Markets Further development of the capital markets for efficient mobilization and allocation of capital will be continued. The new Law of Association, the conversion of some state enterprises into joint-stock companies, and proposals for establishment of securities market regulation, will help to develop the capital market. As a first step, we have already introduced "capital tickets", which are a redeemable, non-voting profit sharing instrument to be issued to employees by their enterprises in 1988. The enterprise and household bond markets have been integrated with the removal of requirement of a State guarantee for bonds sold to the population. We will further modify the regulatory environment to promote development of insurance, and develop plans to operate the social security system on a self-sustaining basis. These measures will also help to strengthen the development of the capital market. - 45 - To ensure the availability of timely and reliable information about the financial position of enterprises and potential borrowers to the banks and investors, new accounting standards, auditing and disclosure requirements have been introduced in January 1988. From mid-1987, several financial institutions, including insurance companies, commercial and specialized banks, have joined together to develop a credit information system and to share information on bond issues and trading. The Government will support an initiative to develop a stock exchange that can serve the needs of an active and diversified financial market. 8. Banking System The most important step to be taken is to integrate the interest rates for enterprises and households in order to unify the flow of savings among all sources and uses through the banking system. The main obstacle to this integration has been the system of subsidized housing loans financed out of low interest rate household deposits. During 1988, we will develop comprehensive proposals for a new housing finance system. As a preliminary step towards the integration of banking services, commercial banks have been permitted during 1988 to issue bonds to households to mobilize resources and to provide banking services to entrepreneurs. By January 1, 1989 we will implement the integration of banking services for households and enterprises and continue the process, with full integration planned in 1989-90. New instruments such as treasury bills have been introduced in 1988 to strengthen the effectiveness of monetary policy. Graduated interest rates have been introduced to improve the refinancing mechanism to reduce excess liquidity in the banking system and facilitate better management of monetary policy. We will continue to review the interest rate structure, refinancing criteria and reserve requirements to improve the effectiveness of monetary policy, resource mobilization and allocation. By June 1988, the newly established commercial banks will carry out a portfolio review by independent auditors to determine the extent of non-performing loans, set up provisions as necessary in accordance with the regulations issued by the State Bank Supervision Board. Steps will be taken to strengthen and systematize the inter-bank market and to establish a clearing center for checks and payments. The Government intends to introduce foreign exchange operations by commercial banks gradually, commencing in 1988. For the time being, borrowing in foreign currencies will be carried out exclusively by the National Bank in view of the need for very careful management of the country's external debt. - 46 - 9. Enterprise Management System The Government intends to extend the system of autonomous enterprise management, at present based on management by partly elected enterprise councils or by enterprise assemblies. While the experience with the present system is too short to draw any defirlte conclusions at present, modifications will be made as required in the light of experiences in the next two years, especially as deregulation of prices and wages is progressively implemented. As mentioned earlier, the new Law of Association will permit State enterprises to convert themselves into joint stock companies. The Government believes that the decision for such conversion should be taken at the initiative of the enterprise managements themselves. To encourage the conversion process, we will identify an initial group of enterprises and facilitate their conversion commencing from 1989. 10. Direct Foreign Investment The Government recognizes the contribution direct foreign investment could make to improving the structure and performance of the Hungarian economy. Besides intensifying promotional campaigns to attract foreign capital and continuing to enter into investment protection agreements with other countries, we will continue to assess the effectiveness of tt.- incentives framework, rules, regulations and operating environment for direct foreign investment and implement modifications as necessary in the context of the newly introduced tax reform and the proposed law of association. 11. Technology Development Technology development is one of the major objectives of our current program. The reform of the tax system and other policy areas radically improves the preconditions for technology development. We have introduced measures for accounting treatment of intangible assets such as intellectual property, e.g., patents and copyrights, and are continuing to develop measures for the accounting treatment of intangible assets and disembodied technology, which will provide necessary incentives for R&D. We intend to review the twelve national R&D programs with a view to concentrating resources on a few selected priority areas, instead of diffusing them thinly and widely. We are continuously developing measures to promote the acquisition of foreign know-how through licensing for indigenous manufacture and for encouraging its assimilation. We will streamline the procedure for approval of licensing, leading to a registration mechanism instead of individual approvals by January 1, 1989. We will continue our effort to make R&D by enterprises more market oriented, and increase the proportion of R&D resources available to enterprises for market oriented R & D activities. - 47 - Conclusion We believe that these actions will contribute to meeting the objectives of industrial restructuring and policy reform as set out in our earlier letters of intent. As in the past, we will continue to consider the reforms as an ongoing process because the specific steps and targets needed to achieve structural adjustment in the industrial sector will change and evolve over time, depending on economic trends and on the results of the reform measures already taken. Accordingly, we will, in consultation with the Bank, continue to deepen the reform process and develop further measures to be taken in succeeding years until the objective of establishing a flexible and efficient structure of production is established. We have always been in mutual agreement that the economic stabilization and structural reform program - of which the industrial sector policy reform program forms the core - both need to be implemented in a consistent and coordinated manner to obtain the necessary supply response, and lead to sustained economic growth. I would like to reconfirm that the Government is committed to implement the program. We appreciate the assistance the World Bank has provided us in this endeavor under the first two industrial restructuring projects. In continuation of this collaboration, I request the World Bank to extend an industrial sector adjustment loan to Hungary in support of the program. This assistance, together with that of the IMF, would help us in restoring equilibrium in the economy and achieving structural changes. It would also strengthen our access to the financial markets during the period of economic stabilization and structural reform. With best regards, Yours sincerely, Joszef Marjai Deputy Chairman of the Council of Ministers of the Hungarian People's Republic 48 - ANNEX fi-I Page I of 8 bUINGARY Summar of Industrial Policy Reform Prooram. 19a8-190 Policy area/Actions Pre-Board PresentatiOns Mid 1988 - end 1988 1989 1990 l. Entry of Enterorise Enact decree permitting individuals to form limited liability associations jointly with a legal entity. Finalization by Council of Submit draft law(s) to Implement law(s) and Continue implementation Ministers of new draft Parliament. Following related regulations legislation (Law of Parliamentary approval. from January 1. '989 Association) permitting amend related laws and (i)State enterprises to regulations. convert themselves into joint stock Companies. (ii)individuals to own negotiable and transferable shares in joint stock companies. and (iii) individuals to form limited liability companies among themselves. and joint stock companies. Prepare new legislation to Enact and implement Continue implementation unify financial environment legislation. facing different forms of associations (e.g. taxation. payment of dividends etc.) and to facilitate mobility among forms. Take further measures to Remove 20X Countervalue Tax. promote foundation and growth Integrate Entrepreneurial Tax of entrepreneurship (e.g.. into personal and corporate immediate rebate of VAT on profit taxes and eliminate other investment for entrepreneurs) anomalies. Increase in maximum number of employees permitted per entrepreneurship from 15 to 30 Assess impact of new tax system on entrepreneurs and implement further necessary modifications. Maintain tax benefits for establishment of new companies and Review and modify tax bene1 its in light of Law of subsidiaries and related incentives for decentralization of Association and unified 1a&' for taxation of business enterprises. profits. Establish schedule for Continue implementation of Complete the program breaking up of some large program. enterprises under State management. and begin to implement program. 2. Liouidation and restructurino of inefficient enterprises Eliminate enterprise and Continue implementation of Continue implementation subsector specific financial policy of policy assistance designed to alleviate financial difficulties of enterprises including (i) tax and loan forgiveness. (ii) State equity allocations. (iii) guarantees of bank loans. and (iv) grants. to individual enterprises outside the Liquidation/Refloatation framework. - 49 - AhZEX 6-1 Page 2 of 8 HNMGARY Sug=arv of Ipdustrial Pmliev Reform Program. lpaa-iqqo Policy area/Acttons Pre-Board Presentations 1id 1988 - end 1988 1989 1990 Eliminate Govt. guarantees Continue implementation of Continue implementation of loans and bond issues for policy of policy Refloatation Organization Reduce budgetary allocations Maintain budgetary allo- Maintain budgetary allo- to Refloatation Organization cation to Refloatation cation to Refloatation from Ft2.0 billion tn 1987 Organization at less than Organization at less than to Ftl.S billion in 1988. previous year's nominal previous year's nominal level level Continue to monitor and enforce adherence to existing refloatation agreements by already refloated enterprises. Require banks to make Continue to implement the Continue implementation Continue implementation provisions for non- measures performirg loans and take measures to encourage banks. tax authorities, and enterprises to collect debts promptly in order to promote financial discipline. Begin implementation of Decide restructuring plan Implement plans action plans for quick and for coach plant of Ganz Mavag efficient resolution of Soroksar Eng. Works and problems of Ganz Havag, Pet Fertilizer Lang Machinery Works, S9roksar Eng. Works and Implement restructuring plans for other enterprises in the liquidation/refloatation Pet Fertilizer, process Begin revising program for Finalize restructuring Begin implementation Continue implementation restructuring of coal mining program. industry to increase efficiency and reduce subsidies. Develop the restructuring Begin implementation Continue the implementation. Eliminate current program for ferrous subsidies except for CHEA price Equalization from metallurgy tncluding limiting the 1988 level and limit Investment support to Ft2 current subsidies except for billion for restructuring investment. CMEA Price Equalization and limiting investment support during 1988-1990 to a total of Ft2 billion. 3. rnterna&tlnal Trade Maintain the import regime free of quantitative restrictions in accordance with the GATT rules and rely increasingly on overall macroeconomic policy and flexible use of market-based instruments, such as an active exchange rate policy, for SOP management. Continue to expand foreign trading rights by introducing automatic registration for legal entities. - 50 - Page 3 of 8 HuIIeARY Summary nt Induttrial Polie ReBtrm Programn IOBa-1990 Policy area/Actions Pre-Pnard Presentations Kid 1988 - end 1988 1989 1990 Continue to encourage establishment of foreign trading houses. offices of foreign companies in Hungary. and offices of Hungarian companies abroad. Review procedures and implement Continue application of streamlined procedures. changes to enzure issue of import licenses to exporters expeditiously. Review the regulatory Implement necessary improvements to make framework framework influencing more efficient. convertible currency trade. Ensure favorable conditions to Continue the process Continue the process create customs free zones. Review and rationalize export Implement necessary changes Continue implementation promotion incentives including regulations for rebate of VAT on investment goods, in light of tax reform. Review implementation of Implement necessary changes Carry out further review Export Promotion Program, to changes. of modified export identify measures for monitoring promotion program. performance of eligible units. Conclude st4dy of export Implement recoomendations Complete implementation marketing of study Continue to lower nominal Camplete ERP study in the first nL!f of 1989. Take tariffs in line with GATT actions accordingly to further rationalize tariffs taking into account the results of the ERP study and results of the Uruguay round. Take measures to improve Maintain appropriate relative profitability of sales to convertible currency markets relative profitability of in relation to sales to other markets. sales to convertible currency markets in relation to sales to other markets. Continuously monitor and take steps to increase effectiveness of the import competition program and broaden its scope. and reduce constraints. 4. Pricing Implement restructuring of relative prices in context of tax reform. Implement plan to move from price regulation towards market regulation. Redefine main role of price authorities to monitoring enterprise compliance with Law of Unfair Economic Practices and regulation of imperfect markets. - 51 - ANNHX i-l Page 4 of 8 sunmary of Industrial Policy Retorm Progam 12l8-1l290 Policy area/Actions Pro-Board Presentations Mid 1988 - end 1988 1989 1990 Increase proportion of Review coverage. level and Implement results of study. Further increase the consumer goods under general methods of price setting. including Increasing proportion of ceonsumer pricing rules to 53% advance reporting and proportion of consumer goods prices subject consultation procedure in goods prices subject only only to the Import producer and consumer pricing to the Import Pricing Rule Pricing Rule and the by end-1988 to limit their and the law of Unfair law of Unfair Economic scope and improve Economic Practices to at Practices in line with effectiveness of market least 62.5% by January the review with the forces. 1. 1989. expectation that the proportion can reach about 70% by January 1, 1990. End current universal requirement for firms to report price increases (April 1. 1988). Examine scope for use of selective imports oe consumer goods to enforce market discipline in cases of unfair market practices. Elaborate legislative framework to prevent monopolistic Implement the legal behavior and enact the framework. framework. S. Taxation and Subsidies Implement tax reform Review/assess infrastructure Review tax system and (introduction of VAT and PIT for tax administration. and propose modifications and rawval of other taxes). modify as needed. (e.g. in rates. brackets to reduce tax burden an etc.) as necessary. enterprise profits (1/S8). Prepare further improvements Eliminate Countervalue tax. in tax legislation Integrate Entrepreneurial tax into personal and corporate profit taxation. Prepare unified law for Subject to parliamentary taxation of business profits approval. implement the law Rebate 20% of VAT on Increase rebate of VAT on Increase rebate of VAT investment goods. investment goods to 40% on investment goods to 60% Eliminate tax incentives for categories of investment other than export promotion (e.g.. energy conservation. waste recycling. raw materials, savings. etc.) - S2 - ANNX fi-1 Page S of a HURM Summry of IndustriAl Polity Reform Program- 1911-log Policy area/Actions Pre-Board Presentations Mid 1988 - end 1988 1989 l990 Reduce total consumr and Oevelop plan to reduce producer subsidies from progressively total consumer Impleiwnt producer and consumer subsidy reduction plan fT242 billion in 1987 and Oroducer subsidies by by 1S to FtzOS billion at least 10% per year in 1988 in 1989-90. 6. Waoe D'fferentiation and Labor Mibilitv Introduce wage club to exempt Review experience and enterprises meeting defined evaluate results criteria from earnings regulation. Prepare reform of the Submit proposals for approval Permit enterprises to Continue implementation wage system determine Individual of wage reform earnings freely. subject Eliminate mandatory to an overall ceiling en application of wage scale their wage bill relatbd ceilings. to enterprise performance. Introduce unified Employment Review operations of Fund Smplement improvements Fund in 1988 Budget to identify and implement possible improvements. Modify conditions for use of Develop further proposals to Review effectiveness and Review effectiveness and retraining benefits to facilitate worker mobility. make modifications as make modifications as facilitate labor mobility. needed. needed. 7. Capital larket Enact decree to liberalize and integrate household and enterprise bond market (including removal of required state guarantee) tntroduce non-voting. redeemable, profit sharing instruments for issue by enterprises to their employees (Capital tickets). Take further measures to develop securities information Evaluate effectiveness of Complete implementation system based on initiatives by participating institutions system and implement ImplerAnt new Evaluate effectiveness and Implement improvements accounting/auditing/information implement appropriate disclosure requirements for modifications enterprises. Review and modify, as necessary, the regulatory environment to promote development of insurance business. Review and develop, as necessary, the measures to encourage wider use of instruments to supplementary pensions. Review and develop. as necessary the plan to operate social security system on a self-sufficient basis over a period. - S3 - ANNEX 6-1I Page 6 of 8 HUGARY SumarX of Industriag Policy Roform Program. 198a-1990 Policy area/Actions Pre-Board Presentations Mid 1988 - end 1988 1989 1990 8. Bankina SYste Permit coesercial banks to engage in household transactions Integrate household and Continue implementation enterprise banking services. Develop proposals for new housing finance system and submit Begin implementation Continue implementation for approval Require comurcial banks to Monitor compliance carry out portfolio review to determine extent of non-perforining loans Require banks to set up Apply regulations for Continue to apply Continue application provisions for nonperforming providing for nonperforming regulations loans and increase capital as 1oans. necessary. Establish institutional Prepare and publish audits Prepare and publish audits Prepare and publish arrangements for annual audits independent audits of comercial banks Introduce issue of treasury Evaluate effectiveness and Continue to implement bills introduce modifications as modifications as necessary necessary Oevelop methods and action Implement system Continue implementation Continue implementation plans for cl ercial banks to conduct foreign exchange operations (excluding borrowing in international markets) and to make adequate provisions for associated risks. Facilitate institutional Assess operations of market Implement improvements. Implement improvements. arrangements for interbank and initiate improvements as mrket needed Finalize proposals for Begin to implement proposals Continue implementation Complete establishment setting-up of bank clearing of clearing center center. Take further measures to develop credit information system Implement credit Evaluate effectiveness based on initiatives by financial institutions. information system. of system and implement needed improvements. Permit enterprtses to open current accounts in more than one bank. Reassess interest rate structure. refinancing criteria, and reserve requirements and implement modifications as needed to improve efficiency of financial system. Complete design of Begin to implemnt the Implement program. Complete implementation program for bankers training program school. - 64 - AlNtYi 6-1 Page 7 of 8 HUNGARY Sumry ot Industrial Policy Reform Program-. 13a-1,00 Policy area/Actions Pro-Board Presentations Mid 1988 - end 1988 1989 1990 9. Enterprise Management System Oecide an and begin Continue implementation Complete implementation implementation of enterprise management system in group of enterprises remaining under State and council management, inter alia. in coordination with decentralization program. Complete study to assess Continue to implement modifications as needed effectiveness of the enterprise management system. Establish and begin to Continue implementation. Continue implementation implement management development and training program. Develop and implement Continue implementation Continue implementation proposals to reduce statistical reporting requirements for enterprises in line with reforms in accounting and taxation. Identify enterprises for conversion into share companies Facilitate conversion of Complete conversion of selected companies selected companies 10. Direct Foreign Investment Continue to assess effectiveness of incentives framework. and Implement measures in context implement modifications as necessary in context of tax reform of Law of Association and preparation of law of association. Intensify promotional campaign to attract foreign Continue promotional campaign capital/technology to Hungary. Continue to expand number of countries with whom investor protection agreements in place. 11. Technology Develomnent Implement new tax incentives Conduct a review of economic Begin implementation for R&D under tax reform incentives for R&D and prepare proposals for implementation Implement national R&D Conduct a midyear review of Continue implementation Continue implementation programs in priority R&D programs and modify them Based on the evaluation areas. to improve effectiveness of present R&D plan. and greater concentration develop R&D strategy for on the more promising areas the 191-9S period if necessary. Abolish regulations Design and introduce Evaluate the impact of for compulsory establishment measures to strengthen R&D measures implemented and of tech. dev. funds facilities of universities policy followed. by enterprises. with the aim to upgrade the level of education and R&O capabilities - 55 - AIIIIX 6-1 Page 8 of a Summaery of Industrial Poliny Reform Program 1988-1990 Policy area/Actions Pre-Board Presentations Mid 1988 - end 1988 1989 1990 rncrease share of allocatt0n frem central funds for market oriented R&D activities. Prepare measures to Introduce measures streamline procedures for the approval of acquisition of foreign licenses including the substitution of present approval procedure with registration mechanism in specific areas for introduction by January 1, 1989. Implement accounting rules to Study measures to extend Introduce measures capitalize intangible accounting rules to identified as a result of assets acquired commercially capitalize other types of study. intangible assets. e.g. proprietory technology developed within the company for implementation. Implement moderniation Continue Implementation of the program Based on evaluation of program for R&D the ongoing program. infrastructure. prepare a long term strategy to upgrade the infrastructure for R&D over the period 1991 _2e5O. 8.i nn term program for 1991 95. including imple- mentation plan. (O6lif) - 56 - ANNEX 7 Page 1 of 2 HUNGARY INDUSTRIAL SECTOR ADJUSTMENT LOAN SUPPLEMENTARY LOAN DATA SHEET Section I: Timetable for Key Events (a) Time taken to prepare project: 8 months (b) Departure of Appraisal Mission: March 4, 1988 (c) Completion of Negotiations: May 13, 1988 (d) Planned Date of Effectiveness; July 15, 1988 Section II: Special Bank Implementation Actions None Section III: Special Conditions (1) Conditions of Loan Effectiveness None (2) Conditions for Release of the Second Tranche (i) Adoption of the 1989 Annual Plan and State Budget, including a public investment plan, which: (a) further reduces the State Budget balance and is designed to lead to a halting in the growth of Hungary's external debt in convertible currency by the end of 1990; and (b) further reduces the total producer and consumer subsidies and other financial support from the 1988 Annual Plan level of Ft2O4.9 billion by at least 10%. (ii) Enactment of a law of associations and related legislation which would permit: (a) State enterprises to convert themselves into joint stock companies; (b) individuals to hold negotiable shares in joint stock companies; and (c) individuals to form limited liability and joint stock companies. (iii) Adoption and commencement of implementation of programs, satisfactory to the Bank, to restructure the ferrous metallurgy and coal mining subsectors. - 57 - ANNEX 7 Page 2 of 2 (iv) Enactment of legislation which would eliminate the Countervalue Tax and integrate the Entrepreneurial Tax as part of the corporate profit and personal income taxes. (v) Enactment of legislation which would allow enterprises to determine freely individual earnings subject to an overall ceiling on the enterprise's wage bill related to its performance. (vi) Integration of banking services for enterprises and households. MAP SECTION Hr 20lBRD 17361t H U N GARY EXISTING FEATURES4 BANK ASSISTED PROJECTS Mtorwy CZECHOSLOVAKIA 4% --' Jo Uivf-i u s s R. PROJECTS. Reilways 1. Inniastroa Cornals -sw r X , r > A A9l-ltu,.I ~~~~~~~~~~~~~~~~Ri-er AW Agrocuitorol Nlationl Copita1 Pntioleonr 0~ ~~~~~~~~~~~~ Megye Capitolss I Tronspors . Internetionol Boon-drie. Container Terminols - Rend ~~~~~~~~~~~~~~ELEVATIONS; 0-200 et.,s ~~~~~~~~~~~~~~~~~~~~~~~~~~Tsoona y regyh6za Sov-, ILDornodwdr , , M< 2 <>f >< > s POLAND ( enO- h ~~ MehedesOd 57 \Wt _§_d__8_ o' ~~~~~~~~~~~~~~ S ROMANIA _n Szorabjthely rniIzk6fkr)t IISCAL -/~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Sbs,rTO Karn L GiO STeRag an ---dmn\_tme.\ .S IL tr v- j C g -. .,wGiEEce 1983TURKEC Kcsisem6tJb re oet ad Rt.WOig' t9,l fo,Ante T-eepws ~OI' RodO 19"85 P_ ~~~~~~~~~~~1986 Iro Prdoam lnrpenan 986 hdid~r ReW ormim - It 1986 TaZegreA'1 Tnlmaarmssotmoe 1987~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~,p rt Ir l'18 -,,!,OLA ANND ~ JHUNGARY ULGRI T. -v b- wpw by ROMANJA~~~~~~~~~ aneaeioreateete\orver 9 201 4 60) BI :\pR ToOs.nenR ~~~~KILOMETERS o7nirmeOtoo oat eanatOn ~ ITAL ALBANlA~~.r ~ 4 TRKEY MARCH 19d8