The European Central Bank (ECB) said Hungary needs "stability-oriented economic policies" and "wide-ranging structural reforms" in a report on the progress of the countryʼs euro convergence released on Wednesday.
The ECB reviews the progress which member states that have not yet adopted the euro are making in "fulfilling their obligations regarding the achievement of economic and monetary union" in its biannual Convergence Report.
"Hungary would benefit from structural reforms aimed at promoting private sector-led growth, such as by improving the governance of institutions and by cutting red tape and the tax burden where excessive," the ECB said.
"In order to further bolster confidence in the financial system, the national competent authorities should continue to improve their supervisory practices, among other things, by following the applicable recommendations from the relevant international and European bodies, and by collaborating closely with other national supervisors of EU Member States within the supervisory colleges," it added.
The ECB noted that Hungary had met the Maastricht criterion for the general government deficit last year, but exceeded the threshold for state debt. Long-term interest rates were under the reference value, but inflation was over the threshold, it added.
Euro convergence criteria limit CPI to 1.5 percentage points over the average rate of the three EU member states with the lowest inflation, and long-term interest rates to 2.0 percentage points over the average ten-year government bond yields in those three states.
The criteria set the thresholds for the general government deficit and state debt as a percentage of GDP at 3% and 60%, respectively.
Although Hungary did not participate in the ERM II, the "waiting room" for the euro, the forint exhibited a "relatively high degree of volatility" over the two-year reference period covered by the report, the ECB noted.
"Hungarian law does not comply with all the requirements for central bank independence, the prohibition of monetary financing, the requirements for the single spelling of the euro, and legal integration into the Eurosystem," the ECB noted in the report.
"Inflation is expected to increase in the coming years, and over the longer term, there are concerns regarding the sustainability of inflation convergence in Hungary," the report said, citing robust job creation and dynamic wage growth, capacity constraints and uncertainty about future oil prices.
Additionally, the process of catching up is likely to result in positive inflation differentials with regard to the euro area, unless this is counteracted by an appreciation of the nominal exchange rate, it added.
The ECB noted progress in strengthening the banking sector, but said net income growth is still largely due to one-off factors. In the current low interest rate environment, there is a need to further increase cost efficiency and diversify sources of income in the sector.
Financial policies should continue to aim at maintaining the sustainability of lending growth to the private sector and prevent excessive growth of asset prices, the report said, noting the need to further improve supervisory practices.
Hungaryʼs fiscal deficit, within the Maastricht criterion, is set to rise in 2018, said the ECB. Fiscal loosening explains the rise of the structural deficit (the deficit excluding one-off and cyclical items) in 2017-2018, which was partly offset by a more buoyant economy.
The ECB noted that the European Commission 2018 spring report points at a high risk of a significant deviation from the path towards the medium-term budgetary objective (MTO).
"Hungary is at low risk of fiscal stress over the short term, but at high risk over the medium term and medium risk over the long term, mostly on account of projected adverse demographic developments," which suggest the need for further pension reform, the report said.
The ECB report sees a need to respect European fiscal rules and EU statistical methodology, increase the efficiency of both revenues and expenditure, and ensure compliance with the 1.5% medium-term objective for the structural deficit.