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The finance minister forever – Hommage to István Hetényi ____________________5

PUBLIC FINANCESTHE GLOBAL ECONOMIC CRISIS AND THE HUNGARIAN NATIONAL ECONOMY

MIKLÓS LOSONCZ: The new wave of the global financial crisis and a few consequences thereof on the global economy ______________________________9

LÁSZLÓ PRÁGER: The global crisis and possible paths of Hungary's economic development ________________________________________________________25

MONETARY POLICY – FINANCIAL STABILITY

ISTVÁN ÁBEL – ÁDÁM KÓBOR: Monetary policy, exchange rate and stability ______34GYÖRGY KOVÁCS: Financial stability and the banking system, or the imbalance

of the intermediary system ____________________________________________50SYSTEMIC RISKS OF HUNGARIAN LOCAL GOVERNMENT SECTOR

ANDRÁS VIGVÁRI: A possible scenario of modernising the Hungarian local government model __________________________________________________69

GÁBOR KOZMA: Environmental, regulatory and control risks in the financial management of local municipalities ____________________________________90

PÉTER HALMOSI: Risks in the local government system from the stakeholders' point of view ______________________________________________________104

KÁROLY JÓKAY – KATALIN VERES-BOCSKAY: Only in Hungary: experiences with municipal debt adjustment and suggested regulatory changes __________115

BARNABÁS REKE: The controlling background of the financial management of municipalities ____________________________________________________130

SUPERVISION AND AUDITPÁL CSAPODI: Advisory activities in the State Audit Office __________________140LÁSZLÓ NYIKOS: The legal and professional regulation of the financial control

of local governments in some EU member states ________________________157

WORKSHOPKLÁRA BUSA – TAMÁS KÓTI – TIBOR TATAY: Proposal on the development

of the voluntary health insurance fund system __________________________177MIKLÓS NAGY: What does the ferryman pay? Quantification of a public

foundation's losses __________________________________________________189

BIBLIOGRAPHY REVIEWBOOKS

SÁNDOR LÁMFALUSSY: Financial crises in emerging markets (Katalin Botos) ______205MARGIT RÁCZ: Challenges and choice of alternatives for the EU in the

2000s (István Benczes) ______________________________________________211ANDRÁS VIGVÁRI (EDITOR): The family silver. Studies on the asset management

of municipalities (Ildikó Gyõrffy) ______________________________________216

PUBLIC FINANCE QUARTERLY

Journal of Public FinancePublished Quarterly

Founder and Owner: Ministry of Finance, Hungary, since May 1954State Audit Office, Hungary, since July 2005

The purpose of this journal is to present an authentic picture of the domestic financial system in Hungary, to show the major features of operating

the public sector and the national economy – as reflected by the principal financial interactions –, the efforts aimed at convergence and at building a future, as well as presenting

the related professional debates.

EDITORIAL COMMITTEE

László Akar, László György Asztalos, Henrik Auth, Gusztáv Báger, Péter Ákos Bod, Katalin Botos, Attila Chikán, Pál Csapodi (Editor-in-Chief), Tamás Erdei (Co-President), Károly Fazekas,

Erzsébet Gidai , Tamás Halm, István Hetényi, Tamás Katona, Lajos Kósa, Árpád Kovács (President), Mihály Kupa, Tamás Mészáros, Zoltán Nagy, Éva Palócz, László Parragh, József Roóz,

Iván Schweitzer, Péter Székely, Elemér Terták, Ádám Török (Co-President), Mihály Varga, József Veress, Éva Voszka

EDITOR STAFF

Pál Csapodi (Editor-in-Chief), János Lévai (Senior Editor), László György Asztalos, Gusztáv Báger, Tamás Halm, Iván Schweitzer, Ádám Török (Head Columnists),

Ildikó Nagy (Editor), Pálné Görgényi (Proof-Reader), Éva Palló (Layout Editor)

Public Finance Quarterly publishes articles proofread by editorial committee members holding scientific degrees.

No part of this publication may be reproduced or distributed for commercial use in any form or by any means without the prior permission of the Publisher.

Public Finance Quarterly – Journal of Public Finance Editorial Office: 1052 Budapest, Bécsi u. 5., Phone: 484-9104, 235-4075,e-mail address: [email protected] Translation: L.C. Bt. Publishing House of Hungarian Official Gazettes, 1085 Budapest, Somogyi Béla u. 6., Phone: 266-9290 Responsible Publisher: dr. László Kodela, Chief Executive Officer of the Publishing House of Hungarian Official Gazettes. Printed by: The printing House of the Publishing House of HungarianOfficial Gazettes; Responsible Executive Norbert Burján, Executive Officer. HU ISSN 0031-496-X., www.hknyomda.hu

Price: HUF 5,775

Authors of this Issue

ISTVÁN ÁBEL

Senior Advisor to the Executive Director, International Monetary Fund,Habilitated University Professor, Budapest Corvinus University

ISTVÁN BENCZES

Associate Professor, Budapest Corvinus University

KATALIN BOTOS

D.Sc. – Hungarian Academy of Sciences, University Professor, Pázmány Péter Catholic University, University ofSzeged

KLÁRA BUSA

Attorney-at-law,Honorary President, Tempo Health Insurance Fund

PÁL CSAPODI

Secretary General, State Audit Office,Titular Associate Professor, Ph.D. student, Szent István University

ILDIKÓ GYÕRFFY

Ph.D. student, University of Miskolc

PÉTER HALMOSI

Ph.D. in Economics, Assistant Professor, University of Szeged

KÁROLY JÓKAY

Managing Director, IGE Consulting Ltd.

ÁDÁM KÓBOR

Ph.D. in Economics,CFA – Chartered Financial Analyst,Portfolio Manager, World Bank

TAMÁS KÓTI

Physician, Economist,Director, Budapest IXth District Outpatient Clinic, Consultant, National Health Insurance Fund

GYÖRGY KOVÁCS

Assistant Professor, University of Szeged

GÁBOR KOZMA

Auditor Counsellor, State Audit Office

MIKLÓS LOSONCZ

D.Sc. – Hungarian Academy of Sciences, Research Manager, GKI Economic Research Co.,University Professor, Széchenyi István University

MIKLÓS NAGY

Managing Director, Budapest Enterprise Agency

LÁSZLÓ NYIKOS

Ph.D. in Economics,University Professor,Former vice president of the State Audit Office,Managing Director, Hungaricus Research and Consulting Ltd.

LÁSZLÓ PRÁGER

D.Sc. – Hungarian Academy of Sciences, University Professor, Head of Department, Károli Gáspár University of theReformed Church,University Professor, Budapest Corvinus University

BARNABÁS REKE

D.Sc. – Hungarian Academy of Sciences,Habilitated University Professor, University of Debrecen

TIBOR TATAY

Assistant Professor, University of Western Hungary

KATALIN VERES-BOCSKAY

Financial Trustee, Vertigalis Co.

ANDRÁS VIGVÁRI

Habilitated Associate Professor, Budapest University of Technology andEconomics,Scientific Consultant, Research Institute of the State Audit Office

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economy, but the system needs modernisation by all means. The main reasons for the lat-ter are that budget withdrawal is much higher than in rival countries in the region andthere is excessive tax burden on the workforce. The round table has worked out a singlemodernisation package for the government, underlining that it was to be treated as a sin-gle unit only. Unfortunately, the amendments of the system of taxation implemented sincethen have selected parts of the proposal package, because of which the desired effect has notbeen and cannot be attained.

The transformation of the system of taxation and even its sensible amendment are dif-ficult to implement because of what are referred to as distribution coalitions and interestgroups. This is a global phenomenon, which is made worse in Hungary by the fact thatthose in authority are reluctant to implement changes even at the detriment of less influ-ential interest groups.

The other lecturer, scientific researcher Zoltán Pitti, member of the board of HEAagreed with Ádám Török in that it was wrong to talk about a tax reform, while taxmodernisation was essential. The latter should not be an ultimate goal but should be ameans, however, that would simultaneously serve the social model and the economicstrategy to be implemented as well as the financing of state commitments. Since therewas no agreement at the societal level on any of these, the term to be used should ratherbe a change in taxation. Given the situation of the Hungarian budget at present and theexpectations for the medium run, this change could, unfortunately, not involve any gen-eral tax reduction, he said. It was not at all sure that growth would develop accordingto the convergence programme and it was thus falling economic performance anddecreasing earnings that were to be burdened by assumingly higher taxes. The effects ofthe system of taxation on competitiveness should not be identified with the extent ofbudget centralisation in any case; economic influences should also be consideredbecause the current regulations were a restraint on performance – both in corporate andin personal income taxation. (The latter as well as the importance of internationalcomparisons had been pointed out also by István Hetényi in Issue 1/2006 of PublicFinance Quarterly.) Finally, Zoltán Pitti recalled that it was at the initiative of IstvánHetényi that the fundamentals of taxation and tax policy became individual subjects inthe curriculum of the University of Economics.

After the invited lecturers, András Vértes, president of GKI Economic ResearchInstitute, recalled, in a few sentences, the activities of István Hetényi in the board of direc-tors and the supervisory committee of GKI as well as the creative contribution by whichhe had helped the institute in laying a better foundation for its economic predictions.

It was finally József Drecin, once vice president of the National Planning Board andstate secretary of education later on, to recall the decades of working together with IstvánHetényi. There were two important conclusions that the participants of the session couldmake from his account. Firstly, there had been open and comprehensive professional work-shop discussions at the National Planning Board, with well prepared experts participating.Secondly, as is also proven by the example of István Hetényi, would be leaders usually pro-gressed through all stages of career development at the time and it happened more rarelythan today that people without genuine professional experience were appointed into man-aging positions by politics.

T. H.

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University of Economics, and his students were precisely aware what professor withimmense knowledge they had.

Probably the best evidence for István Hetényi's unchallengeable professional prestige isthe fact that, after his retirement, for 22 years (with the exception of two years) he was anadvisor of the finance ministers in office.

Minister of justice and law enforcement Tibor Draskovics commemorated IstvánHetényi in his double quality of a former colleague and a representative of the government.Tibor Draskovics had been a secretary of István Hetényi for two years.

István Hetényi's work philosophy was the following: whatever politicians want, the onlything a serious person may take as a basis is facts. He had the courage to recognise whatneeded to be done and to try to reach that goal even under unfavourable circumstances.He was persistent: if his proposal was rejected by the political leadership, he did not giveup upon realising his objective but tried to find new ways – and he usually did find them.

All his actions were characterised by long-term thinking: this was evident in both thetransformation of corporate management and in working out the system of taxation. Hewas a genuine promoter of the political change in the sense that he supervised the estab-lishment of the market economic institutional system (two-level bank system, Europeansystem of taxation).

István Hetényi was a model student of “learning as long as you live”. As a high-rankPlanning Board leader, he learned to speak Russian so as to be able to participate in thenegotiations with Soviet partners with higher efficiency. It was even later that he famil-iarised with computers and informatics. He continuously studied the most up-to-date eco-nomic theories as well.

He was well familiar with corporate operation: already as a pensioner, he was a mem-ber of the boards of Aegon Insurance and Fotex for decades.

István Hetényi was characterised by a respect for knowledge and performance as well asan unquenchable interest in culture. In addition, he even performed everyday householdduties – even as a minister.

How did he use his power? He used it for the implementation of duties, but never for hisown interest! When participating in debates, he was calm and open to the viewpoints of oth-ers, while representing his own standpoint flexibly but consistently, never raising his voice.

Tibor Draskovics, who had worked as a secretary for István Hetényi for two years said,also with reference to his own personal experience, that István Hetényi had always lookedfor talented youths, having a good eye for choosing the best, and acted as their manager,assigning them duties and sending them into conflicts, praising or scolding them, as required.

There were also two professional lectures delivered at the commemorative session. Thefirst one, under the title “Why is it difficult to make a tax reform in Hungary? On the failedefforts of a »think tank«”, was delivered by professor Ádám Török, regular member of theHungarian Academy of Sciences, deputy chairman of the Hungarian EconomicAssociation. Ádám Török is the head of the round table convened by the prime minister inFebruary 2007 with the aim of exploring opportunities to enhance the competitiveness ofthe economy. The round table comprises the most prominent representatives of the profes-sion, who have made seven studies and have held numerous debates on several issuesincluding the system of taxation. The main conclusion of their efforts is that there is no needfor a tax reform because the current tax categories do meet the demands of modern market

responsible statesman, the school founding leader and university professor, the deeplyhumanist intellectual with an encyclopaedic knowledge.

Already in his family background, István Hetényi was thoroughly prepared for hiswould-be leading intellectual role: at a young age, he learned respect for knowledge andperformance, humble behaviour in one's chosen profession as well as love for literatureand music.

István Hetényi attended Palatine Joseph University of Technology and Economics,where he was one of the last students of Farkas Heller (who was also deputy chairman ofthe Hungarian Economic Association at the time). It was partly under Heller's influencethat he learned about Marx – still before World War II – with great enthusiasm and per-sistent thoroughness, and about growth theories later on, always making an effort to attainthe latest theoretical publications.

Hetényi spent his 32-year official career at only two work places: the National PlanningBoard and the Ministry of Finance. There was a series of initiatives related to him and theworkshops and institutions under his leadership. In the team led by Tamás Nagy, he tookpart in preparing the reform of 1968; he worked with the “great generation” and, from themembers thereof, with Béla Csikós-Nagy, for example: a determinative personality in thenew age history of the Hungarian Economic Association.

It was under his leadership that input-output models were first used at the PlanningBoard. He had huge disputes with András Bródy and other outstanding researchers, as wellas with other important economists like Lajos Faluvégi and Mátyás Tímár.

Hetényi had an outstanding role also in the price reform implemented in the early1980's, which was meant to establish market relations in the price system, and it was underhis term as finance minister that the movement was launched which, with the same goal,opened up room for new forms of small enterprises (economic work partnerships, enter-prise economic work partnerships and small cooperatives).

The preparation for the introduction of the really modern taxation system can also berelated to his term as minister, even if he had no chance to submit the related bill due to hisearly forced retirement.

László Békesi quoted from several of István Hetényi's budget speeches, in which thefinance minister had reminded of the necessity to respect economic laws and of the impor-tance of economic balance and market value judgement.

While he always kept away from political wrangling, he did not conceal his negativeopinion of politically determined, wrong economic political decisions, which he, however,formulated with the elegance characteristic of him and often with soft irony. At the end of1986, it was exactly because he stood up for his opposition of a voluntarist economic poli-cy even in the publicity of Parliament that he was forced to retire.

The respect for work and performance permeated the activities of István Hetényi, whichwas what he demanded of his colleagues also. He took institutes employing “hotheadedyoungsters”, like Pénzügykutató (Financial Research Plc.) and the Institute of EconomicSciences of the Hungarian Academy of Sciences, under his protective wings. His team pro-duced a prime minister, six finance ministers, two ministers of economy, two bank of issuepresidents and even a minister of justice.

Although the “paperwork” necessary for academic titles was not one of his strengths, hedelivered excellent lectures, making a great impact at both professional forums and at the

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IIstván Hetényi, once vice president of the National Planning Board, former minister offinance, university professor, one of the best known Hungarian representatives of the pro-fession of economics, once deputy chairman of the Hungarian Economic Association,member of the editorial committee of Public Finance Quarterly, passed away onNovember 11, 2008.

The Hungarian Economic Association chose the most solemn framework available toexpress their respect for István Hetényi: they convened an enlarged board session held atFestetics Palace on January 14, 2009, attended by the members of the executive bodies ofthe Hungarian Economic Association (HEA) as well as those of the editorial committee ofPublic Finance Quarterly, together with numberless former colleagues and respecters ofIstván Hetényi.

In his introductory address, private professor Árpád Kovács, president of the StateAudit Office explained that the best way a scientific professional body could pay tributewas by discussing an issue, with excellent theoretical and practical experts participating,that had been important also for István Hetényi; an issue that he himself had cultivat-ed, researched and taught, at the highest possible standard. The professional lecturestherefore focused on tax affairs, the system of taxation and the development opportuni-ties of the latter.

As chairman of HEA, Árpád Kovács emphasised that István Hetényi had played animportant role in the Hungarian Economic Association. As is publicly known, HEA wasforced to suspend its activities – under political pressure – in the early 1950's; the organisa-tion with over half a century's past at the time was not dissolved but its operation was prac-tically banned. HEA was re-established on December 15, 1959, and István Hetényibecame the founding chairman of the newly established Department of National EconomicPlanning, keeping this position for several terms and being a member of also the nationalboard thereby. In 1987, he was elected deputy chairman of HEA, which position he keptuntil the next general assembly in March 1990. His relations with HEA remained excel-lent even thereafter; he was a most acknowledged member of the association, with high pres-tige and authority, until his death.

The editorial committee (and reading audience) of Public Finance Quarterly remem-ber István Hetényi with similar gratitude. Several years ago when the then finance minis-ter decided to close down Public Finance Quarterly, the professional journal of the Ministryof Finance with a 50 years' past at the time, it was István Hetényi who contacted the boardof the State Audit Office, persuading SAO to take over the publication of the journal, andhe, as a member of the editorial committee, helped in the formation of the professional pro-file of the journal the same in name, but radically new in content and form.

On behalf of the colleagues and friends, it was university professor László Békesi, twiceformer minister of finance to commemorate István Hetényi, the creative economist, the

The finance minister foreverHommage to István Hetényi

PUBLIC FINANCES – The global economic crisis and the Hungarian national economy

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T

Miklós Losoncz

The new wave of the globalfinancial crisis and a few consequences thereof on theglobal economy The crisis that started on the subprime mortgagemarket of the U.S. in August 2007 has graduallyspread to other areas of the financial market andto other countries. In the second wave, whichstarted in September 2008, the crisis evolved intoa bank crisis (liquidity and then solvency crisis)in the developed countries, into a currency crisisin other countries, and has become increasinglyglobal, i.e. it has spread to a growing number ofcountries, and has increasingly affected the realsector.1 It is now clear that in the developed mar-ket economies the financial crisis culminates ineconomic recession, the depth, spatial spread andexpected length of which can hardly be forecasted.

This paper analyses the latest developments ofthe global financial crisis. The first part of thepaper presents the characteristic features of thecurrent phase of the crisis. The second part pro-vides an overview about a few impacts of the cri-sis on finances and the real economy. The thirdpart deals with crisis management at nationaland EU level, while the fourth part is about glob-al crisis management. The study of the topic ismade difficult by the fact that events on themoney and capital markets have recently acceler-ated, and many of the former analyses havebecome obsolete within a short period of time.The fifth part of the paper presents some of theimpacts on the real economy. The sixth part con-tains the summary and the conclusions. Due to

the nature of the topic this study mostly relies oninformation and analyses published in foreignand domestic daily papers, weeklies, and on theinternet, since for the shortness of time expositionsof theoretical rigor could not be prepared aboutthe developments of the latest weeks and months.Naturally, the wider background and the prece-dents were thoroughly discussed in the nationaland international literature, and the conclusionsthereof were taken into account in this study.2

THE MAJOR CHARACTERISTICS OF THEFINANCIAL CRISIS

The first phase of the financial crisis, whichbecame increasingly global, started on the sub-prime mortgage market of the U.S. in August2007, due to the payment difficulties ofdebtors following a drop in property prices.(The majority of borrowers on the subprimemortgage market either lacks an adequatecredit history, or has had mortgage delinquen-cies in the past.) The crisis spiralled into otherrisky fields of the financial market, such as theprime mortgage market (good debtors), themarket of commercial properties, the marketof vehicle loans, bank cards, shares, foreigncurrencies, the market of corporate loans, aswell as to insurance companies (monoline


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insurance companies) that guarantee therepayment of the principal of the bonds in casethe issuer of the bonds goes bankrupt. In par-allel with this, the crisis spread spatially, too,and affected a growing number of countries. Inthis phase the financial intermediaries coveredand mitigated their losses and growing risks byselling their risky assets. In part due to thedecreasing risk-taking willingness of the eco-nomic players, the prices of instruments,which had broken away from the fundamentalsof the real economy, were significantly cor-rected (property prices and stock exchangerates dropped, the dollar, which had becometoo weak, and the yen have gained strengthagainst the major currencies).3

The second wave of the global financial crisisbegan on 15 September, with the bankruptcyof the U.S. investment bank Lehman Brothers,which was followed by the failure or increasedrisk of failure of several other financial inter-mediaries. On one hand, this questioned theoperation and regulation, and even the exis-tence of the investment banking sector in thecurrent form. On the other hand, it led to acrisis of trust encompassing the entire bankingsystem. This crisis first took the shape of a liq-uidity, and then that of a lending crisis, first ofall in the developed countries. As a result ofshattered trust, the crisis first of all manifesteditself in the reduced lending willingness ofbanks, and consequently in the shrinkage, oroccasionally in the temporary “drying up” ofliquidity on the interbank market, as well as inthe rapid rise in the costs of liabilities (due tomutual lack of trust the banks were not willingto lend to one another, or if they were, onlywith a short maturity and high interest rate).The shrinkage of the interbank marketadversely affected corporate and retail lending,too. In parallel with this, several emergingcountries became the targets of speculativeattacks, and the risk of speculation againsttheir currencies increased (Iceland, Hungary,

the Baltic states, Romania and Bulgaria). Theglobal financial crisis began to spread into thereal economy.

The aforementioned segmentation of thecrisis does not reflect reality completely real-istically, since the two phases cannot be sepa-rated in a clear-cut manner. The first phasehad characteristics typical for the secondphase, however the rate and stability of thesecharacteristics were weaker than those typicalfor the second phase. Likewise, some trendsof the first phase continued in the secondphase.

The global financial crisis reflects the aggre-gate impact of a large number of factors, a realeconomic and financial imbalance that accu-mulated for a longer period of time. Theprocess started with the quick rise in risky sub-prime mortgage loans given to people with poorcredit ratings between 2004 and 2006. Thistype of lending was made possible by the lowinterest rates of the market, as well as the factthat the American banks made their lendingconditions more lax. Within all mortgageloans, the share of subprime mortgages grewfrom 3–4 per cent in 1998 to 20 per cent in2006. In the 1990s as much as 25 per cent ofhousehold consumption was covered fromloans in the U.S., which rate increased to 35per cent in 2007. Credit expansion occurred ata time when real wages hardly grew in the U.S.As a result, consumption in the U.S. economygrew while wages did not or did only slightlyincrease, which significantly contributed tothe maintenance of the international wagecompetitiveness of the U.S. The real innova-tion was that the U.S. economy could increaseits lending and pass its outstanding debts on tothe global investors.4

The crisis of the U.S. real estate marketspread to Western Europe with a delay of1.5–2.5 years, albeit to a different extent andwith different characteristic features in theindividual countries. The downturn of the real


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estate market is the strongest in the UnitedKingdom, Spain, Denmark and Ireland. Thesize of the now illiquid U.S. mortgage market,which reduces in value and consists of securi-ties which offer doubtful return, is estimated tobe USD 11,000 billion.

The mortgage crisis is aggravated by theprofiteers of the crisis. When the first signs ofthe crisis appeared on the U.S. subprime mort-gage market in 2006, many lenders and loanintermediaries shifted the focus of their activi-ties to loans backed by the Federal HousingAdministration (FHA). The FHA issuedlicenses to many intermediaries with a ques-tionable background, too, and ill-reputed com-panies registered themselves under new names.A lot of market players resumed the old prac-tice of lending to clients of modest means. Bythe autumn of 2008, FHA backed loansaccounted for 26 per cent of all new mortgagesbeing issued nationwide, up from 4 per cent ayear earlier, with a high rate of actual andpotential bankruptcy. According to estimates,over the next five years fresh loans backed bythe FHA will generate a loss of around USD100 billion.5

The various financial innovations fosteredsecuritisation and the development and spreadof various derivative transactions. As far assecuritisation is concerned, lenders sold a sig-nificant portion of mortgages in the form of socalled structured securities around the globe.Structured investment or loan products arespecial securities that are backed by the port-folios of homogeneous debt groups (mortgageor motor vehicle loans, credit cards, bonds andother assets). The banks sell the assets theylend (mortgages, etc.) in the form of securities(bonds) on the free market, and through“repackaging”, bank loans turn into assets-backed securities.6 Structured securities con-vert loans, as well as securities derived fromloans into bonds of various quality in terms ofcredit rating. However, in the course of this

transaction it is ignored that the losses of pri-mary securities exponentially grow in thestructured products, and take heavy toll of theprincipal.7 In the U.S. and Europe the aggre-gate issue value of the different structured loanproducts is estimated to be USD 2,600 bil-lion8. Within this amount debt-backed securi-ties or collateralised debt obligations (CDOs)and mortgage-backed securities (MBSs) totalUSD 1,200 billion and USD 1,000 billion,respectively. Credit rating institutionsfavourably rated the risks implied in the prod-ucts that had been repackaged several timesdespite the fact that they were unable to assessthe actual threat they carried with their tradi-tional methods.

The other large group of financial innova-tions is made up of loan-based and highly lever-aged derivatives, wherefore they are very sensi-tive to changes in market prices, exchange ratesand interest rates. A significant portion ofthese derivatives serves speculative purposes.One of the most important derivatives is thecredit default swap (CDS), which providessecurity against the insolvency of the borrower.This derivates transaction makes it possible totransfer the credit risk: the buyer of protectionmakes periodic payments (swap spread) to theseller of protection, who in return provides aguarantee for the debtor's obligations. Thistransaction allows investors to separate risksimplied in changes in the interest rate from therisk of non-payment by the borrower. CDSissuance exploded during the credit marketboom after 2001. They were used to secure notonly government and corporate bonds, but alsomortgage-backed securities. The value of out-standing CDS grew from USD 1,563 billion atthe end of 2002 to USD 54,611 as of 30 June20089 (this latter amount equals 88 per cent ofthe global GDP). Early 2008, this value was ashigh as USD 62,200 billion.10 The financial sys-tem is placed under significant pressure even ifonly one of the major participants of CDS


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transactions becomes insolvent. The liquidityproblems of Fannie Mae, Freddie Mac andLehman Brothers in August and September2008 affected USD 700 billion worth CDS.11

AIG (American Insurance Group) was throwna lifebelt partly because it was a major seller ofCDS.

Risky financial instruments also include theso called carry trade transactions, in which theeconomic players borrow low-yielding (e.g.Japanese yen) and lend high-yielding curren-cies (e.g. New Zealandian, Australian or USdollar, etc.), or invest in futures contracts onthe market of raw materials, or indexes, oroften in high risk, leveraged speculative instru-ments (that by far exceed their own capital) onrisky markets (in developing or emergingcountries). Carry trade significantly con-tributed to the development of the currencymarket bubbles (to the considerable undervalu-ation of the Japanese yen, and the excessivestrengthening of target currencies – Australianand New Zealandian dollar, etc.), and it alsonourished the stock market bubbles. The sizeof the currency market bubble has recentlyreduced due to the dollar and the yen gainingstrength.

In addition to other factors, low interestrates also encouraged investments into thefutures raw material and energy markets (main-ly into the oil market). Apart from the tradi-tional market players, institutional investors(primarily investment funds) and to a smallerextent individual speculative investors havealso appeared. Raw material and fuel futuresand indexes have become a separate class ofinvestment. Speculations on the commodityand energy exchange contributed to the soaringprices of raw materials and fuels on the worldmarket – which was naturally very much linkedto changes in the prices of underlying productsdue to fundamental reasons. However, theweight of this role is seen rather differentlyaccording to the literature.

A FEW FINANCIAL CONSEQUENCES OFTHE CRISIS

There is no doubt that securitised loans andleveraged derivatives reduced or eliminated theindividual risks of the economic players, byspreading such risks throughout the interna-tional financial system. However, they did noteliminate the risk of the financial system as awhole; in fact, they increased such risks. Thesize, spatial existence and the location of theserisky financial products in the sector of finan-cial intermediaries are not known. Their identi-fication and regulation are made difficult by thefact that it is often difficult to draw the border-line between certain financial products andinstitutions. On one hand, banks in the regu-lated segment can also possess mortgages andother securities embodying loan relations andderivatives, etc. On the other hand, the interac-tion between the individual products and thefinancial intermediaries is extremely strong.The latter can explain the fact that the bank-ruptcy of relatively small financial intermedi-aries can trigger a strong domino effect, i.e. thespiralling effects of their failure can be signifi-cant. The clearly distinguishable institutions ofthe “shadow banking system” are hedge fundsthat invest into risky assets.

Several estimates have been made about thesize of securitised loans and leveraged deriva-tives. The largest estimate is USD 516,000 bil-lion, which is nearly ten times the world'sGDP calculated on the basis of purchasepower parity. The current global financial crisiscan be compared to the world economy crisisof 1929–1933 only on the basis of the size ofimbalances that need to be alleviated.Otherwise the causes, driving forces, real eco-nomic effects and other consequences of thetwo crises are different.

According to the latest data, the losses of thefinancial intermediary sector incurred (writtenoff) so far are close to USD 1,000 billion. The


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developments of the latest period have furtherdecreased the value of mortgage bonds andother securities that embody debts, whereforefurther write-off for losses can be expected.The World Bank estimates the total loss causedby the global financial crisis to be USD 3,000billion, or 4.5 per cent of the world's GDP. TheUSD 1,400 billion estimate of the InternationalMonetary Fund is smaller than that, but it sig-nificantly exceeds the loss of USD 945 billionforecasted in April.

The course of the global credit crisis depends onhow soon and at what pace the accumulated realeconomic and financial imbalances can bereduced and eliminated. For example, in the US1.1 million residential properties are beingforeclosed, but even without these foreclosuresmore than 400,000 homes are on sale.According to the forecasts of market players,residential property prices will drop by a fur-ther 15 per cent in the next one and a half years.Even if the decline of property prices stops in2010, the demand for homes will remain low.The consolidation of the housing sector in theUnited Kingdom, Ireland and Spain will alsorequire a longer period of time.

The cut-back of securitised positions andleveraged derivative instruments will also lastlonger. It will definitely imply tensions, it maylast longer than expected, and may increase therisk of unpredictable capital flows due to theconcomitant hectic exchange rate fluctuations.In the case of deteriorating financial and eco-nomic outlooks the markets set prices in antic-ipation of a much higher rate of corporatebankruptcies, as well as of higher losses onloans and securities. Although the extremelystrong financial stress of 15 September dieddown within a short time, the financial upwindand permanent uncertainty will sustain untilthe end of 2009, and even then only slow con-solidation can be expected. In addition to thedirect impacts of the financial crisis, economicactivities are largely restrained by the low level

of trust. As the financial crisis progresses,households and companies are getting pes-simistic about jobs and profits for a longerperiod of time. It is a significant negative riskthat a greater than expected recession in thedeveloped countries may start a second wave ofcrisis in consumption and corporate loans,which may further weaken the capital adequacyof banks and other financial institutions.Overcoming the global financial crisis can beaccelerated, and the aggravation of the crisiscan be prevented by state intervention.

THE MAIN CHARACTERISTICS OF CRISIS MANAGEMENT AT NATIONALAND EU LEVEL

In the current phase of the global financial crisisthe most important objective of crisis manage-ment has been to sustain the operability of thefinancial intermediary system in the developedmarket economies.12 Almost every country'sbanking system has been stricken with threeinterrelated problems: having taken huge lossesthe banks need capital. The shaken balance canbe restored or at least mitigated by reducingthe amount of the balance, by buying out baddebts, or by raising capital. Reduction of theamount of the balance leads to the furthershrinkage of loan offers, wherefore recapitali-sation is a better solution. On the other handthough, because the short-term money mar-kets are closed, the banks are cut off from themain source of liquidity. Finally, since they can-not borrow in the longer-term paper markets,they are short of the funds they need to financethe share of their assets not covered by theirdeposits.13

Earlier, sovereign investment funds partici-pated in crisis management by contributing tothe equity raise of certain financial institutionsby buying stakes therein, and thus saved theU.S. financial intermediaries concerned from


14

bankruptcy. Lately, these investment fundshave given up their role in crisis management.This can partly be explained with the fact thatsome of their former investments have provedto be loss-making, while on the other handthey find it extremely risky to acquire financialintermediaries with liquidity and solvencyproblems, since it may turn out that their port-folios include a lot of bad debts. Therefore,they are more interested in taking over compa-nies.

Under such circumstances, recapitalisationof the banks must be undertaken exclusively bythe state by way of individual (bilateral) trans-actions as requested by the banks. The out-come of such transactions is usually not public,information about them can only be obtainedfrom indirect information.14 In the U.S. thestate first tried buying all or part of risky assetsfrom the banks. In Western Europe certainstates acquired stakes in the banks' share capi-tal through capital raise. Recently, the U.S. hasalso shifted to this practice. According to thecalculations of the International MonetaryFund, U.S. and European banks need USD 675billion of new capital to restore their solvency.Two thirds of this sum is needed by Europeanbanks.15

Efforts for the elimination of money marketdisturbances have so far focused on short-termloans from the central banks. Short-term loansare secured by securities and other illiquidinstruments backed by mortgages. The stateintends to encourage the resumption of long-term lending by giving guarantees for newloans, which it will provide after the expirationof old loans. Since the beginning of the crisis,the Federal Reserve has increased the liquidityof the financial system by around USD 2,000billion in the framework of “quantitative eas-ing”. Assistance to domestic banks, and secur-ing the liquidity and solvency thereof haveinternational aspects, too, if the financial insti-tutions in need of help have foreign sub-

sidiaries, too. Since the bankruptcy or lendingproblems of the parent banks may aggravatethe position of the foreign subsidiaries, too,since they depend on the foreign exchangeresources of their respective parent banks. Theextension of state guarantees to retail deposits– differing in size and content country bycountry – was devised to avoid a bank panic.

Apart from making the above mentioned liq-uidity loans and guarantees available, the mon-etary policy actors in the U.S. and WesternEurope wanted to contribute to crisis manage-ment, and the improvement of the liquidity ofthe financial system by cutting the central bankbase interest rates. Following earlier interestrate cuts, the major central banks of the world(the Federal Reserve of the U.S., the EuropeanCentral Bank, the Bank of England and theSwiss central banks) collectively slashed theirbase interest rates by 0.5 per cent on 8 October2008. (Since 2001, this was the first coordinat-ed action for reducing the interest rate).However, in certain emerging countries theinterest rate was raised to avoid capital flights.

The leeway of monetary policy in crisis man-agement is rather limited. On one hand, the cen-tral bank base interest rate cannot be reducedbelow zero. (The reference interest rate of theFed, which acts as a central bank in the U.S., is1 per cent, and that of the Japanese centralbank is even lower.) On the other hand, in themidst of general mistrust the interbank interestrate is much higher that the central bank baseinterest rate. The interest rate policy of thecentral banks did not achieve the desired goalin that the interest rate cuts of the centralbanks failed to boost borrowing and consump-tion. Consumption has not been encouragedby the drop in raw material and fuel priceseither despite the fact that lower prices meanincome saving for households. Probably, thiseffect was significantly neutralised by the risein unemployment, and the growth in savingsdue to fear of losing jobs.


15

Under such circumstances, it was for the fis-cal policy to ease the burden on monetary pol-icy. Countries affected by the crisis havelaunched fiscal programmes that are primarilybased on the expansion of the expenditure sideof public finances and/or tax cuts to counteractthe consequences of the global financial crisis,with a total of EUR 2,600 billion so far.16 Fiscalexpansion means that on one hand automaticstabilisers are allowed to play their role, whileon the other hand, discretionary expendituresare raised. (Automatic stabilisers are budgetaryitems that follow the fluctuations of the GDP.For instance, during weaker booms tax rev-enues drop, unemployment benefits grow, i.e.automatic stabilisers increase and decrease thepublic finance deficit in times of recession andboom, respectively.) The increase of discre-tionary spending must be timely, the rise inexpenditures must be targeted (must focus onhouseholds that use their income, increaseddue to fiscal stimuli, on consumption) and shallbe temporary.17 Fiscal policy and public financeexpenditures are both affected by the measuresthat aim to provide assistance to the debtors ofnon-speculative mortgages (by the reschedul-ing of loan repayment and other means). Thesocial costs of this move are significantly lowerthan massive forced liquidations. Fiscal expan-sion and recapitalisation of the banks by the stateincrease the public finance deficit, and conse-quently, government debts, wherefore it could beconsidered only in countries with tolerable gov-ernment debt.

In the European Union the interest rate pol-icy of the ECB still has reserves: it can reducethe current base interest rate of 3.25 per cent.Despite this fact, a fiscal incentive programmewas tabled at the December meeting of theEuropean Council, which fosters both econom-ic growth and long-term competitiveness(infrastructure development, R&D, innovation,environment friendly technologies, investmentprojects, etc.). The programme was tailored to

the specific features of the member states; thegovernments may choose between expenditureraise or tax-cuts depending on the strengthsand weaknesses of public finances. Countrieswith poor public finances cannot use the toolof fiscal incentive. The budget of the pro-gramme totals EUR 200 billion, or 1.5 per centof the GDP of the member states. As much asEUR 170 billion of this sum is financed by themember states; EUR 30 billion is providedequally by the European Investment Bank andthe European Commission.

The fiscal programme does not affect thebasic principles of the Stability and GrowthPact, however, in line with the practice fol-lowed so far, it treats them flexibly. In 2009,Ireland, the United Kingdom, Spain, Portugal,France and Italy will violate the requirementof the Stability and Growth Pact, according to which the public finance deficit cannotexceed 3 per cent. Therefore, the EuropeanCommission will launch the excessive deficitprocedure. However, since the reason behindthe violation of the Pact is not irresponsiblefiscal policy, but recession triggered by theglobal financial crisis, no sanctions will beimposed. The limit specified in the Stabilityand Growth Pact can be temporarily exceeded,if the member state concerned undertakes torestore the balance of public finances in themedium run, i.e. by 2013.

In addition to the fiscal incentive packagethe Commission also wants to use the existingprogrammes for crisis management in part byreducing red tape, and in part by reschedulingthe given programmes. For example, the pay-ment of EUR 6.3 billion from the StructuralFunds (2 per cent of the appropriation for theperiod between 2007 and 2013) will be broughtforward. This amount, which will be used as anincentive for small and medium-sized compa-nies, the development of education, the estab-lishment of scientific parks, the developmentof environment friendly technologies and


16

infrastructure, will become available for thebeneficiaries by the middle of 2009. This prac-tically means pre-financing instead of post-financing. The Commission will make effortsfor the better utilisation of the resources ofthe European Social Fund, too (EUR 11 bil-lion per year, which will first of all be used forthe alleviation of employment problems.). Thenew EU member states will be allowed toreceive regional grants originally scheduled tobe disbursed at a later time (a total of EUR 347billion between 2007 and 2013) in 2009 and2010. Special support will be given to the auto-motive and construction industries that areespecially hit hard by the global financial crisis.The provision of support is linked to certainconditions. Passenger vehicle manufacturersmust speed up the development of environ-ment friendly cars, otherwise they will not beeligible for the support of EUR 5 billion.Similarly, construction industry players mustmeet energy saving requirements during con-struction projects. The resources of theEuropean Investment Bank are also increas-ingly rendered to serve crisis management. Forinstance, the bank wants to lend EUR 15 bil-lion more than planned to small and medium-sized companies.

The fiscal incentive programme of theEuropean Union coordinates the national meas-ures. It renders short-term crisis managementto serve the Lisbon objectives. At the sametime however, it is not clear to what extent it isabout retailoring the existing programmes, andto what extent it is about new resources. Thefiscal incentive jeopardises the sustainability ofpublic finances, fiscal easing and the recapitali-sation of the banks lead to a growth in govern-ment debts in certain countries, and may createa debt trap.

As a rule, during financial crises there is aneed for stronger state regulation. One of theproposals for the regulation of the CDS marketis that only economic actors licensed to con-

duct insurance business should be permitted toissue CDS. This proposal also attacks “naked”CDS (buying protection on a company inwhich the protection buyer does not holddebt). (This is similar to the ban on short sell-ing, in which a market player sells a financialinstrument that the seller does not own at thetime of the sale.) The activity of the most activeplayers of the CDS market, the so called mono-line insurance companies (insurance companiesthat guarantee the repayment of bonds shouldthe bond issuer become insolvent) has beenregulated since the late 1990s. Paradoxically,these financial intermediaries have become thelargest victims of the recent market turbu-lences. Market transparency would definitelyimprove if CDS were traded on the stockexchange, or at least there existed a clearinghouse for the completion of transactions. Themost significant risk of such proposals is thatin case privately negotiated contracts are treat-ed as securities, these derivatives may bepushed back into market segments in which thesupervisory authorities have no jurisdiction.18

CRISIS MANAGEMENT AND INTERNATIONAL COOPERATION

The global financial crisis has hit hard the liq-uidity and solvency of certain emerging coun-tries, too, in part due to the rise in risk marginsand the decline in global financing liquidity.The growth of risk premiums has severelyaffected countries with a vulnerable macroeco-nomic balance. The shortage of global liquidityhas severely affected states the banking sectorsof which heavily depend on external moneymarket, and in which loans increased at a high-er rate than it would have been desirable tomaintain to the balance.19 Iceland experienceda financial crisis, while Hungary could avoid aspeculation driven financial crisis throughinternational cooperation (loans from the


17

International Monetary Fund, the EuropeanCentral Bank and the World Bank). The exter-nal balance and liquidity are vulnerable inPakistan, Ukraine, the Baltic states, Romania,Bulgaria and Turkey. Had a few at-risk coun-tries become insolvent, it would have threat-ened the spread of the crisis to other countrieswith unpredictable consequences, which raisedthe issue of the need for international coopera-tion with dramatic force. It is worth notingthat the global financial crisis has also adverse-ly affected – through the banking system ofsignificant international exposure – countriesthat possess large currency reserves by interna-tional comparison (Russia, the Republic ofKorea, Singapore, etc.).

In conjunction with the European CentralBank and the World Bank, the InternationalMonetary Fund played a prominent role in crisismanagement in Iceland, in crisis prevention inHungary, as well as in the aforementioned coun-tries. The IMF has USD 200 billion in equity,and USD 50 billion in quickly accessible for-eign resources. The Charter of the Fund allowsthe disbursement of loans funding current pay-ments account deficits, but does not allowlending for liquidity purposes. This problemseems to have been solved: as much as USD 2billion has already been given to Iceland, USD16.5 billion to Ukraine and USD 15 billion toHungary. The size of the assets falls short ofthe forecasted needs, and is extremely modestin general terms, too, compared to the imbal-ances accumulated in the global financial sys-tem. Countries struggling with financial prob-lems can receive maximum three times theirnational quotes. Yet, Ukraine and Icelandreceived 8 and 11 times their respective quotas.The IMF would not be able to help countries ofthe size of Brazil, Turkey or Argentina.However, it must be added to the rather com-plex picture that the International MonetaryFund was established at a time when interna-tional capital flows were not liberalised. Its

equity was adjusted to the realities and needs ofthat period.

The IMF requires adequate resources forsuccessful crisis management (in the form ofcredit guarantees and the availability of addi-tional credit sources). This can be implementedeither through capital increase, or through ascheme in which countries with a positive bal-ance on current account and significant foreignexchange reserves (mainly China, Japan and theoil exporting countries) offer part of theirresources unconditionally to the InternationalMonetary Fund to mitigate global imbalancesand to assist countries hit by the global finan-cial crisis. Japan has already done so, it hasoffered USD 100 billion from its USD 980 bil-lion foreign exchange reserve to the IMF. TheWorld Bank intends to provide USD 100 bil-lion in new resources to the developing coun-tries, especially to those with modest meansand medium-level income.

The financial crisis has brought to the surfaceand highlighted a few strengths and weaknesses ofthe European Union and the Economic andMonetary Union (EMU). The most significantstrength is that through the common currencythe Economic and Monetary Union protectedits member states from potential exchangecrises, wherefore the appeal of EMU member-ship has grown for EU and non EU countries(Iceland) alike.

As far as the weaknesses are concerned,according to the EC Treaty the Community isnot responsible for the obligations of the gov-ernment agencies and other public law institu-tions of the member states, and the memberstates are not responsible for the obligations ofgovernment agencies and public law institu-tions of other member states. With the excep-tion of liquidity loans the European CentralBank cannot provide loans to the organisationsor agencies of the Community, or to the centralpublic administration agencies and otherauthorities of the member states. Therefore, in


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the case of a financial crisis the EU memberstates must turn to the International MonetaryFund for help.

Otherwise the competence of the EuropeanCentral Bank extends to the EMU memberstates, and in certain cases to countriesinvolved in the ERM-2 exchange rate mecha-nism, considered as the “ante-room” of theEconomic and Monetary Union. This lattermeans that if the exchange rate of the currencyof a given country relative to the euro leavesthe ±15 per cent intervention band around themiddle rate of the central bank, then not onlythe central bank intervenes, but also the ECBin order to keep the exchange rate within theband on the foreign exchange market.However, this can happen only if the exchangerate leaves the intervention band for reasonsother than the economic policy failure of thegiven member state. This is a theoretical possi-bility of assistance. In line with the specificcharacteristics of convergence to the developedcountries (Balassa–Samuelson effect, etc.), thecurrencies of the new EU member states are, asa rule, revalued both in real and nominal terms,and at the strong end of the band the centralbanks can intervene even without assistancefrom the ECB (euro must be bought fornational currency). The weak end of the band is“farther away”, and the central banks cannotallow the devaluation of the national currenciesto the weak end of the band. They must pre-vent further devaluation much earlier by inter-vening into the foreign exchange market, andby using other means.

Due to these institutional and operationalobstacles, the governments of the membersstates, the European Central Bank and the cen-tral banks of EU member states that do notbelong to the EMU acted independently, yet inharmony with one another to remedy the liq-uidity and solvency problems of financial inter-mediaries.

At the same the European Union's room for

manoeuvre was increased by the fact that inanticipation of situations similar to the currentone, in 2002 the European Council created acredit line of EUR 12 billion, which is at thedisposal of the European Commission, andwhich has not yet been activated. (Hungary hasreceived a lump sum of EUR 6.5 billion fromthis credit line.) It must be noted that the U.S.Fed also assumes an active part in crisis man-agement. It has offered a liquidity credit line ofUSD 30 billion for Argentina, South Korea andSingapore.

Another example of international coopera-tion is the G-20 summit held in Washington on15 November, which envisaged the elaborationof a crisis management action programme byMarch 2009. The G-20 group was set up by thefinance ministers and central bank presidentsof Argentina, Australia, Brazil, Canada, China,France, Germany, India, Indonesia, Italy, Japan,Mexico, Russia, Saudi Arabia, the Republic ofSouth Africa, South Korea, Turkey, the UnitedKingdom and the U.S. in 1999, in the wake ofthe Asian and Russian financial crisis so thatthe representatives of the major industrialisedand developing countries would regularly meetto discuss the key problems of the global econ-omy. These countries account for 90 per centof global production and 80 per cent of globaltrade. The composition of the G-20 is not per-fect for today's problems. It excludes Spain,which is considered to be a big economy, butincludes a mid-sized country that has becomeirrelevant to global finance because of its ownmismanagement (Argentina).20 Still, due to itscomposition the G-20 is a better forum for cri-sis management than the G-7 group of devel-oped countries.

In 2009 the G-8 Group may expand toinclude China and India. A smaller, and there-fore more efficient group than the current onecan be formed only if European representationis reduced. For the time being Western Europeis over-represented in all international organi-


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sations. It would be reasonable if only the EU,and not the member states represented them-selves in the International Monetary Fund.This is a significant precondition for the inter-national regulatory reform.

When in the autumn of 2008 the UnitedKingdom was the first country to announceintervention in the banking system, the mar-kets did not react positively. However, whenthe enlarged Eurogroup embraced the sameproposition, the market reaction was alreadypositive. The decisive role was played by a bodythat has no formal existence: the eurozoneheads of government and state (France andFinland are represented by their respectiveheads of state due to their public law status), aswell as the head of the British government, theEuropean Central Bank and the EuropeanCommission. The enlarged Eurogroup is not inconformity with the provisions of the LisbonTreaty.21

Recently, it has been more and more widelyrealised in the European Union that in additionto interest rate cuts by the central banks andthe recapitalisation of banks, crisis manage-ment requires fiscal incentives, too.

Joining international cooperation frame-works China has taken measures to increasedomestic demand. In the next two years itwants to spend a sum equalling EUR 468 bil-lion on infrastructure development, environ-ment protection, tax cuts and welfare expendi-tures. This amount equals 14 per cent of theannual GDP, and is considered as a significantfiscal incentive in time of peace. According tothe signs, the Chinese leadership has under-stood the weight of the problem, and the risksof non-action. It is not negligible either thatChina has the resources needed for crisis man-agement. After the two-digit growth rates ofthe past years the deceleration of the GDPdynamics to 6 per cent is like a recession, andmay generate significant social tensions.(According to the Chinese leaders, GDP

dynamics of at least 8 per cent are needed inorder to avoid a jump in unemployment.)

Crisis management is made difficult by thetug-of-war between globalisation and nationalsovereignty. On one hand, big financial insti-tutions have far outgrown their domesticmarkets, wherefore finance has become themost globalised and unstable segment of theworld economy. In a crisis the state has toplay a big role in making lending safer inreturn for more stringent regulation andoversight. Governments broadly welcome thebenefits of global finance, yet they are not pre-pared to set up either a global financial regula-tor, which would interfere deep inside theirmarkets or a global lender of last resort.22 Insuch circumstances it is already progress ifnational regulators coordinate their stand-points and measures.

REAL ECONOMIC EFFECTS

Until mid-September, macroeconomic fore-casts assumed that the growth rate of the glob-al economy would slightly decrease. However,after the liquidity, trust, and then the solvencycrisis set in, which hit the financial institutions,the concomitant wave of bankruptcies andnear-bankruptcies in the U.S. and in Europe,the increasing costs of loans, the plummetingshare prices and the growing exchange rate ofthe dollar against the major currencies madethe earlier forecasts null and void. The tighten-ing of loan conditions affects households andthe business sector alike. However, independ-ent of this, both households and businesseshave become more cautious in borrowing. Thefall of share prices contributes to the decline ofprivate consumption and investment projectsprimarily in the U.S. and the United Kingdom.

The most significant change triggered by thecurrent stage of the global financial crisis,which began in mid-September, is the revalua-


20

tion of risks on the money and capital markets.Among other things this is indicated by thefact that the yield margin of U.S. and Europeancorporate bonds (the difference between theyield of BAA-rated corporate bonds and U.S.government securities with a 10-year maturity)is the highest since 1931–1933. Whenever theyield margin permanently increased by over250 basis points in the U.S. after 1930, it led toa decline in business investments.

Under the current circumstances the reliabil-ity of the forecasts depends more on the prop-er assessment of risks premiums, and less onthe quality of the applied models. Although theprocess has not ended yet, according to thecurrently available information, in the longerrun the risk premium (the difference betweenthe expected yield of risk-free and risky instru-ments) is going to be 150 to 200 basis pointshigher than before the global financial crisis. Asfar as the impact on the real sector is con-cerned, according to estimates based on modelcalculations, the growth of the risk premium by200 basis points will reduce the long-termpotential growth rate by around 2 per cent inthe developed countries, i.e. the former highgrowth rate is not very much likely to resumeafter the end of the crisis. However, for theshort- and medium-term growth trends it isfavourable that the raw material and fuel priceshock has significantly subdued, even disap-peared lately, which diminishes the inflationaryrisks, and somewhat mitigates the negativeeffects of the global financial crisis on the realeconomy.

On this basis, the GDP is expected to fall by2 per cent in the OECD countries in 2009(which is the greatest recession since 1982).This decline will be followed by near stagnationin 2010 (a growth of 0.2 per cent), and a slowupswing is expected only in 2011.23 Thisassumption is supported by the experience thatupswing is more protracted after financialcrises than after “traditional” recessions. The

negative, downward risks of this forecast aresignificant. Recession can be stronger if thegovernments' efforts to save the financial insti-tutions fail. On top of that, the risk of deflationis extremely high in Japan and the U.S. It is apositive risk if the impacts of recession cansomewhat be offset by international coopera-tion and coordinated economic policy.

After a 1.14 per cent growth experienced in2008, the GDP of the U.S. is expected toshrink by 1.6 per cent in 2009, and is expectedto stagnate in 2010. One of the main reasonsbehind this is the reduction of the 70 per centshare of household consumption in the GDP(which is unsustainable already in the shortrun), and the downsizing of the inflated finan-cial sector. The effects of the fiscal package ofUSD 700 billion accepted in the autumn of2008 will relatively soon melt away, howevernew programs will follow.

As a result of the extension of crisis manage-ment by the state, the GDP relative publicfinance deficit of the U.S. may grow from 5.9per cent in 2008 to over 10 per cent in 2010. Thenegative risk factor in the growth of the U.S.economy is represented by further bankruptciesof banks, i.e. the fact that the state will not pre-vent the failure of large financial institutes.

Under the conditions of globalisation, theEuropean Union, including the Economic andMonetary Union, could not avoid the real eco-nomic effects of the financial crisis. The con-solidated GDP of the EMU is expected todecline by 2 per cent in 2009, and stagnate in2010. The growth prospects are especially grimin Germany, where the economic players heav-ily depend on bank loans, and in Spain, wherethe hosing bubble has burst (a decline of 2.5and 1.7 per cent in 2009, respectively). Theoutlooks in France and Italy are not bettereither. The drop in the GDP of the EuropeanUnion is expected to be slightly smaller (1.8per cent) than in the EMU, and this will be fol-lowed by near stagnation in 2010. The strong


21

decline in the GDP of Britain will be somewhatoffset by the more favourable performance ofSweden, Denmark and mostly that of the newmember states.

From among the new EU member states theglobal financial crisis hits the Baltic countriesthe hardest, where recession started already in2008. The growth rate is expected to diminishthe most in Poland and the Czech Republic, butthe GDP dynamics of Slovakia, Slovenia andRomania will also significantly fall. Within theOECD countries the Japanese economy willalso slump into recession in 2009, which will bedifficult to get through. The GDP dynamicswill also fall in Canada and New Zealand, butmay stay relatively favourable in Australia.

The recession expected in the OECD coun-tries will not lead to a decline in global produc-tion. It will only strongly reduce the growthrate from 3.4 per cent in 2008 to 0.5 per cent in2009, which is expected to be followed by adynamics of 2 per cent in 2010. China and Indiaplay a prominent role in the stabilisation ofglobal production. The growth rate will declinein these countries, too, but will remain dynam-ic due to the expansion of domestic demand.(It is another issue that the reduction ofgrowth will cause tensions in both countries,and the effects in China will equal those of aminor recession.) As a result of a drop in rawmaterial and fuel prices on the global marketdue to shrinking growth, the role of oil and rawmaterial exporting countries (OPEC, Russia,etc.) will diminish in the regulation of globaleconomic growth. In case no banks go bank-rupt, growth promoting initiatives can beexpected in Brazil, Mexico and South Korea.

The global financial crisis adversely affectsthe financing of international trade, too.Consequently, the growth rate of global trademeasured in dollars will dip by 2.8 per cent in2009, and is expected to grow by 3 per cent in2010. The decline in the dynamics of globaltrade affects almost all countries of the global

economy, but in general it will be stronger inthe developed than in the emerging countries.The expected decline of global trade in 2009has been unprecedented since the wake ofworld war II.

SUMMARY AND CONCLUSIONS

The financial crisis that started out in the U.S.mortgage market in August 2007, and thatbecame a global crisis from September 2008,severely affecting the operation of the financialsystem, seems to be the gravest crisis in manyyears. However, the current crisis can be com-pared to the great depression of 1929–1933only on the basis of the financial and real eco-nomic imbalances that need to be alleviated,and consequently, maybe its length. Otherwisethe causes, driving forces, real economic effectsand other consequences of the two crises areradically different.

In order to alleviate the real economic imbal-ances that serve as a basis for the current glob-al financial crisis, the oversupply of residentialproperties must be reduced or eliminated in theU.S. and in several European countries (UnitedKingdom, Ireland, Spain, Denmark, etc.). Itcannot, or can be forecasted only with greatuncertainty at what housing prices the balanceof the housing market will be restored. Thedecline of real estate prices is much likely tocontinue for some time. The other real eco-nomic basis of the global financial crisis is thatin the U.S. the level of consumption versus theGDP swell, and the households financed a sig-nificant portion of this consumption fromloans.

The excessive consumption of U.S. householdsis financed by countries – mostly emergingcountries – with a positive balance on currentaccount (China, India, Asian industrial com-modity exporters, and crude oil exporters).The alleviation of this imbalance requires adap-


22

tation and more savings on the part ofAmerican households, as a result of which therate of consumption will decrease relative tothe GDP, and therefore a significant drivingforce of economic growth will weaken (asmuch as 70 per cent of the U.S. GDP is spenton consumption), as well as growth in domes-tic demand in countries with a positive balanceon current account. According to the indica-tions, China is interested in maintaining thehigh dynamics of domestic demand not onlybecause of its increasing global role, but alsofor domestic reasons, to keep social tensionsunder control. Therefore, it is ready to takeeconomic policy steps to boost domesticdemand. Finally, imbalances can be in part alle-viated by streamlining the financial intermedi-ary sector, which grew excessively in the U.S.during the years of the credit market boom,and by reducing its outstanding share of 40percent from the GDP and the profit of thebusiness sector.

The mitigation and elimination of imbal-ances in the financial sector requires the cut-back of abnormally inflated securitised andleveraged derivative instruments. On one hand,the process is made difficult by the fact thatreliable information on the size of such finan-cial instruments and on their location in theglobal financial system does not, and as a mat-ter of course, cannot exist. On the other hand,risky securitised loans can and will somewhatreproduce themselves due to regulatory defi-ciencies and anomalies.

The cutback of securitised and leveragedinstruments, together with the elimination ofreal economic imbalances, goes together withthe destruction of values that take the form ofhuge paper (virtual) profit at macroeconomiclevel, but represent real losses for many eco-nomic actors. In order to cover losses incurredfrom financially innovative risky instrumentsnon loss-making financial assets must also besold, which leads to the general fall in the price

of financial assets, and which adversely affectsthe playing field of the economy. On the otherhand, from time to time this generates exces-sive tension in the financial system. In thedeveloped countries the short-term effect isrecession, which started in the middle of 2008,and may end at the end of 2009 at the earliest,but the risk of prolonged recession and slowupswing is great.

The most significant change triggered by thefinancial crisis is the revaluation of risks on themoney and capital markets. Under such circum-stances the reliability of macroeconomic fore-casts depends more on the proper assessmentof risks premiums, and less on the appliedmethods. As a result of the sustained growth ofrisk premiums, the potential growth rate, sus-tainable in the long run, decreases in the devel-oped countries. This means that after the endof the recession the GDP dynamics will verymuch likely be slower than before the crisis,which projects the decline in the growth of theglobal economy, too.

Due to the strong globalisation of the finan-cial sector witnessed in the past years, thefinancial crisis has also reached economic play-ers and countries that did not, or hardly boughtfinancial instruments backed by mortgages orother risky securities “prone” to be devalued.These economic players and countries wereaffected by the crisis through the generaldecline in risk-taking on one part, and throughmore difficult access to external fundingresources on the other, i.e. trust and liquiditycrises followed.

Experience shows that market mechanismsby themselves are not able to resolve the glob-al financial crisis; they deepen the crisis both inthe developed and emerging countries in a self-exciting manner. The targets, means and insti-tutional system of crisis management by thestate are taking shape in practice. As the muni-tion of monetary policy is running out, thefocus of crisis management is increasingly


23

being shifted to fiscal policy. The introductionof fiscal incentives is a possibility only inslightly indebted countries with relatively lowpublic finance deficits. Despite the possibleformal similarities, this is not the renaissance ofKeynesian economic policy. At best this is thetimely, targeted and temporary use of certainelements of that policy. The state's shareacquired in the banks through capital raise doesnot mean wide-scale and permanent nationali-sation, and proprietary role exercised by thestate. In fact, this is not a state task, but tem-porary crisis management. As soon as the situ-ation consolidates, the state will sell its bankshares, albeit it is another question, at whatprice it will do so. The impacts of governmen-tal crisis management on the public financesand government debts of the different coun-tries cannot be seen yet. At any rate, in the longrun it will adversely affect economic growth,and represents a downward, negative risk fac-tor.

The globalisation of the financial crisis haspromoted international cooperation, too. In the

European Union it has brought to the surface afew weaknesses of the Economic and MonetaryUnion, and the Stability and Growth Pact.Crisis management first of all requires theexpansion of the scope of the internationalfinancial institutions, primarily that of theInternational Monetary Fund, as well as theincrease of the available resources. Strongerinternational cooperation is hampered by thefears of losing national sovereignty.

For the time being it cannot be clearly deter-mined how radical the changes induced by theglobal financial crisis will be in the global finan-cial model based on the liberalisation andderegulation of the financial markets. It is afact that state regulation increases duringcrises, and this experience is valid for the cur-rent global financial crisis, too. For the timebeing it cannot be unanimously stated whetherthe increased role of the state in crisis manage-ment, the tightening of the regulations on themoney and capital markets will put an end to thecurrent, so called neoliberal model, or will justmodify it.

1 In connection with the definition of financial crisessee for instance Katalin Mérõ: A pénzügyi stabilitásalapkérdései (The basic questions of financial stabili-ty), National Bank of Hungary, October 2003.http://lucifer.kgt.bme.hu/pub/penzugytan/torolt/Penzugyi-stab.ppt

2 Júlia Király – Márton Nagy – Viktor E. Szabó: Egykülönleges eseménysorozat elemzése – a máso-drendû jelzáloghitel-piaci válság és (hazai)következményei (Analysis of a special series ofevents – the subprime mortgage crisis and its/domestic consequences), Közgazdasági Szemle,volume LV, July-August 2008, pp. 573–621., ÉvaFischer – Gergely Kóczán: Rendkívüli hatóságiintézkedések és tanulságaik a jelzálogpiaci válságkapcsán (Extraordinary measures taken by theauthorities and the lessons drawn from them inconnection with the mortgage crisis). Study by theNational Bank of Hungary, No. 72, Budapest,

February 2008, 59 pages, Downloadable from:http://mnb.hu/Engine.aspx?page=mnbhu_mnbtanulmanyok&ContentID=10766

3 For more details see for instance Miklós Losoncz:The U.S. credit crisis and its implications on globaleconomy, Public Finance Quarterly, Volume LIII,Issue 2/2008, pp. 253–268

4 Viktória Dobsi quotes Frédéric Lordon: C'est la vie,or just on the contrary, what do the French thinkabout the financial crisis? Magyar Narancs, 20November 2008, page 26

5 The subprime wolves are back. Business Week, 1 December 2008, pp 39 and 37

6 For more details see Gyula Nagy: Globális pénzü-gyi piacok: virtualizálódó befektetési világ valósá-gos kockázatokkal (Global financial markets: vir-

NOTES


24

tualising investment world with real risks, manu-script), Budapest, 2008, to be published in thejournal Külgazdaság

7 Júlia Király – Márton Nagy – Viktor E. Szabó: workcited above, page 614

8 IMF Global Financial Stability Report – ContainingSystemic Risks and Restoring Financial Soundness,April 2008, Washington D.C., page 56 http://www.imf.org/external/pubs/ft/gfsr/2008/01/pdf/text.pdf

9 Chris Giles: Into the storm, Financial Times, 14November 2008, page 10

10 CDS market faces up to a new reality, Euromoney,October 2008, page 24


12 For the description of crisis management in the firstphase up to January 2008 see the above cited workof Éva Fischer – Gergely Kóczán

13 Global finance: Lifelines, The Economist, 11October 2008, page 83

14 Éva Fischer – Gergely Kóczán, page 7 of the abovecited work

15 Global finance: Lifelines, The Economist, 11October 2008, page 85

16 Chris Giles: Into the storm, Financial Times, 14November 2008, page 10

17 see Lawrence Summers: Why America must have afiscal stimulus, Financial Times, 7 January 2008,page 9


19 Júlia Király – Márton Nagy – Viktor E. Szabó, citedwork, page 615

20 Redesigning global finance, The Economist, 15November 2008, page 13

21 Marta Dasu: Europe must act as one on theworld stage, Financial Times, 20 November 2008,page 11

22 Redesigning global finance, The Economist, 15November 2008, page 13

23 The source of 2008 and 2009 figures is the latestforecast of the International Monetary Fund:International Monetary Fund: World EconomicOutlook Update, Global Economic SlumpChallenges Policies. Washington, 28 January 2009.Downloadable from: http://www.imf.org/exter-nal/pubs/ft/weo/2009/update/01/index.htmFigures for 2010 are own forecasts.


25

T

László Práger

The global crisis and possiblepaths of Hungary's economicdevelopment1

The global economic crisis, which became promi-nently visible in 2008 is of a global nature in sev-eral senses of the word; it has various dimensions.The US mortgage crisis is, on the one hand, a partof it and, on the other hand, a factor that revealedit. Yet there is a correlation that lies much deeper,namely, a tension that results from an excessivedivergence or split between the real economy andspeculative financial flows. That tension was cou-pled with indebtedness that had become universaland affected countries, companies, local govern-ments and individuals alike. This, on the onehand, further increased the gap between the cashflowing in the world and the actual production orthe level of material goods; on the other hand, itmade the four groups dependent on banks and, atthe same time, made their creditors depend onthem, and, finally, made banks depend on eachother within the framework of the financialworld.

The crisis is global in terms of geographicaldimensions, as well. In the first years of the 21stcentury it cannot happen otherwise. In a glob-alised world, where borders have ceased to exist,economic processes can spread without borders:the crisis, which had started in the US, spread allaround the world.

In the global crisis, Hungary needs to find anew path of development: not only a pace ofdevelopment that is increasing, but, at the same

time, those internal economic and social struc-tures that prove to be more favourable than theprevious ones. It is not that the crisis spread toHungary. After the democratic transition, theHungarian internal market became internation-al; almost half of our gross production and morethan two thirds of our foreign trade is producedby transnational companies that had establishedthemselves in Hungary.

Undoubtedly, the global crisis opened a newchapter in the process of defining Hungary's pathof development. The crisis, on the one hand,made changes inevitable, and, on the other hand,accelerated their pace. Yet the crisis in itself mayconceal the erroneous paths and inefficiencies ofHungary's internal development temporarily, ormay serve as a warning sign that gives informa-tion on the weak points of our post-transitiondevelopment of almost two decades.

INTERNATIONAL TRADE INCREASESFASTER THAT PRODUCTION

The global nature and the spread of the crisisare due to the fact that the openness of worldtrade has become more prominent than everbefore. The process of the opening of foreigntrade started one and a half centuries ago andaccelerated after World War II. As for the


26

beginning of the process, that is, the first phaseon the path to globalisation, in 1870 the ratioof the world's exports of goods to global GDPwas below 5%. By the turn of the 20th and 21stcenturies, this ratio had roughly tripled: it wasabove 17%. It is also worth noting the changeswithin the general figure of the global average.The ratio of Western Europe, originally under10%, had increased above 35% by 2000, whilecountries with enormous internal markets (e.g.the USA or China) had transformed into openeconomies whose level of foreign trade, if com-pared to production, gradually increased. (SeeTable 1)

From the perspective of individual countriesand the world alike, the major reason for this is,that in the phase of economic history referredto above, world trade displayed a developmentthat was 1.5–2 times faster that that of produc-tion. In the 50 years after World War II, globalproduction increased sixfold, while the level ofworld trade grew to 18 times its former size.On the one hand, the process of foreign tradegrowing faster than production affected pro-duction, more specifically, accelerated its rate

of expansion; on the other hand, the widedivergence between the two processes – albeitit did not constitute the root cause – did makethe separation of production and financialflows possible.

THE DEVELOPMENT OF GLOBAL ECONOMIC OPENNESS

The limitless spread of the global economic cri-sis of 2008 is due to the fact that since the1970s, parallel to a continuous growth of for-eign trade, the flow of working capital hasstarted and its role in international trade hasgained an ever-increasing significance. Thisprocess marked the beginning of a new era ofopenness. Within the framework of interna-tional foreign trade, there was a movement ofproducts (development was limited to a certaindegree by geographical distances); in the era ofthe flow of working capital gaining ground, bigcompanies establish affiliates everywherearound the world – and the production of theseaffiliates form a part of the economy, GDP and

Table 1

THE RATIO OF EXPORT OF GOODS AND GDP BETWEEN 1870 AND 1998 (prices of 1990; percentage)

Country, region 1870 1913 1929 1950 1973 1998Western Europe 8.8 14.1 8.7 18.7 35.8

France 4.9 7.8 8.6 7.6 15.2 28.7

Germany 9.5 16.1 12.8 6.2 23.8 38.9

Netherlands 17.4 17.3 17.2 12.2 40.7 61.2

Great Britain 12.2 17.5 13.3 11.3 14.0 25.0

Eastern Europe

and the former Soviet Union 1.6 2.5 2.1 6.2 13.2

United States 2.5 3.7 3.6 3.0 4.9 10.1

China 0.7 1.7 1.8 2.6 1.5 4.9

India 2.6 4.6 3.7 2.9 2.0 2.4

Japan 0.2 2.4 3.5 2.2 7.7 13.4

World 4.6 7.9 9.0 5.5 10.5 17.2

Source: Gács, János: A gazdasági globalizáció számokban. A nyitottság alakulása az EU-országokban [“The Economic Globalisation in Charts.The Development of Openness in EU Member States”], Közgazdasági Szemle, October 2007, pp. 876–902


27

performance of the host country. In 2000,approximately 60,000 transnational companycentres were operating in the world. The num-ber of subsidiaries located and functioning inother countries, is over 700,000 – more thanten times higher than the number of parentcompanies. (See Table 2)

Nowadays the role of the flow of working cap-ital, capital leasing and the establishment ofcompanies abroad far surpasses the economicimportance of traditional foreign trade betweencountries. The working capital base, which wasaround UDS 600 billion at the beginning of the1980s, had exceeded USD 10,000 billion by2005, while the sales of foreign affiliates hadrisen above USD 22,000 billion, which amount

is approximately twice as much as the globalexport of goods. (See Table 3)

In a new, open and globalised world, transna-tional companies were given a role that is inde-pendent of countries in many respects. This factis manifest in gross absolute figures and per-formances. (See Chart 1)

The annual performance (level of addedvalue) of major transnational companies, suchas Exxon Mobil, General Motors or Ford equalsthe annual GDP of a medium-sized country(e.g. the Czech Republic or Hungary). Yet theessence of the economic functioning of a glob-alised world does not lie simply in gross values.In the periods of global economic booms aswell as crises, interlinked assets and complex

Table 2

THE NUMBER OF AFFILIATES OF TRANSNATIONAL COMPANIES IN VARIOUS REGIONS AT THE TURN OF THE CENTURY

Region Number of parent companies Number of affiliatesDeveloped countries 48,791 94,269

Developing countries 12,518 355,324

Eastern and Central Europe 2,150 239,927

Global (total) 63,459 689,520

Source: UNCTAD

Table 3

TRANSNATIONAL COMPANIES GAINING GROUND BETWEEN 1982 AND 2005

Term Value at current prices Growth rate (Billions of USD) (percent, 1982=100)

1982 1990 2005 1982 1990/1982 2005/1982FDI outward stock 600 1,791 10,672 100.0 298.5 1,778.7

Sales of foreign affiliates 2,620 6,045 22,171 100.0 230.7 846.2

Assets of foreign affiliates 2,108 5,956 45,564 100.0 282.5 2 161.5

Exports of foreign affiliates 647 1,366 4,214 100.0 211.1 651.3

Employment of foreign affiliates

(thousands) 19,537 24,551 62,095 100.0 125.7 317.8

GDP (global, in current prices) 10,899 21,898 44,674 100.0 200.9 409.9

Exports of goods and services (global) 2,247 4,261 12,641 100.0 189.6 562.6

Source: table constructed on the basis of the 2006 data of the World Investment Report (www.unctad.org)


28

proprietary structures evolve. This, on the onehand, makes the interconnection of variousprocesses global and, on the other hand, accel-erates decision-making – and then the process-es as a whole – to such an extent that they ceaseto be controllable or manageable.

Another decisive factor and, at the sametime, the cause of the large-scale spread of theglobal crisis of 2008 is the fact that by the endof the 20th century the value of products andservices produced in reality and the amount ofcapital, including the amount of speculativecapital, had displayed a considerable diver-gence. It is almost impossible to give statisti-cally exact data on the degree of divergence orthe magniture of these two figures, yet thereare estimations according to which the magni-tude of the financial space that has become large-ly speculative is 5–10 times as big as the annualGDP of the world.

As for the evolution – and, more significant-ly, the intensification – of the global economiccrisis of 2008, analyses (and facts) show thatstock exchanges and stock exchange processesplay a role of paramount importance. Again, thepoint is that recently (especially in the lastdecade) processes that differed from previousones have begun: the production of companieslisted by stock markets, the changes in theirprofits and total actual value on the one hand,and the value of quoted shares on the otherhand, diverged increasingly. Particularly in thepast five years, market indices have soared to anunprecedented degree; they doubled and grewcontinuously, thus giving the impression of sta-ble value increase that seemed to go on for ever.In the 21st century, in a global world of a newstructure that can be seen but partially and can-not be defined by the means of traditional sta-tistics and concepts, any kind of partial “break-

Chart 1

DIVERGING TRENDS OF GLOBAL PRODUCTION, WORLD TRADE, FLOW OF WORKING CAPITALAND THE PERFORMANCE OF THE FOREIGN AFFILIATES OF TNCS (1982=100)

Source: figure constructed on the basis of the 2006 data of the World Investment Report (www.unctad.org)

Exports of foreign affiliatesExportsGDPEmployees of foreign affiliates)

Assets of foreign affiliatesFDI outward stockSales of foreign affiliates


29

down” that hit a certain level was sufficient tomake a seemingly local problem spread over thewhole fabric of the global economy with unpar-alleled speed and thus turn into a “global crisis.”

It follows from what has been said on theessence of a global crisis that the “reconstruc-tion period” of the global economy, which hasbecome indispensable by now, is not merely aseeking and a re-establishment of economicbalance, but a reconsideration and redefinitionof the old structures that involve much tension.It is impossible to foresee the content that willactually evolve and come real; yet it is certainthat the balance will require a framework widerthan before. This wider framework includesnot only the United States and Europe, butChina and a large number of emergingeconomies, as well; it also includes – albeit at adifferent scale of magnitude – Hungary, whichhas the opportunity to define and formulate itsrenewed path of economic policy within theglobal framework outlined above.

HUNGARY'S GLOBALISING ECONOMY

Even in September 2008, when the crisis wasaccelerating, major figures of economic policyand leading economic workshops often raisedthe question if the crisis would spread toHungary. Obviously, when a global crisis isunfolding, no country can stay intact with theimplementation of some kind of isolation orautarchy (which, let us add, are both non-exis-tent in the present age). Yet at the same time –and this is the point of the present essay and, ingeneral, of economic policy – the fight againstthe global crisis and the success of such a fight,are determined by the strength of the givencountry's internal economy and the level of itsgross economic performance, development,competitiveness, inner cohesion and employ-ment standard. Returning to the issue of“spread”, it is to be stated that in the perspective

of the nature of global economy, it seems basi-cally unjustified to raise the question. Almosttwo decades after the democratic transition,Hungary has become a part of the global econo-my; furthermore, Hungary's internal market hasbecome international, that is, a location wheretransnational companies and international banksare operating. Hungary has also traversed thepath described above (and traversed by the glob-al economy as a whole): the democratic transi-tion at first brought about an immediate open-ing in the field of foreign trade, while, almostconcurrently, a rapid and large-scale flow ofworking capital began, and the stock exchangeevolved – the paths of the financial space and thereal economy that do not necessarily move par-allel or are connected sufficiently.

Immediately after the democratic transition,due to the collapse of COMECON and thecessation of former economic contact points,and in parallel with a favourable structuralchange, the gross level of several basic per-formance indicators of Hungary's economyfell. The GDP decreased by 15%, the exportfell to below USD 10 billion, the internal mar-ket weakened to an even greater extent, theemployment rate decreased from 5 million to3.8 million. Out of the four selected basic indi-cators that characterise international contacts(foreign trade), the condition of the internalmarket, the condition of the labour force, thelevel of total production, and exports, it wasthe latter that was the fastest to regain its for-mer dynamics and turned from decline togrowth.

It is worth examining when the value of thehighlighted indicators reached the 1989 level. Adecade later, the GDP (taking the 1989 level as100%) was 99%, and reached and exceeded the“transition level” in 2000. Retail turnover,which is illustrative of the strength of internalmarket and the population's purchasing power,displayed a major recession; it hit rock bottom(65%) in 1997, to reach the 1989 level as late as


30

in 2003. Twenty years after the transition,employment – one of the most complex factorsof economic and social processes – is stillaround 75% although employment level is per-haps the most important indicator ofHungary's actual modernisation in terms of itseconomy as well as in other fields. It wasexport that was the fastest to recover; it tooksix years to reach the 1989 level (101% in1995). However, one of the most importantquestions concerning economic policy andpossible paths of development is whetherexports can still be considered a developmentindicator with the same significance.

The question is answered – and, at the sametime, a description of the entrance into anoth-er path of openness is given – by the history ofthe flow of foreign working capital to Hungary.At the time of the democratic transition, therewere some 250 companies with foreign owner-ship in Hungary, with USD 250 million ofworking capital base. A decade later there were25,000 companies with partial or total foreignownership in Hungary and approximately USD25 billion of working capital base.

Hungary's economy changed not only interms of gross indicators of economic per-formance, but its inner structure was funda-mentally transformed, too, including owner-ship structures, distribution conditions, theroles of large, small and medium sized compa-nies, regional differences or the level of thedivergence between the earnings or theincomes of various social groups or of individ-uals. Beside several other aspects, in terms ofthe present investigation it is a fact of deep sig-nificance that, as far as GDP generation is con-cerned, the ratio of foreign and Hungarian com-panies is 50–50%. Equally important are thefacts that the number of companies is over400,000, large enterprises produce 52% of thenet turnover and the share of international com-panies in Hungarian exports is around 75%. (SeeChart 2)

At first, the openness of Hungary's economy(on the basis of which Hungary faces the glob-al crisis or plays a role in it) was the result ofthe above-mentioned fast expansion of foreigntrade. In the year of the democratic transition,Hungary's export of goods (in USD, at currentprices) was 9.5 billion; in 1995, 12.9 billion; in2000 it exceeded 28 billion, and in 2003, 43 bil-lion. In the recent years, the growth rate of for-eign trade has continued to accelerate: in 2004,2006 and 2007, it exceeded the rate of the pre-vious year by 18-18 and 16% respectively. In2007 the value of exports was EUR 68.6 billion.

The main consequence for economic policyis the realisation that the role of exports inHungary's economy has undergone a change: thetrends and volumes of internal production andforeign trade turnover have displayed a diver-gence. Although export growth is still a majorfactor of the expansion of Hungary's economy,if compared to its scale, it exercises but a limit-ed effect: the direct relation of export growthand GDP increase is less intense. This is due tothe above-mentioned second wave of theprocess of opening: transnational companiesgaining ground in Hungary's economy. In theHungarian economy, with its low level of cap-italisation, there were but a limited number ofother ways; however, the possibility for amore harmonious formation of inner struc-tures did exist in certain contexts. Yet by 2008it was an undeniable fact that the condition anddevelopment of Hungary's economy – given thecountry's weak internal market and feebleSME sector – had become greatly dependent onthe functioning and results of transnationalcompanies.

EXTERNAL BALANCE, INNER HARMONISATION AND GROWTH

Now, in the period of the global crisis – andmost probably in the forthcoming period, too,


31

Hungary's economy is and will be charac-terised by the presence of two seeminglyopposite factors. Without an adequate level offoreign direct investment, the Hungarianeconomy as a whole cannot come up withproper economic results; yet if foreign capitalfails to integrate into Hungary's economy to agreater degree, then the internal market willstay weak, the employment situation willremain problematic and Hungarian enterpris-es will not gain strength. The growth ofexports, and its specific form that bringsabout internal strengthening, follow fromthese relations. Today, a significant part ofHungarian exports is made up of the re-export-ing of the imported goods of transnational com-panies, with a low level of value added inHungary. However, making foreign workingcapital an organic part of Hungary's economy

can solve the contradictions between exportgrowth and internal development.

Similar to the global international econom-ic environment – described in the first part ofthe present article –, Hungary also displayssigns of an internal crisis similar to those ofexternal crisis: the real economy on the onehand and financial and capital space on theother hand have diverged. It was mentionedthat securities markets, provided that theyfunction reasonably, can strengthen real flowsand thus can exert a favourable influence oneconomic processes. In many respects, thechanges of the Hungarian stock exchangereflect the processes of international stockexchanges. The Budapest Stock Exchange(where the ratio of foreign investors isaround 75% – one of the highest ones, ifcompared to international stock exchanges),

Chart 2

DISTRIBUTION OF COMPANIES OF TOTAL AND PARTIAL FOREIGN AND HUNGARIAN OWNERSHIP ON THE BASIS OF THEIR VARIOUS PERFORMANCES IN 2005

(percentage)

Source: Chart constructed on the basis of Zoltán Pitti's calculations)

Foreign ownership Hungarian ownership

Number of Subscribed Number of Net turnover Export Gross added Public duties Profit after companies capital employees value tax


32

especially since 2005, has seen value changesthat failed to follow the performance of thecompanies behind the stock exchange list-ings. In 2005, the BUX index was 23,000points (more than twice as high as the level of2003, when it was at 10,000 points); in thesummer of 2007, it exceeded 30,000, whereasin the autumn of 2008 – as a result of theglobal crisis and as a sign of an internal crisis–, it fell below 12,000 points. The stockexchange capitalization of shares was HUF2800 billion at the end of 2001; in September,2007, it exceeded HUF 10,000 billion. At theend of September, 2008, the market value ofshares was HUF 5,659 billion, which meansthat the total value decreased by more thanHUF 4,000 billion. Hungary's economic pol-icy has a double task to perform: to consoli-date a securities market that has deviated

from real processes, yet to do so, in any case,it has to consolidate the real economy.

Hungary's economy will have to face theglobal crisis and join in development processesof international scale within the globalisedstructure described above; furthermore, thecountry has to define and realise its own inter-nal growth and development within this frame-work. This makes the re-establishment of bal-ances inevitable. However, in the long run, agenuine catching up can commence only withthe creation of a financial balance (the formeris embedded in and directs the latter) and withthe redefinition of internal structures. (SeeChart 3.)

Returning to the four basic processes men-tioned at the beginning of the analysis ofHungarian conditions, it is to be noted that itis an inevitable task for the economic policy to

Chart 3

THE BASIC FORMULA OF HUNGARY'S “DEVELOPMENT DISORDERS”: DIVERGENT DEVELOP-MENT PATHS OF GDP, EXPORT AND RETAIL SALE BETWEEN 1989 AND 2006

Source: figure constructed on the basis of (various volumes) of KSH Magyar Statisztikai Évkönyv [“Hungarian Central Statistical Office: HungarianStatistical Yearbook”]

Retail saleEmployment

ExportGDP


33

re-order the diverging global growth path(GDP), foreign trade trends (includingexport), the development path of the internalmarket and the development paths of theemployment situation. To establish external and

internal balance, re-align the conditions of thereal economy and the financial space, securesteady growth and launch a sustainable develop-ment, essential issues, internal economic andsocial structures need to be harmonised.

NOTE

1 A related article is the author's sub-study “An Analysis of the Macro-economic Risks of the 2009 Budget”, pre-pared on behalf of the ÁSZ FEMI (Research and Development Institute of the State Audit Office of Hungary),October 2008, pp. 92–97., and his recently published book titled Within and beyond global economy, AulaPublishing House, Budapest, 2008 (a review of the book was published in Issue 4/2008 of the Public FinanceQuarterly – the editor).

PUBLIC FINANCES – Monetary Policy-Financial Stability

34

I

István Ábel – Ádám Kóbor

Monetary policy, exchangerate and stability1

In inflation targeting, it is difficult to managethe relation between monetary policy and theexchange rate. If the central bank pays attentionto this connection, it may be under criticism thatthey are targeting the exchange rate and notinflation. Our paper discusses an element of therelation between monetary policy and theexchange rate which has been overlooked todate. The difference between domestic and Eurointerest rates are in close correlation withexchange rate volatility. What it also means isthat interest rate policy has a significant impacton market stability.

According to one school of new theories, itis hardly possible to grasp monetary policy bythe impact it has on specific macroeconomicvariables or on their average. Instead, moreinformation is conveyed in other statisticalindicators, e.g. dispersion. The differencebetween forint and euro interest rates is animportant attribute of monetary policy yetopinions vary on what and how it affects.According to the traditional theory of uncov-ered interest rate parity, Hungary needs to keepup a higher interest rate than the euro region inorder to offset expectations for the devaluationof the forint against the euro. Real life, howev-er, seems to prove just the opposite of thisthinking. What goes with the positive interestmargin is the revaluation of the domestic cur-rency and not devaluation expectations. What

we discuss in this paper is that a close correla-tion exists between the interest margin, animportant attribute of monetary policy and thevolatility of the exchange rate.

Among the many functions of monetarypolicy, the role to serve the stability of financialmarkets is becoming increasingly importanttoday. This role used to be dominant in thebeginning when the embryos of today's centralbanks emerged in the first half of the last cen-tury. While price stability is undoubtedly animportant element of this stability, it is notnecessarily so important that it should over-shadow everything else. Over time, monetarypolicy will serve efficiently the stability offinancial markets in a different manner. Thischange will depend on the way the key ele-ments of monetary policy, i.e. interest rate pol-icy and central bank communications are trans-formed on the financial markets (monetarytransmission). While these issues will not beresolved in this paper, we underline their sig-nificance and point out an overlooked congru-ence. We will take the exchange rate fluctuationof the forint as an example to demonstrate thatalthough there is no direct, easily describablecorrelation between monetary policy andexchange rate changes, the impact on exchangerate volatility is apparent.

We will present the correlation betweeninterest margin and exchange rate volatility in


35

graphic form. The significance of this correla-tion can be interpreted in two ways. One inter-pretation suggests that it is not the averagevalue of macroeconomic variables used in vari-ous models that monetary policy affects buttheir volatility or dispersion. This conclusionmay supply guidance to or set requirement formodel building and analysis. The other inter-pretation says that since monetary policy pri-marily impacts the volatility of macroeconom-ic variables, it is of special importance to takeinto consideration the stabilisation goals ofmonetary policy and stability of financial mar-kets in general.

ABOUT UNCOVERED INTEREST RATEPARITY

In this section, we review the theoretical andempirical attributes of the categories and correla-tions used herein based on data from Hungary.Readers who have an in-depth knowledge ofthis subject are free to skip this section as itpresents the traditional, textbook approach in anutshell.

Uncovered interest rate parity is a frequent-ly mentioned term and here we provide a verysimple explanation to it. On an invested Yamount, we expect to get back at least Y(1+rt)forints after one year, where rt refers to theinterest rate in period t.

If we happened to invest in Euro bonds, theformula is extended with the forint/euroexchange rate, represented by zt at a t point oftime. This is the price of the euro expressed inforints, i.e. the increase of the figure refers toforint devaluation. Converting Y forints toeuro we get euros. The returns on that arecalculated at the r*

t euro interest rate. At theend of the period, we reconvert our euroinvestment into forint and get to this formula:

. As we make the investment deci-sion in period t, the exchange rate of period

t+1 is unknown at that point, thus we can onlycalculate with the E(zt+1) exchange rate.Assuming that both investment options areavailable without limits, the returns are expect-ed to converge: = = , i.e. thecorrelation between interest rates and exchangerates, the interest rate parity can be expressed asfollows:

As we did not use any hedging to secure theexchange rate during the financial transactiondescribed in a somewhat complicated mannerabove, the accurate name of the formula isuncovered interest rate parity.

Thus interest rate parity means that ifinvestors anticipate the devaluation of theforint against the euro, domestic interest ratesmust be higher than euro interest rates. Thisdifference must be large enough so that thedomestic interest margin matches the surplusgain which a forint investor would obtain inforints thanks to the euro returns and thedevaluation of the forint in the meantime, or tocompensate the loss of a euro investor whichhe would realise upon changing his devaluatedforint returns into euros.

One proven approach in analysing this typeof nonlinear correlations is to transform theequation into log-linear format which is theneasier to analyse with mathematical and econo-metrical methods. The first step is to take thelogarithm of the equation presented above:

(1)

By rearranging equation (1) and introducingi=log(1+r), we get to the following expres-sion2 of interest rate parity:

(2)

Even after the transformations described

*1log ( ) log( )t t t ti i E z z+− = −

*1log(1 ) log(1 ) log( ) log ( )t t t tr r z E z ++ = + − +

*

111 ( )t

t tt

rr E zz +++ =

*

11 ( )t

tt

rY E zz ++

(1 )tY r+

*

11 ( )t

tt

rY E zz ++

1

t

Yz


36

above, equation (2) is still saying the same: Ifinvestors expect the devaluation of the forintagainst the euro, domestic interest rates mustbe higher than euro interest rates and the dif-ference must be sufficiently big to allow thedomestic interest margin to compensate thelosses suffered on converting the devaluatedforint returns into euro. This correlation is animportant element of macroeconomics text-books. The only trouble is that empirical stud-ies are in contradiction with it. (The main find-ings of relevant studies are summarised inAnnex 1)

The impossibility of grasping the notion ofinterest rate parity derives from the fact that itincludes an unobservable category, namely theE(zt+1) exchange rate for day t+1 as expectedat a certain t point of time. There is a long listof bridging solutions, e.g. the replacement ofthe relevant figures in the equation with theactual exchange rate, as if the investor's predic-tion was perfect. If we do this, the equation (2)will be as follows:

(2a)

Neglecting the original assumption behindthe formula temporarily, i.e. by looking backand not forward in time, equation (2a) can beexamined empirically. Taking the interest mar-gin as a difference between three-month inter-bank interest rates (BUBOR) and EURIBOR,the corresponding indicator of the euro region,we get the trend shown in Chart 1 for Hungary.The interest margin calculated on the basis ofthree-month interbank rates is usually com-pared to the change of exchange rate projectedfor the same period, i.e. the change calculatedwith a view to the exchange rate three monthslater. This is what we do in the first step.

This comparison is shown in chart 1 wherethe two time series reflect a distinctive negativecorrelation (–0.37 for the entire period). Thisnegative correlation is just the opposite of thecongruity assumed in (2a), as the equality ofthe left and right side of equation (2a) wouldsuggest a significant positive correlation

*1log( ) log( )t t t ti i z z+− = −

Chart 1

INTEREST MARGIN AND EXCHANGE RATE FLUCTUATIONS

Source: Bloomberg, authors' calculations

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2001

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ge

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onth

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inte

rest

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gin

Change in exchange rates 3 months later

3-month interest margin


37

between the two sides. Based on the uncoveredinterest rate parity, the forint should weakenagainst the euro when the interest margin ishigh. The chart, however, shows the oppositeof that: Typically the forint becomes strongerwhen the interest margin is high and weakenswhen the interest margin is low. (This finding isin line with the results referenced in Annex 1)

What comes from this immediately is thatthe gracious assumption of a perfect predictionapplied upon moving from (2) to (2a) did notprove to be a fruitful approach in the world ofexchange rates. Maybe we should be more care-ful already upon interpreting equation (2) as itis suggested by the failures or rather the con-sistently negative outcome of the countlessempirical takes at uncovered interest rate pari-ty, i.e. equation (2). However, FernandoAlvarez, Andrew Atkeson and Patrick J. Kehoe(2007) came up with a remarkable idea. In theiropinion, the starting point (2) is more or lesscorrect. The problem lies in the conclusionsderived from it, or in the overall theory andmodelling of monetary policy impact mecha-nisms. The reason is that it does make a differ-ence whether we monitor the average of a vari-able or its dispersion.

AVERAGE AND DISPERSION, EXCHANGERATE AND VOLATILITY

To illustrate the key point of the proposal ofFernando Alvarez, Andrew Atkeson andPatrick J. Kehoe (2007), let us transform equa-tion (2) further relying on the fact that E(z)expected value of random variable z with a log-normal distribution assumed for the staticattributes of economic time series is expressedwith the formula.

(3)

Here we note that if we were to apply the

same assumption on equation (3) which tookus to the (2a) formula, we would have at leastone hopeful candidate for explaining the devia-tion in chart 1 – namely, the last member inequation (3). For the sake of a simpler refer-ence, now we introduce the expression

for that member along withx=log(z) which takes us to the following equa-tion:

(3a)

There are disputes concerning the interpre-tation of equation (3a) and the t factor in it.One objection says that when interpreted as asemi-variance of the exchange rate, t leads to away too low figure, since a 10 per cent changein the exchange rate would result in a semi-variance of 0.5 per cent. This argument is men-tioned by Engel (1995) as well (op.cit. p. 133).In this context we must note that formula (3)is only a simplified expression, e.g. here weonly consider the expected exchange rate as alikelihood variable. The referenced distortionsmay originate in simplifications of this sort.The representation reviewed in Annex 2, whichfollows the article of Fernando Alvarez,Andrew Atkeson and Patrick J. Kehoe (2007),considers interest rate as a factor in pricing(pricing kernel). Thus the stochastic linkbetween interest rate and exchange rate alreadyappears in this presentation and it is represent-ed by the covariance member in formula (F.2.7)in the Annex. This way, in this broader sto-chastic approach, factor t contains more thanonly the semi-variance of the exchange rate.According to formula (F.2.7) in Annex 2, thisrisk factor will be the sum of the semi-varianceof the logarithm of exchange rate change andthe covariance of the stochastic discount factorand the logarithm of exchange rate fluctuation.

The use of index t in the expression t here-in emphasises that at a certain t point of time,we assume concerning the exchange rate

*1t t t t ti i Ex x δ+− = − +

( )1logvar21

+= tt z

( ) ( ) ( )( )11* logvar

21

loglog ++ +−=− ttttt zzzEii

( ) ( )zzEzE logvar21

loglog +=


38

expected at the next point of time that the sto-chastic attributes of the exchange rate or atleast its dispersion will not change. Thereforewe assume that this rate is known based oninformation available at time t.

Regarding the naming of factor t, we followthe paper of Engel, Mark and West (2008). Notsurprisingly, these authors call this factor thedeviation from uncovered interest rate parity.Engel, Mark and West (2008) note that while itis well known about this deviation that empiri-cal results disproof the t=0 hypothesis (this isagreed by professionals), we do not knowmuch regarding t. This way, there is no com-mon agreement on how we could model thisfactor or what it expresses in reality. As point-ed out by Gyula Barabás (1996) the deviation(represented by t here) is a kind of a risk pre-mium, it may express a short-term deviationfrom rational expectations may reflect the con-sequence of another market attribute or barri-er.3 The interpretation of t as a risk premium(3a) can be derived from the followingrearranged version of the formula:

(3b)

The first member on the right side of equa-tion (3b) represents the domestic interest rate,the three-member expression next to it is theforint value of the expected yield of Eurobondsbought for forints and calculated at the expect-ed exchange rate. Thus the difference betweenthe two can be interpreted as risk premium.

Obstfeld and Rogoff (2003) do not excludethe possibility that the changes of t may con-vey important information concerning theexplanation of exchange rate trends or at leastthe related expectations. In other words, thetheory of exchange rates has been challengedquite a bit. In this paper, we do not wish to diveinto the depths of these theories. We ratherreturn to the concept of Fernando Alvarez,Andrew Atkeson and Patrick J. Kehoe (2007)

which does not focus on exchange rate theorybut on modelling the impact mechanism ofmonetary policy, or more specifically, on criti-cism that shakes the very foundations of mon-etary policy.

THE IMPACT OF MONETARY POLICY

Theoretical explanations will follow, so we inter-pret monetary policy in a rather narrow sense andidentify it with interest rate changes. As a furthersimplification, we limit our focus to the shortterm money market interest rate (interbankrate, BUBOR) as opposed to the central bank'sbase rate. Chart 2 presents the day-to-daytrends of these variables during the past sixyears.

The fluctuations of interbank rates are notonly affected by the central bank's base rate butby a number of other factors. And the base ratehas an even further-stretching significance.Still, the interbank rate can be considered oneof the key elements of the interest transmissionmechanism. The channels of this mechanismare summarised in detail in a study by Vonnák(2006). Vonnák notes that the 3-month inter-bank rate is a preferred and frequently usedvariable for analysing the monetary policy. Thereason is that while this interest rate moves invery close correlation with the central bank'sbase rate, its day-to-day fluctuation is a goodindication of market expectations concerningthe future changes of the base rate.

One popular and widely used method ofmonetary policy evaluation is the analysis ofthe central bank's response function. A potentialobjective of an analysis carried out on this basisis to present the correlations between interestrates and other macroeconomic variables. A paper by János Hidi (2006) provides a veryinteresting overview of the response functionassessment of Hungary's monetary policy.

Just for a brief experiment, we can interpret

*1( )t t t t ti i Ex xδ += − + −


39

equation (3a) as a cut back response function.Going from right to left the equation illustrateshow monetary decision makers are affected bythe trends of exchange rate expectationsE(xt+1) and the risk premium ( t) that reflectsmarket stability attributes and how this effectshows up in interest rate trends.

The response function can also be read fromleft to right. Looking at it from this direction, itprovides an interpretation of the changes ofinterest rate fluctuations as opposed to explain-ing why the central bank changed the interestrate. In the dream world of equation (3a), it callsfor the analysis of what and how is impacted bythe growth of domestic interest rates whichexceeds the growth of foreign interest rates.

Naturally, playing this game back and forthdoes not add anything to the picture at thisextreme level of simplification. It does notmake the model more realistic and it does nottake us to a deeper level of understanding. Thisway, we can even alternate freely between the“directions” applied for arguing.

Let us take the latter direction and readequation (3a) from left to right. So if thedomestic interest rate goes up, what will hap-pen on the right side of the equation? Whilethis is a simple question, it is not easy to answerit and the question itself needs further specifi-cation.

One potential interpretation of the questionmay be to seek the immediate response of theexchange rate to momentary interest ratechanges. This immediate connection isanalysed in a study by András Rezessy (2005)who examined the one-day and two-dayresponse of the forint's exchange rate, domes-tic interest rates of various terms and the stockmarket to the fluctuations of the central bank'sbase rate. He concluded that the forintresponded with a 0.27–0.30 per cent revalua-tion when the base rate was raised by surprisewith 50 basis points. For the first sight, thisresult does not differ from the negative corre-lation between the interest margin and thechange of the exchange rate presented in chart 1.

Chart 2

MNB'S BASE INTEREST RATE, THE INTERBANK RATE (3-MONTH BUBOR) AND THE EXCHANGE RATE (HUF/EURO)

Source: Bloomberg

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200

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r

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MNB base interest rate

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(rev

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sca

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40

Still, due to the complex technical details andthe different time horizons (one day to threemonths), we have to be careful with wording.4

When embedded in monetary transmission,the long-term consequence of the centralbank's interest rate change may be more impor-tant than its momentary impact. Another inter-pretation of our question might be as follows:On a time horizon identical to the term of inter-est rates discussed herein, i.e. 3 months, whatwill be the impact of the interest margin calcu-lated at interbank rates (3-month BUBOR)changed due to the central bank's interest ratechange on exchange rate fluctuations? Whilethis assumption extends the time horizon to 3 months, it does not answer the questionwhether we want to know the impact onexchange rate expectations for three months intothe future or the difference between theexchange rate today and three months later.

If we take the latter of these choices as abasis and focus on the actual change of theexchange rate, we have an easy road ahead. Wealready discussed it in conjunction withChart 1 and found that on a 3-month hori-zon, the growth of forint interest rates trig-gered the strengthening of the forint, i.e. typ-ically there is a negative correlation betweeninterest rate parity and the change of theexchange rate. This conclusion contradictsthe uncovered interest rate parity concept.Thus from a monetary policy standpoint, wecannot draw conclusions on exchange ratetrends from within the closed system ofinterest rate parity.

If we want to know the impact on exchangerate changes we have quite another story. If wetake a closer look at equation (3a), we see thatit includes exchange rate expectations on the onehand and, at the end of the formula, the t fac-tor on the other hand. Building on these sub-tleties, Fernando Alvarez, Andrew Atkesonand Patrick J. Kehoe (2007) lands a huge strikeon the traditional theory. For what they say5 is

that if exchange rates are like random walks,monetary policy does not directly impact theactual average value of the exchange rate orother variables (including inflation). Whenanalysing interest transmission, nobody islooking for any immediate impact so it is natu-ral that the preferred focus is on the futuretrends of macroeconomic variables (fundamen-tals). Concerning the attributes of these futurevariables, we tend to forget that our predictionsare usually imperfect and therefore we can onlyhave an idea of the statistical attributes of thevariables in the present. E.g. dispersion charac-teristics convey important information.Overlooking them is a false practice. If for noother reason, this approach should be objectedbecause it places too big an emphasis on theexpected future value of variables about whichvery little can be known (both for sceptics andoptimists) while overlooking statistical attrib-utes which are significant for assessing futurevariables trends and on which more informa-tion is available. E.g. one attribute of this sortis the conditional dispersion of variables (calcu-lated on the basis of past observations) takeninto consideration upon decision-making. Thisproblem has an important practical conse-quence.

On the short run, monetary policy affectsmarket risks, meaning that the increase of theleft side of formula (3a) after the raise of thedomestic interest rate does not affect theexchange rate variables (expected values) onthe right side and the impact of monetary poli-cy step is manifested in the changes of the trisk premium.

In formula (3b), we rearranged the variablesand expressed t as the difference between theinterest margin and the expected exchange ratetrends. This difference can be considered thecounterpart of the difference between theexchange rate change expected by analysts andpresented in Chart 3 and the change ofexchange rate implied by the interest rate pari-


41

ty. According to the model, t is in close corre-lation with the dispersion of the exchange rate.Now we also examine that congruence empiri-cally, using Chart 3. To do this, we need theforward-looking exchange rate volatility figure.We can obtain relevant data, specifically 3-month implied volatility figures from the euro-forint option market. By definition, impliedvolatility is the volatility parameter which wecan put in the Black-Scholes option formula asa substitution to calculate the market price ofthe option. (We will explain implied volatilityin more detail in Annex 2) In the case of for-eign exchange options, this substitution step isnot even necessary, as the price of foreignexchange options is usually presented involatility, thus the data are available fromReuters or from another official source.6

Chart 3 compares the 3-month t value from(3b) calculated as a residue based on exchangerate expectations7 to the implied volatility ofoptions with a 3 month expiry. The simultane-ous motion is clearly visible and the correlation

between the two variables was 0.61 between2003 and 2007.

Based on Chart 3, we can risk the statementthat risk premium t defined as the deviationfrom the uncovered interest rate parity is inclose correlation with exchange rate volatility.We do not think that this close relation is actu-ally an identity.8 In reality, the deviation fromthe uncovered interest rate parity is not likelyto be equal to the exchange rate semi-varianceas the simplifying assumptions of our equation(3) would suggest. Beyond volatility in a statis-tical sense, other things also fit in this devia-tion, e.g. considerations and explanations thatrelate to the volatility of risk appetite and othermysterious things. What would be hard to fit inthis picture is the neglecting of the role ofvolatility and the impact of monetary policy onexchange rate volatility. In the previous sectionof this paper we saw that the impact of interestrate changes on the exchange rate is ungras-pable, i.e. most of the interest rate change isabsorbed in the change of the risk premium.

Chart 3

THE DEVIATION OF 3-MONTH EXCHANGE RATE EXPECTATIONS FROM INTEREST RATE PARITYAND THE IMPLIED EXCHANGE RATE VOLATILITY

Source: Reuters, authors' calculation

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i–i*–(Ex–x)

3-month option volatility


42

This factor, however, is very easy to relate toexchange rate volatility based on Chart 3. Sothe impact of the interest rate changes mostlymanifests in the fluctuations of exchange ratevolatility. It is likely that monetary policy pri-marily affects exchange rate volatility, marketstability in general while its impact on theexchange rate (value or average) is weaker.

To refine the analysis, we break up the rightside of formula (3b) and express separately themarket expectations concerning exchange ratechanges and the interest margin. Exchange rateexpectations are represented by the–(Ext+1–xt) member and this is what we showtogether with volatility in Chart 4. Member–(Ext+1–xt) represents the expectations con-cerning the changes of the forint exchange rateagainst the euro. What we see is that in highvolatility periods the market expects a moresignificant strengthening of the forint whichcan also be put as follows: market playersexpect a higher risk premium from a forint thatconveys a higher risk. As a further explanation,we can add that the volatility of the forint

jumps upwards in stressful times, typically inperiods when the forint weakens. Compared tomomentary exchange rate shifts, however,exchange rate expectations for a longer (in ourcase 3 months) outlook change only to a lesserextent. This way the momentary weakening ofthe forint may open the way for futureexchange rate growth, as expectations predictthat the exchange rate will return to the fore-casted level on the long run. The correlationbetween the two variables was 0.45 in theexamined period.

Chart 5 matches volatility to the interestmargin, i.e. to monetary policy. As it is visiblein the chart, the interest margin and theexchange rate risk showed a perceivable corre-lation in the past five years.

Based on these experiences, we can draw theconclusion that the risk premium determinedby the (3b) formula is in close correlation withexchange rate volatility in an empirical sense aswell. Either member of formula (3b), i.e.exchange rate expectations or interest margincan be correlated to exchange rate volatility on

Chart 4

3-MONTH EXCHANGE RATE FLUCTUATIONS AND IMPLIED EXCHANGE RATE VOLATILITY

Exch

ange

rate

- e

xpec

tatio

n

3-m

onth

vol

atili

ty

–(Ex–x)


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43

its own. In the case of expectations, it is themarket players themselves who express the“need” for a higher exchange rate gain in ahigher risk period (typically following a deval-uation of the forint). From a monetary policyviewpoint, we see that the impact of the inter-est rate change mostly manifests in the changeof exchange rate volatility. It is likely that mon-etary policy primarily impacts exchange ratevolatility, it affects market stability in generalwhile its impact on (the value or average of) theexchange rate is weaker.

SUMMARY AND CONCLUSION

Exchange rate fluctuations and monetary poli-cy are interrelated. We might think that it is dif-ficult to take this congruence into considera-tion in inflation targeting because anyonedoing so would be exposed to criticism that heor she is targeting the exchange rate instead ofinflation. It is like the story about “The miller,his son and the donkey”.9 You can never please

everyone. Common public opinion, however, iswrong. In respect of the exchange rate, mone-tary policy does not directly impact its expect-ed value. What is more, not only the role ofmonetary policy in shaping the exchange rate isquestionable but the impact of many other fun-damental factors is equally ungraspable.Perhaps this is why the exchange rate fluctua-tions described with the “random walk” theoryoften approximate actual exchange rates just aswell as any other theory.

A freely evolving exchange rate is charac-terised by fluctuations, i.e. volatility. Exchangerate fluctuations cause uncertainty whichmakes investors calculate with higher returns(risk premium). Out of these three factors(interest margin, expected exchange rate andrisk premium), monetary policy can only influ-ence one: the interest margin. It does not havean exclusive and obvious effect on exchangerate expectations. At the same time, it is verylikely that monetary policy does impact therisk premium and the volatility of the exchangerate through stabilising money markets. The

Chart 5

3-MONTH INTEREST MARGIN AND IMPLIED EXCHANGE RATE VOLATILITYIn

tere

st m

argi

n

3-m

onth

vol

atili

ty

i–i*


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separate identification and measurement ofthese effects, however, is not simple. It can alsohappen that out of these three factors, theexpected exchange rate and the risk premiumfluctuate at each other's expense, perhaps evenindependently of monetary policy. Still, from astability standpoint, this triangle must not beneglected.

The interest margin calculated on the basisof the interbank interest rate (3 monthBUBOR) and the optional volatility of theforint-EUR exchange rate shows close correla-tion while the theory of interest rate paritydoes not supply an empirical basis for this rela-tionship. Thus it is not necessarily the expect-ed exchange rate value but its dispersion (high-er statistical momentums) that monetary poli-cy affects. From a theoretical standpoint, thisimpact can be explained simply and has beenproved empirically.

Monetary policy can only fulfil its stabilis-ing role on the money market effectively if it

does not limit its focus to inflation but takesother money market factors into considerationas well. Stabilisation aspects also have a keyrole in inflation targeting systems and for areason. Yet in inflation targeting we areinclined to refer this role to central bank com-munication. What we presented in this paperwas that this aspect must also be handled in aninterest rate policy context. Just because inter-est rate policy does not have a clearly describ-able impact on the expected exchange rate val-ues, it does not mean that the exchange ratecould be neglected. The reason is that interestrate policy affects the volatility of theexchange rate instead of just the rate itself. Inthe case of the forint, this impact is well gras-pable empirically as well.

Over time we may be able to understand sta-bilisation congruencies. The horizon of mone-tary policy will broaden accordingly and therole of stabilisation considerations will be moresignificant in inflation targeting.

1 The thoughts presented in this article do not neces-sarily reflect the opinions of the InternationalMonetary Fund and the World Bank.

2 Regression functions which include an exchange rateelement are usually written in logarithmic form inorder to avoid the problem known as the Siegel par-adox (see Siegel, 1972), as 1/E(zt)=/ E(1/zt), butE(–xt)=–E(xt), where xt=log(zt). Otherwise thechoice of exchange rate by the euro/forint orforint/euro convention would distort calculations.

3 The deviation marked as t was examined by Cumby,R. E. – Obstfeld, M. (1981) who found that the sta-tistical attribute of the factor (high autocorrelationindicator) did not refer to a waiting error but to thepresence of a factor with an independent impactmechanism which the authors interpreted as riskpremium.

4 An opposite interpretation of this result also exists aspointed out by András Rezessy. E.g. let us take thepotential scenario that the domestic interest rate in

equation (3a) is raised by surprise. Concerning thefactors on the right side of the equation, this doesnot necessarily shake up the exchange rate expectedfor three months into the future [E(xt+1) does notchange] and we can also take the t risk premiumunchanged for a time horizon of one day. In this case,the momentary growth of the exchange rate (i.e. thedecrease of xt ) can still harmonise with the interestrate parity described with equation (3a) which sug-gests a positive correlation between the two afore-mentioned variables.

5 Actually they do not exactly say this and do not sayit this way. The authors use more careful wordingand their assumptions, explanations are elaborated inmore detail. Here we only illustrate their approach.The theory of Fernando Alvarez, Andrew Atkesonand Patrick J. Kehoe (2007) is explained more pre-cisely in the Annex hereto.

6 A study by Csaba Csávás and Áron Gereben (2005)provides a good overview of the Hungarian foreignexchange options market.

NOTES


45

7 We calculated the expectations concerning the forintexchange rate based on the analyst assessment pub-lished monthly by Reuters. The 3-month expectedexchange rate was calculated by interpolating themedians of exchange rates expected for the end ofthe following month after the assessment and for theend of the actual year or the following year.

8 If we had sufficiently large self confidence to scan allsignificant elements of the world into equation (3),then we could think about an identity here.

9 The miller, his son and the donkeyA man, his son and their donkey were strolling downthe dusty streets of Keshan in the dog days of sum-mer.The donkey was led by the boy while his father trav-elled on the donkey's back. “Poor child” thought apasser-by. “With his short legs, he can hardly keep upwith the walk of the donkey. How can someone beso lazy to ride the donkey and let his child work hissoul out?” The man listened to the criticism: he gotoff the donkey at the next corner and put his son onthe donkey's back.After a short while, another passer-by frowned:

“What an arrogant behaviour! This little urchin is sit-ting up there like a king on a throne and lets his poorold father try to keep pace with the donkey.” Thistime the son was saddened, so he asked his father tosit on the donkey behind him.“What an unprecedented scene?!” – nagged an oldwoman from behind her veil. “What a torture for thedonkey! These two bad hats are sitting on the poorcreature as if he was a couch!” Having been beratedagain, father and son looked at each other and got offthe donkey.They walked with the donkey and just after a fewsteps, another passer-by began to laugh at them:“You morons, how can you be so stupid? Are youwalking your donkey? Why do you keep him if he isso worthless? He is not working and not even carry-ing you.”The father gave a handful of straw to the donkey, puthis hand on the son's shoulder and said: “No matterwhat we do, there is always someone who will not likeit. I think the best we can do is to go our own way.”From: The scholar and the camel drover – Orientalstories to heel Western souls by Nossrat Pesaschkian.Helikon Kiadó (Helikon Publishing House), 1991.page 200

ACEMOGLU, D. – K. ROGOFF – M. WOODFORD

(edit.) (2008): NBER Macroeconomic Annual, 2007,University of Chicago Press

ALVAREZ, F. – ATKESON A. – KEHOE P. (2007): IfExchange Rates Are Random Walks, Then AlmostEverything We Say About Monetary Policy is Wrong,American Economic Review, Papers and Proceedings,May, pp. 339–345

BARABÁS, GY. (1996): Interest rate parity in floatingand crawling peg devaluation exchange rate systems,Közgazdasági Szemle (Economic Review), number 11,pp. 972–994

CHINN, M. D. – MEREDITH, G. (2004): MonetaryPolicy and Long-Horizon Uncovered Interest rateparity, International Monetary Fund Staff Papers,Volume 51, number 3, pp. 409–30

Cochrane, J. (2001): Asset Pricing, PrincetonUniversity Press, Princeton, New Jersey

CUMBY, R. E. – OBSTFELD, M. (1981): A Note onExchange-Rate Expectations and Nominal Interest

Differentials: A Test of the Fisher Hypothesis, TheJournal of Finance, 36 (3, June) pp. 697–703

CSÁVÁS, CS. – GEREBEN, Á. (2005): Traditional andexotic options on the Hungarian foreign exchangemarket, MNB Studies (MNB Mûhelytanulmányok), 35.

ENGEL, C. (1996): The Forward Discount Anomalyand the Risk Premium: A Survey of Recent Evidence,Journal of Empirical Finance, Volume 3 (2, June), pp.123–92

ENGEL, C. – MARK, N. C. – WEST, K. D. (2008):Exchange Rate Models Are Not as Bad as You Think,In: Acemoglu, D. -Rogoff, K. – Woodford, M. (edit.),pp 381–441

FAMA, E. (1984): Forward and Spot ExchangeRates, Journal of Monetary Economics, 14 (3,November) pp. 319–38

FROOT, A. K. – THALER, R. H. (1990): Anomalies:Foreign Exchange, The Journal of EconomicPerspective, Volume 4, number 3 (Summer), pp.179–192

LITERATURE


46

HIDI, J. (2006): Assessment of the response func-tion of Hungary's monetary policy, Közgazda-sági Szemle (Economic Review), December, pp.1178–1199

MCCALLUM, B. T. (1994): A Reconsideration of theUncovered Interest rate parity Relationship, Journalof Monetary Economics http://ideas.repec.org/s/eee/moneco.html, Volume 33(1), pp. 105–132

MOOSA, I. A. – BHATTI, R. H. (1997): InternationalParity Conditions, Theory, Econometric Testingand Empirical Evidence, MacMillan Press Ltd,London

OBSTFELD, M. – ROGOFF, K. (2003): Risk andExchange Rates, Economic Policy in the InternationalEconomy: Essays in Honor of Assaf Razin,Cambridge, MA, USA

REZESSY, A. (2005): The immediate impact of mon-etary policy on exchange rate and other asset prices,MNB Studies (MNB Mûhelytanulmányok), 38.

SARNO, L. (2005): Viewpoint: Towards a Solution tothe Puzzles in Exchange Rate Economics: Where DoWe Stand? Canadian Journal of Economics, (August)Volume 38, number 3, pp. 673–708

SIEGEL, J. J. (1972): Risk, Interest, and ForwardExchange Rate, Quarterly Journal of Economics, May,pp. 303–309

SCHEPP, Z. (2003): Investor horizon and the “for-ward mystery”, Közgazdasági Szemle (EconomicReview), number 12, pp. 939–963

VONNÁK, B. (2006): Key attributes of the monetarytransmission mechanism in Hungary, KözgazdaságiSzemle (Economic Review), December, pp. 1155–1177

Interest rate parity is an important buildingblock of exchange rate theories. Moosa – Bhatti(1997) provided a great overview of the exten-sive literature on the subject. As we could see,the uncovered interest rate parity equation is asfollows:

(F1.1)

We get an apparently similar but actually dif-ferent equation if we replace the E(xt+1)expected exchange rate with the ht futureexchange rate, i.e. the price for which we canbuy 1 EUR for t+1 time at a certain t point oftime:

(F1.2)

This equation describes a hedge deal wherewe actually use a future exchange rate transac-tion to eliminate the exchange rate risk. As wecovered the exchange rate risk with the trans-action, the formula is the covered interest rateparity equation.

When examining interest rate parity empiri-cally, the first difficulty comes from the factthat the E(xt+1) expected exchange rate is notobservable. That is the reason that usually thext+1 observed value is applied as a substitute forit (as if exchange rate expectations were char-acterised by perfect prediction). Taking thelogarithm of the aforementioned equations fora statistical analysis, we get to a linear formula.Using expressions it=log(1+rt), xt=log(zt),ft=log(ht) and taking the two formulae above:

(F1.1)-bõl:

(F1.2)-bõl:

Comparing these two formulae we get to thefollowing equation that is used upon statisticalexaminations:

(F1.3)

By estimating the value, we can decide ques-tions like how can one develop predictions for

1 1( )t t t tx f xα β ε+ +∆ = + − +

*t t t ti i f x− = −

*1 1t t t t ti i x x x+ +− = − = ∆

*11 tt t

t

rr hz++ =

*

111 ( )t

t tt

rr E zz +++ =

ANNEX 1: ABOUT THE EMPIRICAL ANALYSES OF INTEREST RATE PARITY


47

the expected exchange rate using the futurespremium, i.e. if the futures premium indicatesthe trend of a weakening exchange rate or not.

If a positive correlation exists between thedevaluation and the futures premium, the coef-ficient of the futures premium in equation(F1.3) must be positive ( > 0). A similar for-mula was examined by Fama (1984) who foundthat the coefficient is usually negative, i.e. inreality it is revaluation and not devaluationwhich can be linked to the futures premium.Fama called this phenomenon an anomaly (for-ward premium anomaly).

The negative result of the Fama regressiondrew extensive interest. Having reviewed theempirical studies in 1990 and based on 75 pub-lished estimation results1, Froot and Thaler(1990) found that the average of estimates forthe parameter was 0.88. While some of thesewere positive, none of the estimates of pro-duced a result reaching or exceeding 1.

It is not easy to explain the approximatelyminus 1 figure of the coefficient in equation(F1.3). Assuming a flexible market where arbi-trage options are eliminated and perfect predic-tions (which in our case would mean thatE(xt+1)=xt+1 is true), this parameter shouldequal plus 1. Understandably, this question wasin the focus of researchers' interest and theoverview written by Sarno (2005) mentioned

several old and new reasons and approaches toexplain this anomaly. A number of excuses canbe cited for why uncovered interest rate parityis not happening in reality. E.g. the risk premi-um (which increases the return expectations ofrisk-averse investors, but this factor was notpart of the equation that described the uncov-ered interest rate parity), exchange rate expec-tations are not perfectly rational, exchangerates are not only impacted by the market andits free development can be diverted by mone-tary policy interventions (McCallum, 1994,Chinn – Meredith, 2004). In Hungarian techni-cal literature, a great overview of the subject isrendered in a paper by Gyula Barabás (1996)and Zoltán Schepp (2003). Both of them high-lighted considerations that relate to forintexchange rate trends and, applying a newapproach, Zoltán Schepp even provided a moregeneral explanation to the phenomenon.

In the long run, however, macroeconomicfundamentals have a decisive impact on theexchange rate and many analyses prove that theparadox with the interest rate parity disappearsas well.

1 Many of these estimates were also discussed byHodrick (1987), Lewis (1995) and Engel (1996).

In this paper we often refer to the article ofAlvarez, F., Atkeson, A. and Kehoe, P. (2007),yet the explanations provided herein are dif-ferent from theirs. It is worth therefore tooutline their approach briefly which starts outfrom the overall theory of asset pricing. Theterms and congruencies of the theory behindthe explanation, consumption-based assetpricing are discussed in an excellent book byCochrane (2001).

Starting out from the well-known asset pric-ing equation Pt=Et(mt+s

.xt+s) where x repre-sents future cash flow and m stands for the sto-chastic discount factor, we get the followingformula by definition:

(F.2.1)

From this and using theequation which expresses the expected value of

( ) ( )xxExE logvar21

loglog +=

( ) ( )1exp +=− ttt mEi

ANNEX 2: INTEREST RATE PARITY, EXCHANGE RATE AND VARIANCE


48

random variables with lognormal distributionwe get:

(F.2.2)

After the introduction of a foreign exchange,Fernando Alvarez, Andrew Atkeson andPatrick J. Kehoe (2007) arrived at the followingexpression for the interest rate differential:

(F.2.3a) ,where

(F.2.3b)

For complete arbitrage-free markets and,with some qualifications (see Alvarez, 2007,page 342) also for incomplete markets, the fol-lowing equation between exchange rates andstochastic discount factors apply:

(F.2.4) .

Using (F.2.4) and adding it to formula(F.2.3a) as a substitution, we get

(F.2.5)

By rearranging the formula, we can expressthe expected extra returns on and risk premiumof the investment into a foreign currency:

(F.2.6)

We can get a picture of the contents of the ptrisk premium by comparing1 (F.2.3b) and (F.2.4):

(F.2.7)

Consequently, the risk premium is in closecorrelation with the variance of exchange ratechanges and with the covariance of theexchange rate change and the stochasticdomestic discount factor.

1 ( ) ( ) ⎟⎟⎠

⎞⎜⎜⎝

⎛⋅+⎟⎟⎠

⎞⎜⎜⎝

⎛+= +

++

++t

tt

t

ttt z

zm

zz

mm 11

11

*1 log,logcov2logvarlogvarlogvar

⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟⎠

⎞⎜⎜⎝

⎛= +

++

t

tt

t

tt z

zm

zz

p 11

1 log,logcovlogvar21

( ) tttttt izzEip −−+= + loglog 1*

( ) tttttt pzzEii −−=− + loglog 1*

t

ttt z

zmm 1

1*

1+

++ =

( ) ( )( )1*

1 logvarlogvar21

++ −= ttttt mmp

( ) tttttt pmmEii −−=− ++ 1*

1* loglog

( ) ( )11 logvar21

log ++ −−= ttttt mmEi

Based on the Black-Scholes model, the value offoreign exchange options can be calculatedwith the following formula for call (c) and put(p) options:

where

and

.

Using the well-known notation, S stands forthe prompt price (identical to zt in the study),X refers to the exercise price, is the disper-

sion of exchange rate fluctuations, rd and rfare the “domestic” and “foreign” risk-freeinterest rate in T years that matches the expiryof the option. In this study, i*

t stands for rf i.e.the euro interest rate while it represents the rdforint interest rate.

One decisive parameter of the option's valueis the volatility of the underlying. Like withmany other instruments, the price of foreignexchange options is presented in volatility asopposed to a specific money amount, i.e. theoption trader must put actual volatility as areplacement in the formula based on the cur-rent price of the underlying in order to calcu-late the fee receivable or payable on the option.The benefit of this solution is that the traderdoes not need to subscribe a new option price

Tdd 12 ó−=

( ) ( )T

TrrXSd fd

óó 2//ln 2

1

+−+=

( ) ( ) ( ) ( )12 expexp dNTrSdNTrXp fd −−−−−=

( ) ( ) ( ) ( )2d1f dNTrexpXdNTrexpSc −−−=

ANNEX 3: VOLATILITY OF OPTIONS


49

moment by moment if the price of the under-lying changes.

The volatility applied in option pricing isforward-looking volatility, i.e. it reflects theexpectations of market players regarding thevolatility of the underlying until the expiry ofthe option. In case the option fee is presentedin an amount of money, we usually talk aboutimplied or discount volatility. In this scenario,put and call option fees are known for variousexercise prices and with these we can numeri-cally determine the parameter which we canuse in the Black–Scholes formula to get a valuethat is identical to the market price of theoption. This calculated value is the discountvolatility or volatility implied by the marketprice of the option.

While this is forward-looking volatility, itstrend is a good reflection of the actual marketmood. Typically, in turbulent times discountvolatilities go up along with risk premiumsand realised volatilities. If the analyst choosesto calculate volatility not only for the exerciseprices of at-the-money positions but also forprices that are further away from the promptprice (e.g. if X<S, we talk about an in-the-

money position regarding call options andabout an out-of-the-money position regardingput options), we get to the a volatility smile.The term comes from the typical graph shapeof the discount volatilities / exercise pricesfunction: In-the-money and out-of-themoney volatilities are typically higher than thevalues calculated for the at-the-money exer-cise price. The reason is that while theBlack–Scholes formula assumes normal distri-bution for the rate changes of the underlying,market players usually assign higher likeli-hood to extreme events which deviate fromthat distribution. In the case of exercise pricesthat are further away from the prompt price,market players “push up” the volatility valuein order to compensate for the differencebetween normal distribution and observed (orexpected) “fat tail” distributions. Thus we candraw conclusions from the volatility smile onmarket expectations regarding the distribu-tion of the underlying.

A study by Gray, Merton and Bodie (2007)discusses in a clearly structured theoreticalframework the assessment of the volatility ofvariables and the vulnerability of the economy.


50

T

György Kovács

Financial stability and the banking system, or theimbalance of the intermediarysystem This survey intends to address a special segmentin the fiscal imbalance problems of theHungarian economy, namely the peculiar “bal-ance disturbance” of the banking sector, playinga prominent role in financial intermediation,whose capital structure has been increasingly atthe beck and call of foreign funding potential.While alarms have for years been sounding onthe back of declining foreign direct investmentsand an increasing extent of capital incomeextraction by international owners, publicattention has been directed to exchange raterisks related to an increasing bulk of retail debtsand also to an increasing role of foreigninvestors in financing government securities,but it seems that an equally important issue hasbeen addressed at a lesser extent. Namely, theHungarian banking sector has been increasing-ly dependant on foreign funding, which hasbecome a factor of growing significance in pro-viding external funds for a capital-hungryHungarian economy. This becomes a particu-larly interesting issue because the capital inter-mediary role of the Hungarian banking sectorin the economy is relatively low in comparisonto Western European countries, at the same timethe number of players on the banking market iscomparatively high and they boast exceptional-ly high profitability.

NET CAPITAL INTERMEDIARY ROLE OFTHE BANKING SECTOR; DEVELOPMENTOF NET POSITIONS

One of the main indicators of the importancethe Hungarian banking sector is playing in thecountry's national economy by capital interme-diation is the ratio of the combined total assetsof the banking sector in terms of GDP. For rea-sons of economic policy, banking sectors andequity markets in various territories of theWestern civilisation have developed to playroles of different significance in equity inter-mediation, and therefore the banking sectorhas a much more prominent role in the OldContinent than in the United States ofAmerica (Marján, 2003, page 801). Of course,due to decades (if not centuries) of lag in thedevelopment of the institutional system of thefinancial and equity market in the transitionaleconomies of Central and Eastern Europe, theequity intermediary function of both the bank-ing sector and the equity market is lessadvanced, but the dominance of the bankingsector is even more prominent in this limitedfunction in these countries, which – taking thelevel of economic development into considera-tion – is something of an inevitability. (Pálosi –Németh, 2004).(See Table 1)


51

Following the turn of the millennium thefunction of the banking sector in equity interme-diation has increased significantly, but it is stillfar from the Western European level, althoughstill regarded the number one player on equityintermediation (The notion of banking sectorhere includes, beyond the legislative definition,specialised credit institutions and savings coop-eratives as well). (See Table 2)

Before starting to analyse the banking sector'sfunction of intermediating equity between thefour segments of the economy, the way the fund-ing capability and demand of the corporate sec-tor, households, public finance, and internationalrelations have developed since the beginning ofthe new millennium should be scrutinised first.

As Chart 1 shows, following the peculiar sit-uation in the first half of 2003 – when the netborrowing demand of the corporate scope andthe net financing positions of households bothreached an all-time low – the gap between thesavings ability of households going through astabilisation phase until the middle of 2005 andan increasing financing demand on the part ofthe corporate scope made a more substantial

foreign funding necessary in 2004. Since theend of 2005, the net savings capability ofhouseholds has again declined, again starting toconverge to zero in the middle of 2008. As forpublic finance, in 2002 and also in the periodfrom the middle of 2005 to the end of 2006, aconsiderable increase in the funding need is evi-dent with shrinking corporate finance and aconsiderable increase in the need for foreignfunds in the first period mentioned, and a highlevel of foreign funding in public finance and adecrease in corporate funding demands in thesecond period. The decline in the currentfinancing need of Hungary's public financebeginning in 2007 has not resulted in a consid-erable or permanent decline in the financingfunction of international funding sources,because at the same time a smaller growth inthe financing demand of the corporate scopeand a radical downturn in the funding capabili-ty of households had to be faced.

In light of changes in the financing capabili-ties of individual segments of the nationaleconomy and the increasing role of the bankingsystem in terms of GDP, it should be scruti-

Table 1

EXTENT OF EQUITY INTERMEDIARY FUNCTION OF BANKING SECTORS AND EQUITY MARKETS, 2000

(%)

Indicator United States of America Euro zone HungaryTotal assets of banking sector /GDP 100 181 63

Securities issued /GDP 149 90 2

Equity market capitalisation /GDP 149 84 25

Source: author's own chart based on Marján (2003, page 801) and PSZÁF [Hungarian Financial Supervisory Authority] (2008d)

Table 2

EXTENT OF EQUITY INTERMEDIARY FUNCTION OF THE BANKING SECTOR, 2001–2007 (%)

Year 2001 2002 2003 2004 2005 2006 2007Total assets/GDP 66 68 76 81 90 99 107

Source: author's own chart based in PSZÁF (2008a), page 21


52

Chart 1

NET FINANCING CAPABILITY OF MAJOR SECTORS IN TERMS OF GDP(balance of last four quarters / GDP in last four quarters)

Source: MNB [National Bank of Hungary] (2008a), page 1

Chart 2

NET POSITION OF CORPORATE SECTOR, 2000–2008

Source: author's own chart based on NBH (2008b)

Non-financial corporatesPublic finance

HouseholdsInternational

Loans + securities Net positionDeposits

HUF

bn


53

nised how the equity intermediary role of thebanking system – or, in the accurate statisticalterminology, the scope of other monetary insti-tutions including savings cooperatives and spe-cialised credit institutions – has changed inrecent years in relation of various macroeco-nomic players (NBH, 2008b) (See Chart 2).

Looking at the corporate loans disbursed bythe banking sector and the portfolio of corpo-rate savings, an increase in the financing need isevident with a constant growth in the depositand loan portfolios alike. This is to be regardedas a more or less balanced growth, which hasbeen in alignment with the increasing functionsof the banking sector, with small downturns atthe turn of 2002 and 2003, and also in the mid-dle of 2005.

With the stagnation of government depositsor its slow growth marred with downturns, thenet debt of public finance with the Hungarianbanking sector has clearly been defined by theincrease of gross public debt, the bulk of gov-ernment securities in the portfolio of the bank-ing sector (See Chart 3). Similarly to the dra-

matic increase that occurred at the turn of 2002and 2003, there was a considerable bump in2006 and also in 2008. In the latter two cases –contrary to the change that occurred in2002/2003 as indicated by Chart 1 – a smallerincrease took place in the financing need of theHungarian public finance, indicating that inthese periods the Hungarian banking sectorplayed an increasing role in financing theHungarian public finance by bonds due todiminishing willingness on the part of otherplayers (including foreign and domestic institu-tional investors) to finance the Hungarian state.

Beginning in 2002, the loan portfolio ofhouseholds has increased at a greater pace thantheir deposits, resulting in a net position forhouseholds – and NGOs helping them –, as the“classic” financing segment of the banking sec-tor, which was decreasing in terms of absolutevalue as well (see Chart 4). This was close tozero in 2008, which means the debt ratio ofhouseholds reached a level where the financingcapability of the sector died away. All thisresulted in searching for new ways of supple-

Chart 3

NET POSITION OF CORPORATE SECTOR, 2000–2008


HUF

bn



54

mentary funding, which in turn resulted in anincreasing level of foreign funding.

As Chart 5 indicates, Hungary's net positionagainst foreign investors has actually beenimpacted by the development of the debt port-folio in recent years, and a particularly largebulk of debts were raised in 2007 and in thefirst two quarters of 2008. Hungary's foreigndebt grew by more than HUF 1,500 billion in2007 and by nearly HUF 1,000 billion in thefirst half of 2008, increasing the country's net debtby nearly HUF 1,000 billion and more thanHUF 600 billion, respectively.

Based on these factors, there have been twoapparent trends regarding the Hungarian bank-ing sector's capital intermediary role of morethan eight years: on the side of net borrowers, a'race' between the corporate sector and publicfinance with clashes in 2002/2003, on the sideof net lenders the almost perfect switch-overfrom households to foreign investors to securefunding (and also using foreign funding tofinance the increase in the net loan portfolios ofthe two sectors mentioned above) (see Chart 6).

FOREIGN FUNDING BETWEEN 2000 AND 2008

Particular consideration should be given to thestructure of foreign funding in capital-hungryeconomies, especially at the time of an eco-nomic transition. It's equally important for thelong-term development of the economy andsustainable financial balance that fundingshould be done by foreign direct investments atas decisive a rate as possible. This type of fund-ing does not trigger any continuous outflow ofincome (interests), unlike in the case of debt-based financing, and no extraction of capitalinvested should be expected in the short term,either (at least in the case of ownership stake,since it's not necessarily true in the case of aloan provided by the owner). At the same timeinvestments naturally prompt income outflowsin the medium and long term, and the questionhere is the extent of the reinvestment of theseincome and the acquisition of additional stakescompared to this outflow of earnings. Besides,on the back of economic transition in Central

Chart 4

NET POSITION OF HOUSEHOLDS, 2000–2008


HUF

bn



55

Chart 5

NET FOREIGN POSITION, 2000–2008


Chart 6

NET POSITION, 2000–2008


Assets Net positionLiabilities

Corporates Public financeHouseholds International

HUF

bnHU

F bn


56

and Eastern European countries, includingHungary, a flow of capital investments in theopposite direction has been evident after thebeginning of the new millennium, indicatingintensifying capital exports from Hungary andrepresenting another factor to reckon withregarding the decrease of capital availabledomestically. Of course, the income flow to berecorded later should also be taken into consid-eration. Accordingly, the development of thecapital and income balance of foreign directinvestments – both imported and exported – inthe new millennium is surveyed here, filteringout capital flow represented by loans providedby owners and focusing on classic equity flow(NBH, 2006a; NBH, 2006b; NBH, 2007a;NBH, 2008c; NBH, 2008d).

Chart 7 shows that the balance of income hasresulted in a constantly growing deficit in the bal-ance of payments since the beginning of the mil-lennium, growing to HUF 1,450 billion by2007 from HUF 540 billion in 2000. However,a slow increase in the surplus of the capital bal-ance could not offset it all the while. A dramat-ic deficit in the capital balance that occurred in2003 is explained by FDI plunging to 40 percent in comparison to the previous year and a700-percent increase in capital exports. Theaggregate value of the capital and income bal-ance ventured into the positive territory for thefirst time in 2005 due to one-off privatisationincome, and at a marginal extent at that, but adramatic decline occurred in capital inflow in2006 and 2007. Due to all these factors theaggregate balance of the capital and incomeflow has recorded all-time high deficits in thepast two years at HUF 1,026 billion and HUF1,257 billion, respectively.

Capital and income flows related to foreigndirect investments have failed to provide a solu-tion since the dawn of the new millennium tomanage problems of imbalance stemming fromforeign trade deficit, and have even intensifiedproblems of imbalance originating from the bal-

ance of payments. Consequently, the Hungarianeconomy has of course settled in to use foreigncapital at an increasing extent. Thus, loans pro-vided by owners (including loan amounts andcommercial credit) in connection with foreigndirect investments, capital funds originatingfrom securities issues and managed as portfolioinvestments, loans and deposits received fromforeign banks, as well as commercial credits rep-resented the opportunity to effect supplemen-tary funding. In the following section, the roleof the aforementioned forms of supplementaryfunding in the capital supply of the Hungarianeconomy will be scrutinised in line with theclassification used in the statistical records ofthe balance of payments, in fact broken downinto other sectors and other monetary institu-tions – actually the corporate sector and thesystem of credit institutions. Considering thatthe capital flow in the above forms has appar-ently been working in the opposite direction,too – as capital exports – scrutinising net capitalflows will provide an answer for what capitaltypes contribute to finance the Hungarianeconomy and at what extent. In respect offunding types, the data show foreign assets (K),foreign liabilities (T) and the net positions cal-culated as their balance (N=T–K), indicatingyear-end figures for the period between 2000 and2005, and end-of-quarter figures starting from2006 until the middle of 2008.

Regarding the portfolio of loans provided byowners, there was a slower increase between2000 and 2005, which started accelerating in2006 with an interim stagnation, offsetting aconsiderable outflow of equity. At the sametime, the dangers inherent in this capital reallo-cation should be realised: On the one hand, thepossibility of capital extraction is much quick-er than in the case of classic owner's equity, andon the other hand interest payment means aconstant outflow of pre-tax income. To makematters worse, an increase in the liabilities ofHungarian corporations with their foreign par-


57

ents and subsidiaries has been apparent in thisfunding class since the middle of 2006, as aresult of which stagnation in the net debt port-folio has been evident in the past two years.

Regarding the other loan sources of the cor-porate sector, Chart 8 shows that the netfinancing potential has been of less and less sig-nificance in recent years as foreign fundingstarted to increasing slowly then stagnatingwith a considerable expansion in liabilities. Asteady increase in assets and, as a result, arepeated expansion of net debt became evidentin 2007, but as a result of these processes, thetotal of net debt at the end of 2007 reflectedroughly the same value recorded in 2000.(Other loans include assets and liabilities stem-ming from loans and deposits with foreignbanking sectors, and also assets and liabilitiesoriginating from commercial credits). Thoseconsiderable changes in portfolios thatoccurred in 2008 – an increase in liabilities clas-sified as originating from the owner, and alsoother types of liabilities – did not represent

actual changes in the portfolio but a reshuffleas the combined value of these two itemsremained unchanged.

The scope of portfolio investment is domi-nated by stake-type investments, while otherinvestments (bonds, money market instru-ments, and financial derivatives) play a margin-al role, and at times are even registered as a dis-bursement surplus (see Chart 9). In the case ofstake-type investments, the value of the netcapital portfolio is in fact defined by the devel-opment of the debt portfolio, the increase in theliabilities portfolio starting in 2006 was notactual transactions, but revaluation impacts inforeign exchange rates and market valuations.The upswing in the debt portfolio between 2000and 2006 was explained at an equal rate by cap-ital inflow evidenced in actual transactions andby revaluation. Processes in 2007, however,could be explained by actual transactions at aconsiderable extent, because the Hungariancapital market had to suffer a HUF 900 billionactual capital outflow in that year. What should

Chart 7

FOREIGN DIRECT INVESTMENTS, 2000–2007

Source: author's own chart based on NBH (2006a), NBH (2006b), NBH (2007a), NBH (2008c), NBH (2008d)

HUF

bn

Balance of capital BalanceBalance of income


58

Chart 8

LOANS OF OTHER SECTOR, 2000–2008

Forrás: MNB, 2006a; MNB, 2006b; MNB, 2007a; MNB, 2008c; MNB, 2008d alapján saját szerkesztés

Chart 9

PORTFOLIO INVESTMENTS OF OTHER SECTOR, 2000–2008


Loans from owners (A) Other loans (A)Loans from owners (L) Other loans (L)Loans from owners (N) Other loans (N)

Stakes (A) Other (A)Stakes (L) Other (L)Stakes (N) Other (N)

HUF

bnHU

F bn

2000

2001

2002

2003

2004

2005

I. 20

06.

II. 2

006.

III. 2

006.

IV. 2

006.

I. 20

07.

II. 2

007.

III. 2

007.

IV. 2

007

.

I. 20

08.

II. 2

008.

2000

2001

2002

2003

2004

2005

I. 20

06.

II. 2

006.

III. 2

006.

IV. 2

006.

I. 20

07.

II. 2

007.

III. 2

007.

IV. 2

007

.

I. 20

08.

II. 2

008.


59

also be underlined is that a rapid capital extrac-tion could happen any time in the scope ofstake-type portfolio investments by way of sell-ing on the stock market, a likely scenario in casethe financial balance of the economy shouldslump dramatically. And, as data of recent quar-ters indicate, high volatility can also be detect-ed. In light of the aforementioned trends of thecorporate sector's net funding capabilities basedon its loans and securities options, the fundingcapabilities of other monetary institutions – thebanking sector, in fact – should be scrutinised.

Loans provided by owners have just a margin-al significance from the aspect of foreign fund-ing in the Hungarian system of credit institu-tions, unlike in the corporate scope. However,assets – loans and deposits – received from for-eign banking sectors are decisive in the scope ofcredit institutions, starting a dramatic growth in2003 and subsequently rising to HUF 6,732 bil-lion by the middle of 2008 from HUF 1,528 bil-lion at the end of 2002 (see Chart 10). However,since the middle of 2006 the net debt portfolio of

the Hungarian banking sector has increased toHUF 3,824 billion in the past two years withminor troughs from HUF 3,388 billion. Withinthis scope, an expansion of nearly HUF 600 bil-lion was recorded in 2008.

In respect of the capital flow of theHungarian banking sector registered as portfo-lio investments in the past 8 years, a consider-able net funding position is evident (see Chart11). The role of stake-type securities is not deci-sive, there was just a marginal bulk of transac-tions in the portfolio surge of 2008 (by HUF 75billion and HUF 51 billion in the first two quar-ters of the year, respectively). On the otherhand, the increase in the debts related to non-shareholding-type portfolio investments has beendecisive since 2003. In the past 18 months therehas been a particularly considerable surge both inthe gross and the net debt position as they increasedby HUF 1,000 billion and HUF 900 billion,respectively, but the decrease registered in thelast quarter was also caused by transactions (inaddition to a substantial revaluation effect).

Chart 10

LOANS OF OTHER MONETARY INSTITUTIONS, 2000–2008


HUF

bn

Loans from owners (A) Other loans (A)Loans from owners (L) Other loans (L)Loans from owners (N) Other loans (N)

2000

2001

2002

2003

2004

2005

I. 20

06.

II. 2

006.

III. 2

006.

IV. 2

006.

I. 20

07.

II. 2

007.

III. 2

007.

IV. 2

007

.

I. 20

08.

II. 2

008.


60

Looking into the net positions of consider-able capital funds it is evident that supplemen-tary funding in the Hungarian sector of creditinstitutions has played an prominent role inrecent years (see Chart 12). In light of what hasbeen established above, the growth of non-stake-type portfolio investments as well asloans and deposits received from foreign bankshas been increasingly decisive in determiningthe financial balance of the Hungarian economy,an economy dependent on foreign capital. Atthe same time the trends of recent years shouldalso be underlined, as there has been a shift inthe role foreign banking sectors has played infinancing the Hungarian banking sector. Onthe one hand, a decline in the ratio of debts andan increase in deposits within the portfolio ofloans and deposits, representing a higher liq-uidity risk for the Hungarian banking sector.On the other hand, an important role is playedby foreign disbursement of securities issued bybanks, indicating higher risk aversion on thepart of lenders (maintaining the option to sell

at secondary markets as opposed to bankingloans). While 55.5 per cent of the foreign fundsof Hungarian credit institutions were deposits,41.8 per cent were loans, and 2.7 per cent weresecurities in 2003, the corresponding rates were51.2 per cent, 27.2 per cent, and 21.6 per cent,respectively, in the middle of 2008 (PSZÁF,2008b; page 28).

Regarding the capital flows outlined here,the trend that increasing funding prompts agrowing amount of income outflow should alsobe acknowledged, as shown in Chart 13.

(Of course, the net balance of income out-flows and inflows is considered here, as thisdefines the income positions of the nationaleconomy). Consequently, the net income out-flow related to all portfolio and other investmentsincreased fivefold between 2000 and 2007, toHUF 407 billion from HUF 73 billion. (In thefirst half of 2008, the total of income outflowalready recorded HUF 272 million, represent-ing 105 per cent of the amount registered in thecomparative period of 2007).

Chart 11

PORTFOLIO INVESTMENTS OF OTHER INSTITUTIONS, 2000–2008


HUF

bn

Stakes (A) Other (A)Stakes (L) Other (L)Stakes (N) Other (N)

2000

2001

2002

2003

2004

2005

I. 20

06.

II. 2

006.

III. 2

006.

IV. 2

006.

I. 20

07.

II. 2

007.

III. 2

007.

IV. 2

007

.

I. 20

08.

II. 2

008.


61

Chart 12

NET POSITIONS, 2000–2008


Chart 13

INCOME BALANCE OF PORTFOLIO AND OTHE INVESTMENTS, 2000–2007


Loans from owners, other sectorOther loans, other sectorOwner loans, other monetary institutionsOther loans, other monetary institutions

Portfolio stakes, other sectorOther portfolio, other sectorPortfolio stakes, other monetary institutionsOther portfolio, other monetary institutions

Loans from ownersOther loans, other sectorOther loans, other monetary institution

Portfolio, other sectorPortfolio, other monetary institutionTotal income

HUF

bnHU

F bn

2000

2001

2002

2003

2004

2005

I. 20

06.

II. 2

006.

III. 2

006.

IV. 2

006.

I. 20

07.

II. 2

007.

III. 2

007.

IV. 2

007

.

I. 20

08.

II. 2

008.


62

When the aggregate net positions of foreigndirect investments and income flows (Chart 7)and the net income position regarding portfo-lio and other investments (Chart 13) are scru-tinised together, their combined total indicate aHUF 1,664 billion capital outflow from theHungarian economy in 2007. All this meansthat other supplementary funding has had tosecure financing for capital and income expen-ditures related to earlier usage of capital at anincreasing rate (see Chart 14).

PROFITABILITY OF THE BANKING SECTOR; BALANCE PROBLEMS

Chart 15 shows how the profitability of thebanking sector (in terms of return on equityand return on assets) developed in 2004 inselect countries of the European Union.

Table 3 shows the development of the prof-itability of the Hungarian banking sector in termsof return on equity and return on assets since thebeginning of the new millennium, giving a clear

indication that profitability in the Hungarianbanking sector stabilised at a very high levelbetween 2004 and 2006, considerably outper-forming not only old EU members but also newlyaccessed countries in Central and EasternEurope.

In addition to this high profitability and therelatively low capital intermediary functiondescribed in Section 1, the Hungarian bankingsector is characterised by another factor, name-ly it is regarded well-developed, or even overde-veloped, in terms of the number of market play-ers. It is a fitting description even if the numberof banks operating in Hungary (including spe-cialised credit institutions) decreased to 36from 42 between 2000 and 2008 (PSZÁF,2008c). The relative overdevelopment is bestdefined and compared by the capital intermedi-ary function per bank, calculated as the averagetotal assets of banks per GDP (see Chart16).

One would think this would force banksoperating in Hungary to compete more inten-sively, leading to minimisation of costs andmore efficient allocation of funds, like in other

Chart 14

BALANCE OF CAPITAL AND INCOME, 2000–2007


Direct investmentsOther incomes

Consolidated balance

HUF

bn


63

sectors. However, the approach is gettingaccepted that the traditional theory of compe-tition does not apply to the banking market,suggesting that an intensifying competitiondoes not lead the market to prices expected todevelop in a perfect competition. The existenceof fixed fees for switching banks may be one ofthe reasons, for at even a very low fixed fee thebalance is set as it were a monopolistic market,because competing banks apply identical pricesinitially, thus any one of them could raise theprice by a little without running the risk of los-ing customers. Another explanation suggestsasymmetric information is the key to the issue,since declining profitability due to strong com-petition in an asymmetric-information situa-tion may prompt banks to take excessive risks,which could undermine the stability of notonly the banking sector but the entire econo-my. If banks could apply higher lending rates, itcould cover the gathering of customer informa-tion, the constant monitoring and assessmentof the customer base, but they cannot coverthese costs when their profits are decreasingdue to an intensifying competition, thus theybecome less and less interested in reducingtheir losses by gathering information(Várhegyi, 2004). Some opinions say the cur-rent outstanding profitability of banks inHungary is not to be regarded as excessive, forforeign investors are cashing in their profitsafter taking losses in previous years (Csillik,2006). In my opinion, the key to this high prof-itability is related to their intensifying businessactivities and their role as capital intermediaries

as described above on the back of holding gov-ernment securities that ensured relatively highyields, a dynamically expanding portfolio ofretail loans, a significant increase in foreigndeposits, loans, and securities, which represent-ed low funding costs and considerable liquidityrisk but playing a prominent role among fund-ing sources; in other words, due to theHungarian banking sector's increasing role in theflow of foreign capital.

Also, Hungary is in a particular situationthat high profitability has come with a consid-erable increase in the propensity to take risks,also indicated by two factors: Easing of lendingstandards and conditions, and the deteriorationof banks' portfolios. The lending practice ofHungarian banks was first surveyed in 2003,and that of banks accounting for 75 to 85 percent of the lending market has been mappedbiannually since. In light of the experiencegained from these surveys, credit rating stan-dards and lending conditions (collateralrequirements, maximum loan value) in the sec-tor of small and medium enterprises and theretail scope had been easing at most banks bythe second half of 2007, and it was not until thefirst half of 2008 that a slow shift toward strin-gency started (NBH, 2008e). As for the port-folio with rating requirement, a deterioration inquality was evident: While 91.5 per cent of theportfolio was problem free at the end of 2000,this rate decreased to 88.4 per cent by the endof 2005. Although there has been no addition-al deterioration in the composition of the port-folio, the net value loss and provisions of banks

Table 3

PROFITABILITY OF BANKING SECTOR IN TERMS OF ROE AND ROA, 2001–2007 (%)

Year 2001 2002 2003 2004 2005 2006 2007ROE 14.9 15.0 17.1 23.4 22.3 23.0 17.5

ROA 1.26 1.31 1.50 1.95 1.96 1.86 1.49

Source: Author's own chart based on PSZÁF (2008a), pp 25, 40


64

Chart 15

PROFITABILITY INDICATORS IN INTERNATIONAL COMPARISON

Source: NBH (2006c), page 49

Chart 16

CAPITAL INTERMEDIARY FUNCTION PER BANK IN 2004 (Total assets/GDP)

Source: Kiss (2006), page 175

Hung

ary

Czec

h Re

publ

ic

Esto

nia

Lith

uani

a

Unite

d Ki

ngdo

m

Pola

nd

Latv

ia

Swed

en

Irela

nd Italy

Spai

n

Aust

ria

Slov

akia

Belg

ium

Neth

erla

nds

Denm

ark

Fran

ce

EU 2

5

Portu

gal

Slov

enia

Luxe

mbo

urg

EU 1

2

Mal

ta

Gree

ce

Finl

and

Germ

any

Cypr

us

ROE (left axis) ROA (right axis)

Esto

nia

Latv

ia

Lith

uani

a

Pola

nd

Hung

ary

Slov

akia

Slov

enia

Czec

h Re

publ

ic

Grea

t Brit

ain

Aust

ria

Germ

any


65

increased to HUF 150 billion from HUF 77.5billion registered in the previous year (PSZÁF,2008d), and has been high since, which maypartially account for the decrease in the extentof profitability.

Banks' substantial lending activity – as out-lined by Section 1 and Section 2 – has relied onforeign funding at an increasing rate, and loanshave been denominated in foreign currencies ata growing extent. However, forex dominancehas developed much faster on the assets sidethan on the liabilities side, as a result of whichmore than 39 per cent of the total portfolio ofliabilities and nearly 49 per cent of assets weredenominated in foreign currencies at the end ofJune 2008, representing a net long position of9.6 per cent in terms of total assets (PSZÁF,2008b, pp. 40–41). This considerable open posi-tion will be at risk when the forint is easing orfirming. When the forint is firming, the amountof exchange rate losses on the asset sideexceeds that of exchange rate gains, whichcould be offset by off-balance positions butthey come with transaction costs (which alsoexplains the decrease in profitability that hasbeen apparent lately). When the forint is eas-ing, foreign exchange risks are transferred intolending risks because of increasing debt repay-ment obligations of small business and retailcustomers, which traditionally have no appro-priate forex income. Also, an increase in forint-denominated total assets requires and improve-ment in meeting regulatory capital criteriawhile the value of forint-based Tier 1 capitalremains unchanged, reducing banks' capitaladequacy. This is one of the reasons the fastpace of the expansion of forex lending repre-sents a risks, as the dynamic growth of over-year forex loans and a shift toward short-termdeposits triggers an increase in liquidity risks inrespect of forex-denominated items.

Also, the unfavourable effects of a peculiarpiece of regulation is to be reckoned with. InJuly 2006, the EU directives defining capital

adequacy requirements for banks werefinalised, and they could be enforced in themember states beginning on 1 January 2007but their implementation was obligatory as of1 January 2008. In the case of Hungarianbanks, an increase in capital requirements maybe triggered by deteriorating loan portfoliosin the retail and corporate scope, also causinga slump in lending activities. In the case offoreign banks financing the Hungarian bank-ing sector, unfavourable developments are tobe expected in the scope of interbank dis-bursements, because risk weighting is done intwo ways basically in this scope. The standardmethod links the rating of interbank disburse-ments either with the rating of sovereign debt– and this does not necessarily call for opti-mism, considering the state of Hungary's pub-lic finance – or with ratings of the individualbanks by independent credit rating agencies,but in this case the increasing exposure ofHungarian banks to liquidity and exchangerate issues may have negative implications.The weighting regime based on foreign banks'internal compliance system – either in thebasic or the advanced method – could alsocause worse and worse ratings for Hungarianbanks. Hence, increasing capital adequacyrequirements have had to be expected in thescope of disbursement directed to banks operat-ing in Hungary since the regulations wereimplemented. This could lead to rising fund-ing costs and abatement in the lendingpropensity of foreign banking sectors. Allthese factors may cause a slump in the fundingof the Hungarian banking system, and nar-rowing funding opportunities for the Hungarianeconomy, because the banking sector has inrecent years been more and more active ininvolving foreign funds.

Ensuring outstandingly high profitability forbanks, lending activities in Hungary, financed byforeign funds, have included substantial risks foryears, because loss of confidence in the


66

Hungarian economy could not only triggerhigher risk premiums when shorter-term fundshave to be refinanced when they mature butmay even lead to these funds drying out. It mayoccur especially when liquidity is gettingtighter in international financial markets,which seem to be the case as indicated by whathas been happening on global market recently.Also, the fiscal policy consequences of a grow-ing forex debt portfolio in the retail customerscope should not be overlooked, either. On theone hand, as a result of the prompt exchange ofsubstantial forex funding into the forint, a con-siderable forint firming occurred, and theincreasing foreign funding and retail lending inthe Hungarian banking system could beregarded as some kind of a thrust-forward,because as long as this expansion was sustain-able a strong forint protected banks from lendinglosses to be suffered from an easing forint in thescope of small businesses and retail customers.(This situation could be best described as the'balance of imbalance'). On the other hand, aconsiderable forint outflow due to this mecha-nism caused a pressure to purge and has keptshort-term interest rates high. Also, a peculiarsituation is evident in this context, because it isprecisely high interest rates that have renderedforint loans uncompetitive against forex loans,thus they are as much the trigger as the solu-tion of the problem. In my view the problem ofthese short-term interest rates are independentof high interest rates of government securities inthe medium and long term, since this latter isan evidence of lack of confidence in a permanentconsolidation of Hungary's public finance. Themost these two problems are linked is that aforex inflow stemming from foreign investorspurchasing Hungarian government securitieshas triggered a similar process than banks'forex funding has. A high level of short- andlong-term interest rates can be explained by theassumption that continuous austerity measuresreduce the country's current account deficit

almost to no avail, because without structuralreforms – that would improve the operatingconditions of real economy – these measureswould at best have a neutral impact in the longrun, but more likely to have damaging effects.This is why the feverish struggle of theHungarian government to secure the IMF loan,since the conditions bundled with the loancould lead to austerity measures similar to theones referred to above but never to significantchanges in the budget structure, according tointernational experience gained over decades invarious countries. When the inflow of inter-bank forex funds stopped due to liquidityshortage in global interbank financial marketsand commercial banks implemented limitationsin forex lending for retail customers on theback of the financial crisis cascading toHungary – and, in my view, of the surfacingimbalance that had been present in the systemfor decades – the forint started easing natural-ly, because said pressure had lifted. But it is pre-cisely the mechanism described above thatmakes the 300-basis-point prime rate hikeincomprehensible, because this step could actin favour of maintaining an erroneous system,the 'balance of imbalance', which may cause aneven deeper crisis.

Finally, as a researcher specialised in eco-nomic history and Protestant economic ethics,I would like to quote Martin Luther, whoseideas that he wrote down nearly 480 years agocould be useful even in assessing the situationin Hungary today.

“There is great need of a general law anddecree of the German nation against the extrav-agance and excess in dress, by which so manynobles and rich men are impoverished. God hasgiven to us, as to other lands, enough wool, hair,flax and everything else which properly servesfor the seemly and honorable dress of everyrank, so that we do not need to spend and wastesuch enormous sums for silk and velvet andgolden ornaments and other foreign wares. […]


67

In like manner it is also necessary to restrict thespice-traffic which is another of the great shipsin which money is carried out of German lands.There grows among us, by God's grace, more toeat and drink than in any other land, and just aschoice and good. But the greatest misfortune ofthe German nation is certainly the traffic inannuities. If that did not exist many a manwould have to leave unbought his silk, velvets,

golden ornaments, spices and ornaments ofevery sort. It has not existed much over a hun-dred years, and has already brought almost allprinces, cities, endowed institutions, nobles andtheir heirs to poverty, misery and ruin; if it shallcontinue for another hundred years Germanycannot possibly have a pfennig left and we shallcertainly have to devour one another.” (Luther,2004, pp. 146–147)

CSILLIK, P. (2006): A magyar bankok nyereségérõl[The Profits of Hungarian Banks], Published in:Botos, Katalin (ed.): A bankszektor és stakeholderei[The Banking Sector and Stakeholders], SzegediTudományegyetem Gazdaságtudományi Kar Közlemé-nyei, Szeged [Bulletins of Szeged University of Science,Faculty of Economic Sciences ], pp 118–134

KISS, Á. (2006): Kockázatos növekedés(?)Kiemelkedõ jövedelmezõség Kelet-Közép-Európában[Risky Growth(?) Exceptional Profitability in Centraland Eastern Europe], Published in: Botos, Katalin(ed.): A bankszektor és stakeholderei [The BankingSector and Stakeholders], Szegedi TudományegyetemGazdaságtudományi Kar Közleményei, Szeged[Bulletins of Szeged University of Science, Faculty ofEconomic Sciences ], pp 170–182

LUTHER, M. (2004): A római pápaságról,Egyházreformáló iratok [An Open Letter to TheChristian Nobility, Proposals for Reform ], Aeternitas,Budapest.

MARJÁN, A. [2003]: A monetáris unió hatása azeurópai tõkepiacokra [Impacts of the MonetaryUnion on European Equity Markets], KözgazdaságiSzemle [Economic Journal], Issue 50, 9, pp 800–818

PÁLOSI-NÉMETH, B. [2005]: Az átalakuló gazdaságúországok pénzügyi intézményrendszerének konver-genciája – egyedi a jelenség? [Convergence ofFinancial Institutions in Transition Economies? A Singularity?] Külgazdaság [Foreign Trade], Issues 49,8–9, pp 21–46

VÁRHEGYI, É. (2003): Bankverseny Magyarorszá-gon [Competition of Banks in Hungary], Közgaz-dasági Szemle [Economic Journal], Issue 50, 12, pp1027–1048

Magyar Nemzeti Bank [Hungarian National Bank](2006a): Magyarország fizetésimérleg-statisztikái.Magyarország fizetési mérlege és külfölddel szembenibefektetési pozíciója (módszertan, hazai gyakorlat,adatok, 1995–2004). [Hungary's Balance of PaymentsStatistics. Hungary's Balance of Payments and ForeignInvestments Position (methodology, domestic prac-tice, data 1995–2004)] MNB, Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2006b): Fontosabb fizetésimérleg és állományi ada-tok, 2005–2004, Magyarország, [Main Data in Balanceof Payments, 2005–2004, Hungary] MNB, Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2006c): Jelentés a pénzügyi stabilitásról, 2006. április[Report on Financial Stability, April 2006] MNB,Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2007a): Fontosabb fizetésimérleg- és állományi ada-tok, 2006–2005, Magyarország, [Main Data in Balanceof Payments, 2006–2005, Hungary] MNB, Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2008a): Tájékoztató a nemzetgazdaság pénzügyiszámláinak adatairól, 2008. II. negyedév [Report onthe data of Financial Accounts of Hungary, Q2 2008],MNB, Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2008b): Pénzügyi stabilitás – statisztikai adatsorok,2008. augusztus, [Financial Stability – Statistical Data,August 2008] MNB, Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2008c): Fontosabb fizetésimérleg és állományi ada-tok, 2007–2008, Magyarország [Main Data in Balanceof Payments, 2007–2008, Hungary], MNB, Budapest

LITERATURE


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Magyar Nemzeti Bank [Hungarian National Bank](2008d): Fontosabb fizetésimérleg és állományi ada-tok, 2008. I–II. negyedév, Magyarország [Main Data inBalance of Payments, Q1, Q2 2008, Hungary], MNB,Budapest

Magyar Nemzeti Bank [Hungarian National Bank](2008e): Felmérés a hitelezési vezetõk körében abankok hitelezési gyakorlatának vizsgálatára, 2008.szeptember [Survey of Lending Executives to AnalyseBanks' Lending Practice, September 2008], MNB,Budapest

Pénzügyi Szervezetek Állami Felügyelete[Hungarian Financial Supervisory Authority] (2008a):A felügyelt szektorok mûködése és kockázatai, 2008.április [Operation and Risks of Sectors Regulated,April 2008], PSZÁF, Budapest

Pénzügyi Szervezetek Állami Felügyelete [Hunga-rian Financial Supervisory Authority] (2008b): A felü-gyelt szektorok mûködése és kockázatai, 2008.október [Operation and Risks of Sectors Regulated,October 2008], PSZÁF, Budapest

Pénzügyi Szervezetek Állami Felügyelete [Hunga-rian Financial Supervisory Authority] (2008c):Statisztikai adatok, idõsorok a felügyelt szektorok2008. I. félévi tevékenységérõl, [Statistical Data andTime-series of the Activities of Regulated Sectors, H12008] PSZÁF, Budapest

Pénzügyi Szervezetek Állami Felügyelete [Hunga-rian Financial Supervisory Authority] (2008d): A PSZÁF által felügyelt szektorok adatainak idõsorai,[Time-series of Data Provided by Sectors Regulatedby the PSZÁF] PSZÁF, Budapest

PUBLIC FINANCES – Systemic risks of Hungarian local government sector

69

I

András Vigvári

A possible scenario of modernising the Hungarianlocal government model

In Hungarian political and professional dis-course – partly as an effect of the financial crisis –the issue of reform of the local government systemhas been put on agenda again. This welcome –though under-pressure – fact raises various pre-sumptions and illusions at the same time. Themost important of these probably is that thereform must significantly reduce the number oflocal governments, by which considerable savingscan be attained and the sustainability of thewhole state budget can be improved. In this arti-cle, an attempt shall be made to outline a possiblesolution, considering the weaknesses of the cur-rent local government system, the internationalchallenges and the international tendencies of theoperation of the subnational government level.

THE RESERVES OF THE “HUNGARIANMODEL” HAVE BEEN EXHAUSTED

So as to avoid repeating the mistake made in1990, i.e. that the establishment of the localgovernment system was significantly influ-enced by political sentiments and passions, weshould face the weaknesses of the currentmodel. Within the framework of this article,there is neither a need1, nor an opportunity topresent the Hungarian model of the local gov-ernment system or the evolution thereof. Let

us instead focus on some issues that appear tobe relevant for the further development of thesystem. The basic characteristics of the systemare laid down in the local government act(LGA) made in 1990 as a fundamental act.There are other “plain” acts furthermore form-ing and deforming the operational environ-ment of local authorities.

The first question is whether the fragmentednature of the system should be considered itsmost important characteristic, i.e. its majordefect. Is it true that eliminating this wouldsolve the problem? Let us see an internationalcomparison! Table 1 presents data on some EUcountries characterising the extent of frag-mentedness by the number of population perlocal government. It can be seen that, asregards fragmentedness, Hungary is not in aunique position. The data also indicate thatthere are no correlations between the averagesize, the number of population and theincome centralisation of local governments.Furthermore, ,we wish to mention, withoutgoing into detail, that there have been no actu-al local government models developed either inthe international practice or the EU in particu-lar. There is a particular aspect with a relativelyuniform practice in formation, which is thebasic budgeting rule referring to subnationalgovernments, i.e. that the operating budget of


70

these is not allowed to run into deficit; opera-tional loans are not permitted as a main rule.

It is not because of the settlement-centricassignment of local government rights – due tothe peculiarities of the settlement structure andthus, inevitably, due to its fragmented nature –that the Hungarian model is unsustainable butbecause the act on the basis of which the sys-tem was established, laden with serious politi-cal compromise, identified exercising local gov-ernment rights with the possible framework ofperforming local public duties, despite experts'other intentions. The liberal illusions related to

the New Public Management (NPM-) para-digm played a role in the above, as did the pres-sure to find ways to compensate the villagepopulation who had lost perspective and workopportunity due to agriculture losing ground.The practice of one village, one school; oneinstitution, one budget organ could have beenavoided by a more considerate and providentlegislation and by corrections better plannedand implemented later on. With reference tothe birth of practice, it is important to knowthat the introduction of mandatory associa-tions, by which the anomaly outlined could

Table 1

THE NUMBER AND THE AVERAGE POPULATION OF LOCAL GOVERNMENTS, AND THEIREXPENDITURE AS A PERCENTAGE OF GDP IN CERTAIN EUROPEAN COUNTRIES

Country Population, Number of local Population per local Government revenues million ppl governments government, thousand ppl as % of GDP

Czech Republic 10.3 6 237 1 500 11.3

France 58.9 36 559 1 600 10.9

Slovakia 54 2 871 1 700 6.3

Greece 10.5 5 922 1 800 3.3

Hungary 10.2 3 174 3 200 12.0

Luxemburg 0.4 118 3 400 5.1

Austria 8.1 2 353 3 400 8.0

Latvia 2.5 554 4 000 10.1

Estonia 1.4 247 4 200 8.5

Spain 39.4 8 082 4 800 6.0

Germany 82.0 16 121 5 000 7.4

Italy 57.4 8 104 7 000 14.4

Romania 22.5 2 862 7 700 8,5

Slovenia 2.0 192 8 800 8.8

Finland 5.2 455 11 200 19.4

Poland 38.7 2 489 15 000 13.0

Belgium 10.2 589 17 200 6.8

Denmark 5.3 275 19 100 32.3

Holland 15.7 572 27 000 15.4

Bulgaria 8.3 262 28 000 6.4

Sweden 8.9 286 30 900 25.3

Portugal 9.9 275 34 200 5.9

Ireland 3.7 84 41 667 72

Lithuania 3.7 56 58 800 8.2

Inited Kingdom 58.7 491 118 503 12.9

Source: Own compilation based on OECD- and Eurostat-data


71

have been prevented, was blocked on two occa-sions by the liberal party that time still signifi-cant of the political change. In the case of sys-tems more fragmented than or similar to theHungarian model, it is these institutions thatmake the local government systems based on afragmented settlement structure operable. It isimportant to know that until 2004 the per-formance of local duties within the frameworkof own institutions was fostered, at changingintensity, by the source regulation system.

It is a feature determining strongly the pecu-liarity of the model at the same time that it isnot the maintenance of institutions that is pre-scribed under the LGA; local public services aremeant to be guaranteed through a serviceorganisational obligation. It depends on a localdecision if the latter is assigned to budgetorgans, non-profit organs or local-governmentowned, private or possibly mixed ownershipbusiness organisations. Through the latter,principles of NPM revolutionary at the timeeven at an international level were incorporatedinto the regulations (Horváth, 2000; Horváth,2005; Péteri – Horváth, 2001; Péteri, 2003). Asa consequence of this opportunity – especiallyin the case of local governments of towns andcities – the quasi-fiscal sector has a significantrole in the performance of local public duties.This means in turn that – lacking the necessarycontrol – the political bodies in authorities failto supervise a significant segment of the localgovernment economy.

It must be noted that the principle of serviceprovision instead of the institution maintenanceobligation has been violated in practice. Onereason for this was that the asset transfer prin-ciples and mechanisms applied when the sys-tem has got established were inconsiderate2.The asset transfers performed under the LGAassigned several assets necessary for the provi-sion of local services to municipalities, whichgenerated significant inflexibility and is animportant factor in the survival of the practice

of providing services via own institutions. Theother reason can be described by an organisa-tional sociological nature, namely, in the frag-mented system, the day-by-day legitimacy oflocal bodies was guaranteed by the supervisableinstitutions. The presence of institution man-agers or employees in the bodies, in turn,became the ground of typical institutionpreservation and enlargement efforts.

The third peculiarity is that the central fiscalregulation system serving as the financial back-ground of the services assigned as mandatoryto local governments – which revived the “reg-ulation illusion” of the indirect economic man-agement system introduced in 1968 – proved asuitable means for the de facto recentralisationof the de jure decentralisation, the latter alsoserved the decentralisation of a significant partof the conflicts involved in the economic tran-sition. The major milestones in the change ofthe Hungarian model are presented in Figure 1.

The possible distortions of the model werecoded at the birth of its conception. At thetime of the political change, on the one hand,it could not be foreseen how far the statewould continue to “retreat” from the serviceprovision and, on the other hand, the legisla-tion of that time followed the internationalpractice of decentralising public sectorreforms applied in NPM in the 1970–1980's.Pálné (Pálné, 2001, p. 75), following Sharpe,observed that during the first big wave of pub-lic sector reforms even in developed industrialcountries, it was a widespread practice to easethe central budget pressures by decentralizingmeasures not supported by financial sources.After 2000, the Hungarian local governmentsystem borrowing a term introduced by AttilaÁgh (Ágh, 2005, p. 15) – became a “conflictcontainer”. The extreme decentralisation ofseveral services, including public education,was carried out because the governments inpower could thereby decentralise the obviouslyarising conflicts (like the closing of schools).


72

Figu

re 1

THE

HUNG

ARIA

N M

ODEL

OF

FISC

AL D

ECEN

TRAL

ISAT

ION

AND

ITS

EVOL

UTIO

N (S

TYLI

SED

“MAP

”)

M

anda

t or y

du

ties

Sy

stem

of s

tate

co

ntrib

utio

ns

The

fram

ewor

k of

du

ty

perfo

rman

ce

An e

cono

mie

s of

sc

ale

fram

ewor

k fo

r du

ty p

erfo

rman

ce

Asse

t co

nditi

ons

Capi

tal m

arke

t re

latio

ns

Hard

ness

of b

udge

t co

nstra

ints

In

vest

men

t sup

port

syst

em

Birth

19

88–1

991

Not d

efin

ed

prec

isel

y, o

f a

grow

ing

num

ber

Norm

ativ

e, g

ross

fin

anci

ng, w

ith fe

w le

gal t

itles

of b

ound

us

e

Fisc

al a

nd

quas

i fis

cal.

Budg

et o

rgan

s we

re

fragm

ente

d

Oppo

rtuni

ty o

f as

soci

atio

n av

aila

ble;

no

taria

l dis

trict

s fo

rmed

from

the

begi

nnin

gs

Asse

t tra

nsfe

rs

unde

r the

law

and

with

in th

e fra

mew

ork

of

sepa

rate

tra

nsfe

r pr

oces

ses

Free

cho

ice

of

bank

onc

e a

year

, fre

e bo

rrowi

ng

Rath

er s

oft;

it wa

s un

clea

r whe

ther

the

stat

e wo

uld

take

re

spon

sibi

lity

for t

he

oblig

atio

ns o

f the

se

ctor

Earm

arke

d su

bsid

ies

were

bou

nd to

di

scre

tiona

l de

cisi

ons;

targ

et

subs

idie

s to

tend

ers.

Sm

all “

bran

ch

subs

idie

s”

Chan

ges

19

95–1

996

Not m

ade

mor

e pr

ecis

e,

thei

r num

ber

grew

Switc

h to

net

fin

anci

ng, g

rowt

h in

nu

mbe

r of l

egal

title

s

Th

e 19

97 A

ct o

n As

soci

atio

n cr

eate

d m

ore

favo

urab

le le

gal

cond

ition

s

Deba

te o

n th

e pr

ivat

isat

ion

of p

ublic

ut

ility

ass

ets

affe

ctin

g lo

cal

gove

rnm

ents

Rest

rictio

ns

on b

orro

wing

s th

roug

h th

e am

endm

ent o

f Ar

ticle

88

of

LGA

The

cons

train

ts w

ere

mad

e to

ughe

r by

the

rest

rictio

ns o

n bo

rrowi

ngs

of 1

995

and

the

“loca

l go

vern

men

t deb

t act

” of

199

6

The

unsu

stai

nabi

lity

of th

e ta

rget

su

bsid

isat

ion

syst

em

beca

me

clea

r; ru

les

mad

e st

ricte

r. Sm

all

“bra

nch

subs

idie

s”

The

begi

nnin

g of

def

orm

atio

n at

the

turn

of t

he

mill

enni

a

Conf

used

Nu

mbe

r of l

egal

title

s st

abili

sed

at 2

.5 ti

mes

th

e or

igin

al n

umbe

r ,

the

num

ber o

f tho

se

with

bou

nd u

se g

rew.

Du

e to

allo

catio

n ba

sed

on ta

x ca

paci

ty

, int

rans

par

ent

syst

em

The

role

of

quas

i fis

cal

fram

ewor

ks

incr

ease

d

St

reng

then

ing

defic

it fin

anci

ng

base

d on

the

sale

of a

sset

s

“Fre

e ch

oice

of

ban

k”

beca

me

mor

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xibl

e

The

role

of

Emer

genc

y Op

erat

ing

Gran

ts g

rew,

its

cond

ition

s be

cam

e di

scre

tiona

l, se

para

ted

fund

s we

re

crea

ted

at th

e m

inis

ter i

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. Co

nstra

ints

sof

tene

d

The

num

ber o

f su

bsid

isat

ion

chan

nels

gre

w.

Grad

ual

diss

olut

ion

afte

r 20

02

Conf

used

Th

e nu

mbe

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tit

les,

incl

udin

g th

ose

of b

ound

use

, gre

w by

one

third

The

role

of

quas

i-fis

cal

fram

ewor

ks

grew

, sta

te

subs

idis

ed

PPP

appe

ared

Intro

duct

ion

of a

nd

stro

ng s

uppo

rt fo

r a

NUTS

4-le

vel

volu

ntar

y m

ulti-

purp

ose

asso

ciat

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syst

em. C

ount

y-le

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asso

ciat

ion

disp

refe

rred.

Sale

of a

sset

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ntin

ued;

in

debt

edne

ss

grew

The

maj

ority

of

fina

ncia

l se

rvic

es w

ere

subo

rdin

ated

to

pub

lic

proc

urem

ent

Acco

rdin

g to

es

timat

ions

, the

nu

mbe

r of d

e fa

cto

inso

lven

t pla

yers

gr

ew s

igni

fican

tly;

som

e lo

cal

gove

rnm

ents

got

into

a

debt

trap

Expe

rimen

ts fo

r the

de

cent

ralis

atio

n of

ce

rtain

sub

sidi

es to

co

untie

s an

d de

velo

pmen

t reg

ions

Un

satis

fact

ory

resu

lts


73

“Incidentally”, such decentralisation causessignificant disorder and dysfunctions in theprovision of actual public services, which canbe well illustrated by the decreasingly efficientoperation of the public education system.3 The“creeping decentralisation” of the 1990's andthe decrease in the real value of normative sub-sidies were clear signs of the practice, as isillustrated by Table 2.

Certain quantifiable characteristics of fiscalrecentralisation and conflict decentralisationare summarised in Table 3.

Another characteristic of the “Hungarianmodel” worth to mention in this article is theambiguous fiscal discipline4. First, localauthorities operate using a single fund, where-

by they have been given the opportunity touse the revenues from privatising their assetsfor supplementing their deficient currentsources. This is clearly shown by Table 4.Second, the LGA has created the opportunityof extremely liberalised capital market rela-tions. Third, the borrowing limit for localgovernments5 and the act on debt settlementprocedure known as the 'local governmentbankruptcy act', considered a “Hungaricum”,are meant to counterbalance the above. Sincemandatory services are left underfinanced bythe state, a significant circle is affected byEmergency Operating Grants meant to beexceptional subsidies originally; moreover, asupplementary fund accessible under a discre-

Table 2

CHANGES IN THE EXPENDITURE OF THE LOCAL GOVERNMENT SECTOR (1990–2007)

Year GFS expenditure of local Nominal change in Consumer price Change in realgovernments (HUF bn) expenditure (%) index* (%) value (%)

1990 315 – – –

1991 374 118.5 135.0 87.8

1992 489 133.3 123.0 108.4

1993 599 120.4 122.5 98.3

1994 750 125.2 118.8 105.4

1995 800 106.7 128.2 83.2

1996 913 114.1 123.6 92.4

1997 1,135 124.3 118.3 105.1

1998 1,348 118.8 114.3 103.9

1999 1,476 109.5 110.0 99.5

2000 1,651 111.9 109.8 101.9

2001 1,902 115.2 109.2 105.5

2002 2,286 120.2 105.3 114.1

2003 2,533 110.8 104.7 105.8

2004 2,689 106.0 106.8 99.0

2005 2,972 110.5 103.6 106.7

2006 3,210 108.0 103.9 104.0

2007 3,203 99.2 108.0 92.0

2008** 3,410 106.0 106.4 99.6

2008/1990*** – 1.083 995.0 109.0

* CIP is not the most suitable indicator to measure changes in the price level of local public services. According to my estimations, “the localgovernment price index” is higher than that, due to the special consumer basket of the sector. ** Preliminary.*** Due to the widening mandatory tasks and changes in production efficiency the long term real value only a rough estimation.


74

Tabl

e 3

SOM

E IN

DICA

TORS

OF

THE

FINA

NCIA

L SI

TUAT

ION

OF L

OCAL

GOV

ERNM

ENTS

IN T

HE Y

EARS

199

1–20

07

Indi

cato

r

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008 estimate

GFS

expe

nditu

res

a %

of G

DP

15.0

16

.9

16.9

17

.2

14.4

13

.2

13.3

13

.4

13.0

12

.2

12.5

13

.3

13.4

13

.0

13.5

13

.5

12.3

12

.6

Gran

ts fr

om c

entra

l gov

ernm

ent.

% o

f GD

P %

9.

5 9.

6 8.

6 8.

0 7.

3 6.

2 5.

7 5.

8 5.

6 5.

0 5.

2 5.

5 6.

1 5.

9 6.

0 5.

6 5.

2 5.

2

Num

ber o

f ope

rtatio

nal c

entra

l gra

nts

35

42

45

48

54

58

77

86

91

73

89

88

120

137

162

134

158

151

Loca

l tax

reve

nues

% o

f GDP

0.

4 0.

6 0.

8 0.

8 0.

8 1.

2 1.

3 1.

4 1.

7 1.

6 1.

7 1.

7 1.

7 1.

8 1.

8 1.

9 2.

0 2.

1

Inve

stm

ent g

rant

s fro

m g

ener

al

gove

rnm

ent %

of G

DP**

0.

7 0.

9 0.

6 0.

7 0.

5 0.

4 0.

5 0.

5 0.

6 0.

5 0.

6 0.

6 0.

5 0.

4 0.

6 0.

6 0.

7 0.

4

Num

ber o

f inv

estm

ent

subs

idie

s.

1 3

3 5

5 6

6 9

18

7 10

10

12

13

14

15

19

14

Capi

tal e

xpen

ditu

res

% o

f GDP

2.

5 3.

3 3.

1 3.

9 2.

5 2.

1 2.

6 2.

8 2.

3 2.

4 2.

6 2.

8 2.

3 2.

2 2.

6 2.

9 2.

3 2.

6

*exc

l. He

alth

Fun

d.

**in

cl. E

U fu

nds.

So

urce

: the

aut

hor’s

com

pila

tion

base

d on

Min

istry

from

Fin

ance

dat

a


75

tionary government decision also introducedafter the turn of the millennia.

On the whole we can say that the “Hungarianmodel” is characterised by “collective irrespon-sibility” and the lack of fiscal discipline.

Last but not least in the operation of theHungarian local government system the man-agement has always been focused on the pre-vailing budget (flow attitude), whereby tillrecently typically no room has been given inpublic finance systems to the attitude focusingon conditions related to properties (stock atti-tude)6. The reason why it has involved growingtension is that, at the birth of the system, localgovernments became the owners of a signifi-cant volume of different kinds of properties.Operational subsidies do not provide coveragefor the replacement of assets depleted in the

provision of public services and there is noinstitutional pressure forcing local govern-ments to apply responsible asset management.From the beginning, the state system of devel-opment subsidies has carried out allocation bytendering. Despite the refinements made in thepast ten years, the multi-channel nature of pay-ment7, the structure of the matching fundingsystem have distorted the investment prefer-ences of local governments, dispersing ofinvestment sources and, in many cases, the cre-ation of unfinanceable and/or superfluouscapacities. Table 3 reflects the changes in thenumber of the legal titles of allocation of devel-opment subsidies, which fit well to the pres-sures under various coalition constellations.The asset loss of local authorities is apparentnot only in the sale of assets and in the fact that

Table 4

THE GFS BUDGET POSITION OF THE HUNGARIAN LOCAL GOVERNMENT SECTOR WITH ANDWITHOUT PRIVATISATION REVENUES

Year Budget GFS*-balance including Budget GFS*-balance not includingprivatisation revenues privatisation revenues

(HUF billion) % of GDP (HUF billionn) % of GDP1994 –45.5 –1.0 –55.7 –1.3

1995 8.5 0.1 –17.2 –0.3

1996 47.9 0.7 0.6 0

1997 66.5 0.7 –24 –0.2

1998 – 8.7 0 –28.1 –0.3

1999 22.9 0.2 1.1 0

2000 4.9 0 –32.1 –0.2

2001 1.2 0 –91.4 –0.6

2002 –104.9 –0.6 –199.5 –1.2

2003 –31.6 –0.17 –40.7 –0.2

2004 –16.5 0 –119.2 –0.6

2005 –81.4 –0.37 –202.6 –0.9

2006 –156.5 –0.67 –286.5 –1.2

2007 –53.9 –0.2 –168.9 –0.65

2008** –90.0 –0.33 –220.0 –0.8

2009*** –134.0 –0.5 –228.0 –0.8

Source: Ministry of Finance*Under the original (no longer valid) methodology, privatisation revenues were included in the GFS-balance. This is no longer allowed by the newGFS-standard and the ESA- methodology.** Preliminary data*** According to the calculations of the budget act


76

the annual investment of the sector falls shortof the calculated amortisation of local govern-ment assets (Vigvári, 2007b), but also in thefinancial assets easy to measure.

The pecuniary conditions can be analysedfrom a special point of view by reviewing theevolution of financial assets. This reflects theclear fact on the one hand that debts are nega-tive assets. On the other hand – in my opinion– following from the special logic of theHungarian system, local government involve-ment in public utility companies performingmandatory services, considered as assets froman accounting point of view but incorporatingliabilities essentially, should be deducted fromwhat is interpreted as net assets. Giventhe ten-sions related to the service fees charged bythese companies,8 it can be considered a care-ful approach if this item9 is taken as a neutralone, i.e. an item not influencing financialassets. Following this approach, it can beobserved by skimming through the data of the

Hungarian National Bank presented in Table 5that, since 2003, the sector as a whole has beeninsolvent, i.e. the value of its free financial assetsdoes not cover for its financial liabilities10. Thisinterpretation of insolvency follows from theconstitutional characteristics of local govern-ments that they, as a main rule, are obliged touse their assets (including owner's participa-tions) on performing their mandatory services.

In the Hungarian circumstances, the excessiveownership entitlements of local governmentsraise a legal barrier to even the spending assign-ment within the local government- or, in a broad-er sense, the government sector. An example forthis has been the attempt of health care reform.

PUBLIC SECTOR REFORM, LOCAL GOVERNMENT REFORM IN HUNGARY

A wide circle of experts agree that the situationhas matured to be reformed. A positive con-

Table 5

FINANCIAL ACCOUNTS OF THE LOCAL GOVERNMENT SECTOR (S.1313) (HUF billion)

2001 2002 2003 2004 2005 2006 2007 2008.H1Financial assets 1 120.2 1 104.2 1 074.0 1 134.3 1 132.1 1 136.0 1 055.1 1 342.1

cash deposits 196.2 220.5 212.6 243.0 241.2 274.6 382.1 421.5

securities other than shares 129.9 76.9 55.3 70.7 52.5 42.5 50.7 100.3

borrowings loans 54.5 70.6 71.3 79.4 84.2 82.8 66.3 58.8

owner' participations 695.1 697.7 692.2 697.5 705.9 710.5 695.3 691.5

incl. stock exchange shares 22.0 19.4 25.6 36.3 45.4 45.4 25.6 18.2

investment vouchers 16.3 15.8 14.1 16.7 15.7 11.8 16.4 16.0

other shares participations 656.9 662.5 652.5 644.5 644.7 653.3 653.3 657.3Liabilities 279.2 400.2 426.5 533.5 647.6 822.4 1.036 1.017.8

securities other than shares 22.9 24.5 5.7 6.5 4.4 27.4 209.2 317.2

borrowings loans 147.4 241.6 276.7 366.6 415.4 543.8 576.8 471.0

including borrowings from domestic credit

institutions 73.1 115.1 144.0 182.4 241.5 347.3 358.5 338.2

foreign borrowings 13.9 46.9 62.4 83.7 100.3 122.9 132.2 117.7Net financial assets of the local government sector* 184.1 41.5 –5.0 –43.7 –160.0 –339.7 –432.9 –333.0

Source: Hungarian National Bank

*Balance of financial assets and liabilities minus the value of other shares and participations.


77

sensus reach right as far as the “hows” of thesolution, however. We believe that one of thepriority areas of the establishment of a govern-ment sector fostering domestic demands aswell as catch-up, i.e. of a successful public sectorreform, as you like, is the reconsideration of theservices delegated to the state and, within itsframework, a novel reallocation of servicesbetween the central and local government levels:i.e. the reform of the local government system. InHungarian professional discourse, the conceptof reforms has been identified with that ofdownsizing and withdrawal. In the case ofreforms involving a political change and “dena-tionalisation”, the meaning above is correct.Observing the processes in developed coun-tries of times after the 1990's, however, we cansee the application of a post-NPM-reform par-adigm in these countries, referred to as mod-ernisation strategy in the literature11. This isnot only about institutional downsizing but isalso about restructuring; sometimes even aboutthe establishment of new institutions. Thereforms are successful if they are system-likeand the institutions are well adjusted to oneanother.

The modernisation above, starting from thelocal government system, induces changes in allareas of state operation since this area affectssimultaneously the transformation of theregional system of state administration (publicadministration reform), the reconsideration ofthe economic development activity of the state(regional and economic development reform)as well as the provision of certain public servic-es (from human services – public education,health care – to environment protection andthe maintenance of physical infrastructure). Atthe same time, the local government sector isalso an ideal place for the introduction of thepublic finance reforms necessary for the mod-ernisation of the public sector. The interna-tional practice shows that neither some form ofa maturity approach, nor programme-based

budget planning was introduced in a shock-likemanner, but by launching pilot programmes. Inseveral countries, the “field of experiment andtraining” was exactly the subnational level.(Báger – Vigvári, 2007)

In practical action, the reform of the localgovernment system – due to the complexity ofthe system – should be seized in four dimen-sions, in a way that the advance made in theindividual fields should have a system approach.In this case, this overused term means that thesteps made in the subfields should be in accor-dance with the demand of the other fields,should be synergic and, in the progress, meas-ures to be withdrawn later should be avoided ifpossible. The latter is fostered by the scenariotechnique12. The relationship between crisismanagement and measures of a reform natureas well as the question of the rate of progress intime are important “reform technological”dilemmas. A piece of advice in this respect isthat, during crisis management, no measuresshould be taken that contradict the targetmodel of the reform.

In relation with the first dimension, thetasks related to the constitutional status of localgovernments and to the public administrationsystem must be examined. This is basically a“package” concerning issues of the mediumlevel of subnational governments13 (electedregional or “large county” subnational govern-ments, [Verebélyi (2000), possibly a region14

corresponding the NUTS 1 level], the future ofthe level of micro-regions, the exercising ofrights related to local governing and the intro-duction of the institution of mandatory associ-ation. There is a consensus that the mediumlevel of the subnational government system –and the strategic planning, political and centralgoverning functions of this – should be madestronger. There is a lack of agreement, howev-er, on the range of the medium level, the rate ofdecentralisation as well as on exercising therights of micro-regions and local authorities. It


78

is a serious inner contradiction of the establish-ment of the current multi-purpose local gov-ernment associations that decision-makershave tried to “squeeze” public administrational,provision of public services as well as settle-ment- and regional development tasks withinone organisational framework. It is clear thatpublic administration, human services, themaintenance of line infrastructures and region-al development need different spatial frame-works to operate at a close to optimal level.Despite the facts mentioned above, it is truethat the establishment of voluntary multi-pur-pose local government associations has “stirredup the backwater” and, generating some fur-ther pressure for action, may serve as a basis forfurther favourable changes. The debate regard-ing the question whether it is municipalitiesthat should be the basic level of exercising localauthority rights and, if so, whether it is neces-sary to determine some reasonable population

minimum, is not public enough. We believethat via adequate constitutional solutions awell-functioning local authority system couldbe operated even by sustaining the local gov-ernment rights of the settlement structure cur-rently fragmented. The elected mayors of smallmunicipalities – without an office or a body –may be the advocates of the local interests ofsmall settlements and, in this function, theorganisers of local public service provision. It isan economic argument against merging smallmunicipalities into one district that it is not atsmall settlements where the reserves of the sys-tem can be explored; these should be found inthe capital and in counties and cities havingcounty rights by rationalising the cooperationof the latters. The economic potentials of vari-ous types of local government are presented inTable 6.

The greatest waste in the Hungarian localgovernment system is the lack of a reasonable

Table 6

SOME INDICATORS OF THE ECONOMIC POTENTIALS OF VARIOUS TYPES OF LOCAL GOVERNMENTS

Type Capital Districts Cities Towns Villages Parishes County Totalof the with county govern-capital rights ments

Number of players as of

January 1, 2007 (pieces) 1 23 23 274 146 2 708 19 3 194

Distribution of population % 16.80 19.59 29.64 6.46 27.51 0 100

Distribution of LG's GFS

revenues of 2007

national=100 (%) 12.7 11.1 17.8 25.2 3.8 15.0 13.2 100*

Distribution of LG's GFS

expenditures in 2007 (%) 12.5 10.6 18.2 25.5 3.8 14.7 13.4 100*

Distribution of LG's revenues

from local taxes in 2007 (%) 17.3 24.1 21.9 25.7 3.5 7.6 0 100

Distribution of LG's assets 44.2 ND 11.5 27.6 3 8.9 4.8 100

Distribution of debt 25.26 6.39 23.29 28.12 1.66 5.8 9.48 100

Distribution of other LG's

laibilities 0.32 12.53 18.03 27.09 2.89 31.02 8.06 100

Source: own compilation based on Ministry of Finance data

* Figures before the implementation of the government order issued in 2001 prescribing the revaluation of assets.


79

allocation of administrational tasks betweenthe model for the capital and counties andcities of county status, and the consequentlosses, as well as the simultanous political andadministrational activities. The latter is illus-trated by the fact that, from local governmentadministration employees, 3 per cent areemployed by Budapest Mayor's Office, 13 percent by the Mayor's Offices of BudapestDistricts, 15 per cent, 30 per cent and 23 percent by the mayor's offices of cities of countyright, towns and large villages respectively. 6per cent of the employees work at county localgovernment offices and 9 per cent at the notar-ial districts. Administrational expendituresmake up 18 per cent of local governmentexpenditure; in this field there is essentially nooutside budget duty performance14.

The second dimension of the reforms con-stitutes the assignment of local services. Thereare three questions that arise regarding thisdimension. First,, it is necessary to delegatedifferentiated services and responsibilities tomunicipalities (villages, towns, cities) and toregional formations (micro-regions andregions) and, if so, by what legal technique isit possible? By the establishment of theregional level, in what circle should servicedecentralisation be carried out from the cen-tral level and servicerecentralisation from thelocal level? Second, in the case of agglomera-tions, should these be considered as specialindependent units of service provision? Last,but not least: what should be the nature ofmandatory associations be like, i.e. shouldthey involve a special circle of settlementsand/or service provision with economies ofscale and/or specified regional units? There isno need to look for brand new technologiesand “re-invent the wheel” since, with respectto these questions, there is sufficient interna-tional experience easy to use, through thecarefulapplication of which fast achievementscould be attainable in the case of a political

consensus. For the possible alternatives, cf.Gazsó et al, 2008. Another question relevantin this respect is whether it is right to operatehealth services and public education at the set-tlement level. In my opinion, recentralisationwould be necessary in these fields. Withrespect to public education, depending on theimplementation of regionalisation, some ofthe responsibility should be delegated to themedium level, while questions of content andstaff should be made central authority. For theimplementation of the economies of scale andlogistic optimum of the health care supplysystem, the field should be assigned individualresponsibility, also divided between the cen-tral and regional levels.

The third dimension incorporates questionsof service organisation. In our opinion, thenumber and dominance of budget institutionsshould be reduced. One way to make this pos-sible would be the establishment of mandatoryassociations, which could significantly curtailthe number of the currently 13–14 thousandbudget organs as well as the related administra-tional and information service costs. If the sub-mitted bill15 is passed, more up-to-date opera-tional regulations may be worked out for budg-et organs. The regulation questions of task per-formance units outside the budget sectorshould be reconsidered as well16. The downsiz-ing of service organisation focusing on self-sus-taining institutions must couple with makingthe control of public moneys and communityassets used by non-budget organisationsstronger and more efficient.

The fourth dimension is the modernisationof the funding system, the subnational financialarchitecture, and the establishment of institu-tional solutions serving the strengthening ofbudget discipline. It includes changing the allo-cation mechanisms of central state grants aswell as equalisation and development trans-fers, the order of money supply, questionsrelated to the share of own sources, emphati-


80

Figure 2

POSSIBLE FIELDS OF MODERNISING THE LOCAL GOVERNMENT SYSTEM

the modernisation of the state budget infor-mation system

budget rules incorporated into the act ondebt settlement procedure

stabilisation of the rules and techniques ofsource regulation for a political cycle, in a sep-arate act

the modernisation of the system of localrates within the framework of modernisation atthe national economic level

the modernisation of the state budget infor-mation system

liquidation of the single fund; related bud-get rules

stabilisation of the rules and techniques ofsource regulation for a political cycle, in a sep-arate act

the modernisation of the system of localrates within the framework of modernisation atthe national economic level; granting theregional level the right to levy local rates

Financing and finan-cial architecture

increasing the transparency of quasi-fiscalservice provision

in the modernisation of budget management,the introduction of differentiated regulations forvarious types of budget organs

regulation of the relations with the cooperat-ing private sector

encouraging associative duty performancebetween counties

encouraging more differentiated inter-settle-ment associations, instead of today's multi-pur-pose associations

the modernisation of the rules of asset ma-nagement, including the increasingof the trans-parency of quasi-fiscal service provision

in the modernisation of budget management,the introduction of differentiated regulations forvarious types of budget organs

stonger regulations of the relations with thecooperating private sector

encouraging associative service provisionamong the counties

Service organisation

the deregulation of “branch acts” (publiceducation, health care, etc.), financial and legaleffects analyses of the rules

health care and public education should be atleast partly withdrawn from the local governmentlevel

local economic and regional developmentspending responsibilities should be partly trans-ferred to the local level

the assignment of regionally interpretablesome responsibilities (maintenance of line infra-structures, environment protection, flood preven-tion, etc.) to the regional level

Delegation of localgovernment authori-ties and duties

requirement of local associations to provideservices in certain areas of public policy

more precise specification of the range ofmandatory local services

declaration of subnational governments ofvarious levels and fixing the assignment of serv-ices among them

separation of services between the state andlocal governments should be

Constitutional status,public administrationreform

Slower reform by simple majority con-sensus

Radical reform by two thirds majoritypolitical consensus


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cally the modernisation of the system of localrates, the tax or fee financing dilemmas oflocal services, the toughening of budget con-straints and the question of limiting commit-ments. In the majority of developed countries,there are lively professional discussions onquestions related to the ratio of local rates andcentral grants and to the optimal motivatingrole of transfers. OECD has set up even awork team to analyse the international experi-ence and the possibilities to support the bestinternational practices, as well as to strength-en the convergence of the national informa-tion systems utilized in the operation of sub-national governments17.

The possible scenarios of a reform processare presented in Figure 2, based on the findingsof research conducted within the framework ofthe IDEA Public Administration ModernisationProgramme of the Ministry of Home Affairs,the Hungary 2015 Project of the HungarianAcademy of Sciences-Prime Minister's Officeas well as the asset management research of theROP 3.1.1 programme18.

In the case of the lack of the political con-sensus required, action can be taken in the thirdand fourth dimensions basically. Within thescope of this, deregulation of branch acts and pro-fessional acts and the changes in financing close-ly related to these should be launched. Severalmeasures can be taken by simple parliamentmajority: some of the branch acts may beamended, for example, others can be rewrittento have a framework act nature; regional andinstitutional capacity regulation may be intro-duced and, related to this, central source regu-lation may be revised into new directions to bespecified later.

The next urgent task is to transform thesystem of local rates and make tax administra-tion more fruitful and efficient. On the basisof the past 15 years' experience behind us, dif-ferentiation between local rates19 and localgovernment taxes20 should be considered.

Local business tax, in its current structure,should be changed by all means.21 In thereform of the system of local rates, the tax bur-den on enterprises should be decreased and thaton the population increased compared to thecurrent situation. Instead of the current taxburden of 10–90 per cent on the populationand on enterprises respectively, a much moreeven local level tax burden is required.Increasing the role of local population taxa-tion would strengthen the motivation forchecking the accountability of local represen-tatives. Through the transformation of thewhole system of taxation it can be guaranteedthat the global tax burden on the populationshall not increase.22 Leaving the global tax bur-den on the population unchanged does notmean a necessity to implement a much moreeven distribution of tax burden. This wouldalso serve the whitening of the economy. Therole of property taxes should be increased.Raising the rate of the vehicle tax currentlylevied by a transition to value-based taxationand the introduction of value-based propertytax guaranteeing the possibility of writing itoff the personal income tax, could be suitabletechniques for the above. It must be guaran-teed that, in local government revenues, theweight of local government taxes and localrates at least double from the current 12 percent. While it is not necessary to abolish thelocal business tax, the tax base could beamended in a way – also on the basis of inter-national examples – to reduce the cycle andinflation sensitivity of this source of income.The act on local rates may be amended by sim-ple parliament majority as well.

It is necessary to guarantee the toughening ofbudget constraints at subnational governments, aprerequisite of which is the abolishment of thesingle fund. The single fund system followed inthe current Hungarian practice is not widespreadinternationally. This measure, requiring theamendment of the LGA, would make it possi-


82

ble to demand local governments to have a bal-anced current budget or even a slight excess.The change would prevent the continuation ofexhausting assets and would make the systemof Emergency Operating Grants marginalonce again. This rule would, at the same time,also assume adequate central support for thedelegated mandatory duties and/or an ade-quate central tax allocation. Borrowing wouldstill be available for financing investmentexpenditure as well as for liquidity purposes;the extent of borrowings would be specifiedconsidering the rate of net investments. Theact on debt settlement should be modernisedtaking into account the experience of enforce-ment as well as changes in other fields of theregulation. Strengthening the financial disci-pline of local governments and tougheningtheir budget constraints could be forced outby simple majority legislation. Making the acton debt settlement procedure more precisecould be one way to foster the former, whileother ways include simplifying central sourceregulation and making the system of financialcontrol more closed.

A prerequisite for all the above is changingthe “philosophy” and means of central source reg-ulation, which must be made accountable andtransparent. The way to achieve the latter isthat, in the case of the second scenario, thederegulation of professional acts should cou-ple with reducing the number of the legal titlesof operational state subsidies to under 10,complementing this by the application of thetransparent techniques of equalisation. In thecase of the scenario based on the amendmentof the LGA, the system of normative statecontributions could be abolished throughregional and inter-settlement equalisation sub-sidies based on increasing the role of localrates and distributing central taxes. In thiscase, it would be advisable to create an opera-tional guarantee fund in which local govern-ments as well as the central budget would per-

form payments and from which local govern-ments in a special position could be financed.The supervision of the fund should be organ-ised on a partnership basis (central govern-ment, regional governments and local govern-ment interest representations). It must beguaranteed that local government subsidies bereliable in the longer run; the basic rules mustbe laid down in a separate act, in accordancewith the convergence programmes in force23.This is namely the condition for responsibleand accountable local government medium-term planning, which is the basis for successfulEU tenders. In times to come, the decisivemajority of local developments are to beimplemented from the sources of various EUtenders. For the financing of earlier postponedsupplements and renovations, the operation ofa central subsidy system in which the targetsavings of local governments would be com-plemented by the central government if neces-sary, should be considered. This “pre-saving”scheme would encourage local governments'readiness to make savings in the critical yearsof nominal convergence.

CONCLUSIONS

As a way of conclusion, there are three remarksto be made at the end of this study.

The first is related to the dilemma of feasibil-ity and refers to short-term opportunities. Itmay be a justified counterargument that theproposals are of a weight that their implementa-tion requires not only a political but as well as aprofessional consensus reached with the inter-est representation organs of those concerned.In the short run, there seems to be little chanceto achieve this although the crisis has very clear-ly revealed the vulnerability of the country. Thisdoes not free government forces of the respon-sibility of constructive action, however. Suchscope of action includes the modernisation of


83

the state budget information system, the sim-plification of source regulation and the guaran-tee for the relative stability for rules, the imple-mentation of which may generate positivechanges in local government behaviour.

The second remark refers to short-termthreats. If reforms remain at the level of prom-ises, this will intensify the collapse of the cur-rent system. The ideas of change get incorporat-ed into the expectations of players, generatingshort-term focused behaviour leading to fur-ther erosion. A good example for this is the badcommunication of making local governments'debt restrictions stricter. This, like a schoolbookexample, has generated accelerating indebted-ness in the sector since individual local govern-ments are able to take rational action if they tryto reach the desired status on the basis of theircurrent level of informedness. In this case thismeans that, so as to cope with the financing ofthe growing deficit and raise sources for theown contribution and pre-financing requiredfor the absorption of EU sources, they escapeto bond issuing. What makes things worse isthat even banks are interested in this since, assubscribers of privately issued bonds, banksattain considerable profit by avoiding publicprocurement procedure. Financial statistics andmarket information reveal that the growth inrisks involved in the instruments exceeds thegrowth in the credit port folio. Long-termindebtedness in foreign currency denominatedbonds and liabilities involved in the PPP con-structions, which latter can be considered con-cealed credits, involve higher risks than bankloans. In the case of certain cities of countyright, the present value of liabilities involved inthe PPP-contracts is of the same volume as thesignificant credit portfolio. The result of thelatter is the further loosening of local govern-ments' fiscal discipline.

The government's several years' wranglingover local rates is similarly harmful. The earlierdecision to abolish local industrial tax and the

withdrawal of this decision later on, and thepolitical tug of war over value-based propertytax have not only created legal uncertainty buthave also made local planning impossible. Inrelation with the local business tax, a thirdinterest group has emerged. Under theAccession Agreement, local governments wereto abolish the earlier granted local industrial taxcredits from January 1, 2008. It is by no chancethat, prompted by the Italian example24, it wasthe Hungarian subsidiaries of global enterpris-es that lobbied strongly against the total abol-ishment of local business tax. The situation haschanged, the European Court has not foundthis tax unlawful, the government had, howev-er, incorporated this extra source into its budg-et bill for 2008, violating the constitutionallogic of the system once again. Granting taxcredits and exemptions is an efficient means forlocal economic development. Withdrawingthese sources once this policy has “paid”, i.e.incorporating them when calculating centralcontributions means dissuading local govern-ments from any strategic thinking. Thestrengthening of the sector should not be sac-rificed on the altar of momentary fiscal stabili-ty. In addition, it is necessary to establish insti-tutions, mentioned above, that foster thestrengthening of local governments as well astheir transparent operation and guarantee ofbudget discipline.

The third remark is to refer back to the titleof the article and the international tendenciesmentioned in the first part, as well as the impli-cations of the latter to Hungary. We can seethat the Hungarian local government modelhas been increasingly unable to utilise theadvantages of fiscal decentralisation, let alonesupporting perseverance in the global competi-tion. We have seen that, at the birth of the“Hungarian model”, it had several progressivefeatures besides being characterised by severalillusionary solutions as well25. By the tradition-al centralisation reflexes of the Hungarian gov-


84

ernments and the pressure26 that arose duringthe transition, this model was deformed into asystem focusing increasingly on conflict decen-tralisation rather than the reasonable distribu-tion of government functions. The treatmentof the problems of the Hungarian economy

like fostering employment, especially the com-petitiveness of the segment thereof notinvolved in the global allocation of work, sig-nificantly depends on the economic organisa-tion and development ability of the subnation-al government level.

1 Studies by S. Varga (2004), Verebélyi (1995) andVigvári (2006a) have been devoted to the issue.

2 For more details, cf. the volume summarising theresearch conducted with the framework of the ROP3.1.1. Programme, Vigvári (ed), (2007)

3 This is meant to be measured by the PISA surveys.

4 For the term of fiscal discipline, cf. Kornai (1997)

5 Somewhat misunderstanding its effect, the interna-tional literature welcomes this as the only Hungarianbudget rule.

6 It is exactly this problem that the efforts of variousintensity for the introduction of accrual accountingand budgeting in developed countries is meant tosolve.

7 This is partly a price paid for coalition governingsince it seems to be a natural demand by the min-istries of different parties to distribute money withintheir own authority.

8 These fees do not cover for the replacement of phys-ical assets necessary for the performance of duties.

9 The category of 'other shares and participations'

10 The constitutional situation that local governmentsmust not be dissolved without a legal successorbelongs to such an interpretation of insolvency.

11 For a detailed and country-specific description ofthese strategies, cf. Lane, J. E. (1977), Pollit, Ch. –Bouckaert, G. (2004), or, in the Hungarian lan-guage, Zupkó (2002).

12 In the IDEA Work Group, a most interesting studypresenting the “reform technology” has been made.Péteri (2006)

13 For the professional stances on this issue, cf. theworks of Ágh (2005), Pálné, K. J. (2001), Horváth,M. T. (ed) (2004) and Verebélyi, I. (2004).

14 This should be emphasised because the functionalbalance of local governments certainly does notreflect the outside budget moneys related to thefunction concerned. If a central heating service isa budget organ, the total expenditure on it(including the central heating fees) is part of thefunctional expenditure; if this is a business organ-isation- even if owned in 100 per cent by the localgovernment – only the local budget payments orpotential subsidies of this business organisationappear there.

15 Proposal

16 Cf. the studies of the volume Vigvári (ed) (2007) onthe issue.

17 Network on Fiscal Relations Across Level ofGovernment – a forum Hungary has not joined.Some of its important publications are listed underthe References.

18 For the volumes summarising the research findings,cf. the References.

19 An optional tax that may be levied under theEuropean Charter of Local Governments.

20 Taxes to serve as local government revenues exclu-sively, which are obligatory to levy.

21 The developments related to the local industrial taxin Hungary reflect a typical situation. Before thederogation period on the related exemptions and taxcredits was to expire, large companies exercisedconsiderable pressure for the abolishment of thistax, with reference to EU law primarily. It hasbecome clear in recent times, however, that the tax

NOTES


85

suits the legal order of the EU; other reasons shouldbe found for the urged changes.

22 This certainly does not exclude – on the contrary, itdemands enlarging the circle of taxpayers, the gen-eral tax base. A reasonably chosen local tax, throughadequate tax administration, could be significantmeans in whitening the economy.

23 After accession to the Euro zone: stability prog-rammes

24 For the details of this cf. Deli (2006)

25 These are extensively analysed by Pálné (2008)

26 Cf. Csaba (2006)

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MUSGRAVE, R. A. – MUSGRAVE, P. B. (1989): Publicfinance in Theory and in Practice, InternationalEdition McGraw-hill Book Company

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PÁLNÉ, KOVÁCS I. (2001): Regionális politika ésközigazgatás (Regional policy and public administra-tion), Dialóg Campus, Budapest-Pécs

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PÉTERI, G. – HORVÁTH, M. T. (ed, 2001):Navigation to the market, LGI, Budapest

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PÉTERI, G. (2005): Önkormányzati forrásszabály-ozás: ideák és javaslatok (Local government sourceregulation: ideas and proposals), in Vigvári András(ed) (2005): Félúton, Tanulmányok a helyi önkor-mányzatok finanszírozási rendszerének továbbfe-jlesztési lehetõségeirõl (Midway down the road.Studies on the development opportunities of thelocal government funding system), IDEA, MKI,TÖOSZ

PÉTERI, G, (2006): Hogyan csináljunk közigaz-gatási reformot? Dániai tanulságok Magyarországszámára (How to make a public administrationreform – Danish experience for Hungary), inVigvári, A. (ed) (2006): Decentralizáció, transz-parencia, elszámoltathatóság, Tanulmányok a helyi


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PITTI, Z. (2003): Az önkormányzati finanszírozáskorszerûsítése (Modernisation of local governmentfinancing), Magyar Közigazgatás, LIII., Issue 6, 2003,pp. 327–345

PITTI, Z. (2005): Az önkormányzatok pénzügyifinanszírozásának modernizációja (Modernisation oflocal government financing), inVigvári, András (ed)(2005): Félúton, Tanulmányok a helyi önkormányza-tok finanszírozási rendszerének továbbfejlesztésilehetõségeirõl (Midway down the road. Studies on thedevelopment opportunities of the local governmentfunding system), IDEA, MKI, TÖOSZ, pp. 47–70

POLACKOVA, H. (1998): Contingent GovernmentLiabilities: a Hidden Risk for Fiscal Stability, PolicyResearch Working Paper 1989, World Bank,Washington D.C., October 1998

POLLIT, CH. – BOUCKAERT, G. (2004): PublicManagement Reform, A Comparative Analysis,Second Edition, Oxford University Press

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RECHNITZER, J. (2004): A városhálózat és a régiókformálódása (The city network and the formation ofregions), Magyar Tudomány, Issue 9, pp. 978–990

ROZSI, É. J. – DR. VÁRFALVI, I. (1999): Adóerõ-képesség és ami mögötte van, 1999 a helyi önkor-mányzatok költségvetésének tükrében (Tax capacityand what is behind it as reflected by local authoritybudgets), Public Finance Quarterly, Issue 1, pp. 39–61

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VÁGI, G. (1991): Magunk uraim, Válogatott írásoktelepülésekrõl, tanácsokról, önkormányzatokról(Selected writings on settlements, councils, local go-vernments), Gondolat, Budapest, 1991

VARGA, S. (2004a): Fél évszázad a helyi tanácsi ésönkormányzati szabályozásban (Half a century inlocal council and government regulation) I, PublicFinance Quarterly 5, pp. 480–501

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C

Gábor Kozma

Environmental, regulatoryand control risks in the financial management of local municipalities A trap for mice or a trap for cats?

Catch me if you can: but who is going to catchwho? Is it possible to operate a subtle, multi-dimensional control system that can detect, iden-tify, and assess the risk factors of a complexmunicipal environment and set the right direc-tion for the local institutional system? There existseveral sensory mechanisms and municipalitieshave plenty of reaction opportunities. Managingthem properly and fine tuning them are indis-pensable to avoid the cartoon-like set-up of amousetrap set ever so carefully (or carelessly)ending up trapping the animated character thathas set it. Reviewing, analysing and evaluatingthe control system are classical audit tasks. Itsenvironmental and regulatory risks are particu-larly important for internal and external audits.Below, I wish to present the characteristics ofwell-known economic and business environ-mental analysis models in a municipal context“from the cat's perspective”, relying on thenotions of the international and Hungarianaudit terminology. Audit systems have had anincreasing role in each segment of the economy inthe fields of safe operation and risk manage-ment.1 The situation is not any different con-cerning local municipalities.

THE EXTERNAL, POLITICAL, ECONOMICAND SOCIAL COMPONENTS OF THEAUDIT ENVIRONMENT

The special audit environment of the externaland internal audits of municipalities is created bythe multi-aspect and multi-direction segmenta-tion of the municipal system, characterised bythe spatial processes of the economy and thepeculiarities deriving from the legislative envi-ronment of municipalities. Most democraticgovernances are vertically segmented, and all ofthem have developed structures built on coordi-nated local governance organising territorialcoordination mechanisms, which has increasedthe complexity of communal decisions, andfine-tuned the operation of democratic institu-tions (local party politics, the management oflocal public affairs, the institutional representa-tion of regional interests). The federative struc-ture of public finance presupposes a decen-tralised state finance system and fiscal decentral-isation, which is closely linked to the guaranteesof democracy, and creates the financial founda-tion of local governance. In Hungary, the exter-nal audits of this complex system are conducted


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by the State Audit Office of Hungary, while theinternal audits are conducted by town clerksemployed by municipalities.

Economy develops within a special spatialstructure, which can be described partlythrough deterministic, partly through stochas-tic models. To outline the audit environment ofmunicipalities, one can rely on works ofschools of regional economics, literature onmatters of public finance, marketing, and theresults of environmental analyses. Spatial struc-ture may be interpreted as the network-likestructure of the economic activity (Ms Vas,2005), within which nodes are created, whichthen form hierarchies, and finally growth polesevolve. Different resources and factors of pro-duction start flowing towards the growthpoles, while the innovations characterising thegrowth poles start spreading or being diffusedas special counterflows, sometimes consciouslyadopted and encouraged by those in control ofthe poles. The segmentation of the social-eco-nomic space is bound to lead to territorialinequalities. The financial management of amunicipality always affects and reacts to theprocesses of a well-defined fragment of a widerspatial structure, thus the distance from thegrowth pole (i.e. the core-periphery situation)greatly influences the structure of local publicexpenditures deemed as optimal as well as therevenue leeway of municipalities. The spread-ing of the notion of the network as a basic con-cept and its considerable impact are due to therecognition of the (comparative and competi-tive) advantages of the spatial structure to beexploited, which manifests itself in the forma-tion of dynamically developing core areas ofinternational importance, the strengthening ofthe network of metropolises and of their spe-cial role in the world economy, the strategies ofmultinational companies selecting locations fortheir business premises, and the developmentof suppliers' networks influencing local mar-kets (Lengyel–Rechnitzer, 2004).

Basically, municipalities have an allocationfunction; they have limited opportunities toreallocate incomes or have an independent con-junctural policy. Local budgets are usually notallowed to apply independent customs poli-cies.2 Neither is it possible to conduct locallevel monetary policies2. It is by taking fulladvantage of their financial leeway (regardingfiscal3 and income policies4) that municipalitiesare able to influence local economies, whilethey have the opportunity to strengthen thecompetitive position of settlements by har-monising and optimising allocation mecha-nisms locally. However, the opportunities ofdifferent settlements are largely polarised basedon their position within the spatial structure,their size, and their administrative status, andcompetitive conditions are not identical.5

Therefore, it is necessary to operate balancingmechanisms.

In Hungary, the state has provided financingfor municipalities by sharing the personalincome tax with them, by leaving other taxes(currently the motor vehicle tax) with munici-palities, by transferring the levying of tax-likefunds (such as ranger's contribution, and emis-sion charge) to municipalities, and by runninga system of a normative and earmarked sup-ports, and a system of designated and targetedsupports providing funding for accumulationexpenditures – of very significant local budget-ary weights. A part of municipal expendituresrelating to health care is covered by social secu-rity. The remaining part of local budgetaryexpenditures is financed by municipalitiesthrough the imposition of taxes, which they arelegislatively entitled to do.6 In Hungary, the taxpolicy of municipalities is aiming at the point ofneuralgia of the financing system, as the part ofthe operative financing deficit hidden in nor-mative supports that can be compensated forusing their own incomes can be earned fromlocal tax incomes. The remaining part of localtax incomes may provide funding for the capi-


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tal budgeting of municipalities, for the co-financing necessary to be able to avail ofgrants/supports and to take out developmentcredits, and for the repayment of developmentcredits.

In local budgets, the necessity to harmoniselocal taxation and local public expenditureplans appears as a financial constraint, which isthe principle of fiscal equivalence. The strictapplication of the principle may be substantial-ly softened by the funds transferred back fromthe central budget for operational purposes ona non-normative basis, and the loans taken outby municipalities for operational purposes. Atthe same time, it is necessary to provide equal-isation among regions with different opportu-nities, which typically happens at an “above thenations” level in the European Union. A simi-lar federal mechanism operates in the UnitedStates of America.

Decentralisation may result in the cost-effective production of certain goods, anddecrease the administrative and audit expendi-tures relating to service development. Thenotion of goods threshold, which contains therequirements relating to the economies of scalein connection with the production of givengoods, is introduced by the specialist literaturein this respect. Within that, it is possible todefine minimum provision standards, which areset not on a market basis, but on the basis oflegislatively laid down requirements of socialcommitment. Above the provision minimum,we find an interval where the appearance of anextra consumer does not cause any increase infixed costs (management/personal expendi-tures, extension of business premises). Thehigher endpoint of the interval is where fixedcosts start increasing.7 The scope of the princi-ple of fiscal equivalence is limited by the prob-lem of “overflow”. It is because certain publicservices may not only be available for local res-idents, but anyone (e.g. residents of neighbour-ing settlements, people travelling through).

That might have positive effects, too. Still, thiskind of service provision “for outsiders” (e.g.public transport that is free for anyone) pre-supposes a strong local economy and a pru-dently compiled local economic program.Negative overflow also appears, for instance inphenomena relating to the irresponsible finan-cial management of municipalities, and in tak-ing out unjustified operational credits, which,ultimately, are financed by the whole of societythrough additional central budget supports.

Fiscal decentralisation may strengthen therole and importance of the local level organisa-tion of economic activities. Municipalities maystart competing to attract a middle class of astrong income position, offer business premis-es to industries and service providers, andlobby for central investment projects.Observing the American federal system,Tiebout concluded that the operation of localmunicipalities showed some analogies with theoperation of the competitive sector.Consumers of local public services seek themost advantageous service-price combinations,and the price to pay for public services is thelocal tax rate. His model presumes the freemovement of consumers of local public servic-es, who are also fully informed, the existence ofa large number of municipalities, the separationof home and workplace, no overflows, and theexistence of some simplifications relating tolocal taxation and public expenditures. Themost interesting thing about the model isexactly its limited applicability. The more of theelements presumed within the system appear inpractice, the more clearly the applicability ofthe rules of the model can be observed.European municipal traditions differ signifi-cantly from the assumptions of the model;however, the EU-induced development mayfoster the appearance of processes that can bedescribed with the model. Inter-settlementcompetition enhances the innovative activitiesof the public sector and the efficiency of its


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operation. That competitive situation requiresa prudent outlining of the competitive positionof the settlement in Hungary, too, presupposingthe careful consideration and harmonisation oflocal economic programmes, local budgetarypolicies, local accumulation and investmentpolicies, local taxation, housing management,settlement management, local education andsocial programmes.

THE DIRECT, SECTOR-RELATED ENVIRONMENT OF MUNICIPALITIES

The different areas of the financial manage-ment of municipalities may be best seized in thepublic policy sectors producing goods. Sectorscan be formed of groups relating to the mostdiverse municipal tasks, where the criteria ofgroup formation may be common managementand regulatory subsystems, jointly managedinstitutions, identical legislative environments,identical clientele or targeted social groups, orany other practical aspect. The processes ofhow goods are produced may be the basis ofseparating the areas necessary for risk analysis.Interpreting risks may be based on sector char-acteristics that can be generalised. The processof how goods are produced is an operation-centred approach, within which the – relativelynarrowly defined – objective of differentmunicipal tasks is to produce goods and deliv-er them to the whole of society or to certaintarget groups within it. This approach needs tobe fine-tuned by analysing the environment.The given mechanism, regulation, institutionalsystem – the process of producing municipalgoods – can be interpreted as a communalresponse to the challenges of the social, eco-nomic, as well as natural environment, andbeing operation-centred can only be authenticand socially expedient within this context.

Municipal sectors can be grouped in diversemanners, relying on the latest theories con-

cerning the minimal, intermediate and activat-ing functions of the state, as well as on thepractical experience and solution methods ofthe audits conducted by the State Audit Officeat municipalities. Below, I attempt to presentthe intricate system of carrying out municipaltasks through four activity areas, taking intoconsideration the experience of the State AuditOffice based on the knowledge and interpreta-tion of theoretical aspects and the legislativeenvironment (Báger, 2006).

EDUCATION, CULTURE AND SPORT

The Act on Local Authorities stipulates thatproviding kindergarten education and primaryeducation are compulsory tasks of all munici-palities. Having kindergartens and primaryschools plays a key role in the social and eco-nomic life of settlements. The status, way oflife, and employment opportunities of familiesare fundamentally affected by the presence andavailability of educational institutions. Thelonger a child feels attached to the local educa-tional system, the longer they stay in a givensettlement, as a consequence of which they aresocialised locally. The more levels of the educa-tional system a given settlement is capable ofmaintaining, the more attractive it appears toits environment. That explains why settle-ments, primarily towns, strive to fulfil the vol-untarily undertaken task of running institu-tions of secondary education and vocationalinstitutions (the law stipulates that providingsecondary education is a task of counties andthe capital city). It is not accidental that growthpoles have all started off as university seats andtheir agglomerations world-wide, and that theR&D premises of international companies arelocated in core areas. The educational systemsensitively reacts to processes of social andeconomic growth, and may also generate andsustain changes in a positive direction. From


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within the task group of supporting activitiesrelating to public education, science, art, as wellas sport, providing space to host activities ofpublic education, providing public library serv-ices, and supporting local sport activities arecompulsory for all municipalities8. In largersettlements, organising and supporting cultureand sport appear linked to the sector of organ-isation of education, but as an independentarea. Similarly to the educational system, cul-ture is a conjuncture sensitive sector, a poten-tial catalyst of growth. Local residents' level ofprofessional training and level of education inthe broader sense cannot be sharply separatedfrom each other, thus supporting education,culture and sport is a real opportunity to shapethe competitive position of a settlement.Theoretically, the task groups listed above areamong the intermediate functions of the state.

SOCIAL CARE, CHILD PROTECTION,HEALTH CARE

The activities listed encompass a wide range oftask provision. What they all have in commonis that they can be classified as minimum func-tions of the state. Providing basic social care isone of the compulsory tasks of municipalities.It means delivering transfers provided relyingon central budgetary funds to those in need,and social care-related obligations within theframework of care work, whose forms of basicsocial care are: meal service, home help, familysupport service, as well as special forms of basicsocial care.9 Within the framework provided bythe sector-related legislation relating to thesocial agenda, more complex formats of provid-ing care, institutions offering temporaryaccommodation, and other formats of provid-ing accommodation may be established to helpthose in need. The activity of the child andyouth protection sector is very close to the socialagenda. The social sector and the child protec-

tion sector deal with problems of vulnerablesocial groups, and are rather recession sensi-tive. The social sector also plays an importantrole in developing regions as growth does notaffect everyone in a given region, and the fre-quency of occurrence and the number of casesrelating to certain problems may be independ-ent of socio-economic dynamics (disabled peo-ple, the elderly, mentally injured people, fami-lies at risk, children, the homeless). The num-ber of those living near the poverty thresholdmay decrease in a developing region, but it isalso possible that there is only a decrease inproportions (due to better-off people flowingto a prosperous area), while the number ofcases may stay unchanged or might evenincrease slightly. The significance of the socialsector may grow in declining regions and inones falling behind. It is necessary to deal withthe problems of families and individuals withdecreasing incomes, belonging to the less com-petitive layers who may potentially becomeimpoverished. The participation of municipali-ties in finding a solution to employment problemsalso belongs to the activity relating to the socialagenda, which aim may be achieved throughpublic purpose employment and public utilityemployment. Municipalities often take theopportunity to link the provision of social sup-port with participation in public purposeemployment programmes. Within the frame-work of basic health care, municipalities areobliged to provide GP services to adults andchildren, dental services, emergency medicalservices linked to basic health care, health visi-tor's services, and school welfare officer's serv-ices.

LOCAL INFRASTRUCTURE

Municipalities have the compulsory tasks toprovide healthy drinking water, public lighting,and maintain local public roads and public


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cemeteries. Pursuant to sector-related legisla-tion, spatial planning, the creation of an aes-thetic built environment, and the protection ofthe local architectural heritage are also compul-sory. Providing local infrastructure includesactivities connected to settlement develop-ment, the protection of the natural environ-ment, water management and rainwater runoffmanagement, canalisation, and the participa-tion in local energy provision. Pursuant to sec-tor-related legislation, municipalities areobliged to provide sewage disposal and sewagecleaning, and to outline a programme of envi-ronmental protection for the settlement, with-in the framework of which, besides severalother compulsory tasks aiming to protect theenvironment, they are obliged to provide rain-water runoff management in compliance withall regulations. The compulsory task of munic-ipalities stipulated by sector-related legislationconcerning providing protection against inlandwater and floods also belongs here, and, inter-preting settlement infrastructure in a widersense, so do the municipal tasks relating tohousing management, local public transport,and ensuring public cleanliness and settlementcleanliness. Pursuant to sector-related legisla-tion, waste transport and management, and thetemporary storage, transport and managementof liquid waste are compulsory tasks. The pro-vision of local fire protection and the localtasks relating to public security are very closeto providing infrastructure. Pursuant to sector-related legislation, ensuring the opportunity toobtain fire extinguishing water is another com-pulsory task of municipalities. From the pointof view of infrastructure theory, settlements area rather complex area, a system of elementswhere the roles assumed by the state rangefrom its minimum to its activating functions.Due to all these factors, the infrastructure of asettlement may be regarded as highly vulnera-ble. If it is lacking, regressing, or becomes over-loaded, it may become an obstacle to (or the

bottleneck of) local social and economic devel-opment.

LOCAL ADMINISTRATION

The financial management of municipalities isaffected by local administration. A flexible, cit-izen-friendly mayor's office may hold someappeal for the settlement. The activity of themayor's office controlling the different sectorsmay become more effective. Mayor's officeofficials supervising the different sectors arefound in each settlement type, while the size,the segmentation, and the level of specialisa-tion of the office organisation all differdepending on the size of the settlement and thecomplexity of its different activities. The coor-dination and the controlling and supervisingfunctions of mayor's offices may create a seam-less whole out of the intricate, complex activi-ties of the different sectors, thus the directionof the different sectors is also important fromthe point of view of the financial managementof municipalities. It is a complex aspectenhancing the competitiveness of the settle-ment. Theoretically, it represents the minimaland activating functions of the state.

THE INTERNAL ENVIRONMENT, AND THEORGANISATIONAL AND REGULATORYSYSTEMS OF MUNICIPALITIES

By reviewing and coordinating the manage-ment of the different sectors, the mayor'soffice can ensure that the financial manage-ment of municipalities form a seamless whole,the effects of settlement policy be coordinated,and its system of objectives set the right direc-tion for regional harmony. In that respect, themost important document is the economic pro-gramme of the municipality is. The economicprogramme is at the top of the hierarchy of


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planning documents. However, it is not amechanical “sum total” of sector-related pro-fessional policies. The economic programme isto be adequate for the social-economic environ-ment of the settlement, giving an appropriateresponse to the problems deriving from thespatial structure of the environment of the set-tlement, the regional processes, their size andcomplexity. The economic programme is a doc-ument determining the competitive position ofthe settlement, from which sector-specific poli-cies can be deduced.

The economic programme is a result ofnegotiations and trade-offs; however, it consti-tutes a quality type control risk if the econom-ic programme is superficial and does not repre-sent the genuine economic objectives of thesettlement, while sector-related negotiationsare carried out independently of the pro-gramme, through informal channels. In suchcases substantial discrepancies between theeconomic programme and the sector-specificpolicies, as well as among the different sector-specific policies themselves are likely to befound. Such problems might arise during theplanning process and the negotiations relatingto the budget, and indicate conflicts that can-not be resolved within the operative processes.A document containing the financing strategyand medium-term financing plan of the munic-ipality may be part of the economic pro-gramme. Decisions on the desirable position ofthe budget, the extent of the acceptable deficit,the extent of necessary development credits tobe taken out, and the method of obtaining suchcredits are made within the framework of thefinancing strategy. The local tax policy andinvestment policy, fitting to the medium-termfinancing plan, can also be represented in theeconomic programme. Failing to periodicallysupervise the economic programme constitutesa further control risk. Optimistically speaking,the environment is bound to show positivechanges as a result of the programme, while,

quite pessimistically, one can say that the envi-ronment changes adversely independently ofthe programme. Observing the changes in theenvironment occurring due to complex reasonsmay be regarded as a realistic approach.

Reviewing the economic programme andmaking sure it fits to the regional programmescan be regarded as the highest level of localmunicipal monitoring systems. The fact that theAct on Local Governments refers adopting theeconomic programme to the competence of thebodies of representatives is a guarantee elementderiving from democratic governance.10

Pursuant to the amended stipulations of theAct, reviewing, complementing and amendingthe economic programme has been made possi-ble within the decision making competence ofthe bodies of representatives, too. Over thepast years, the audits of the State Audit Officehave paid special attention to the activities ofmunicipalities relating to drawing up economicprogrammes. The reports of the State AuditOffice evaluating a representative sample ofmunicipalities show a gradual increase in theproportion of prominent municipalities andtown municipalities creating economic pro-grammes (76%, 81%, and 82% of them did in2004, 2005, and 2006, respectively).

Policies11 are documents that are intendedfor internal use but may be made available forthe general public, adequately managing therisks arising from the changes of the environ-ment of the given sector. Policies are foundadequate in relation to the inherent risks deriv-ing from the environment and the organisa-tional system of the sector if they provide ananalysis of the municipal goods produced as aresponse to the changes in the environment,and of the extent of the interventions madepossible by the sector-related legislation. Theydetermine the necessary regulations, proce-dures, incentives, and possible financial trans-fers, which then need to be created and amend-ed in municipal decrees. They contain situation


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analyses in view of provision formats renderednecessary due to regional processes, and theprofiles, sizes, facilities, head count require-ments, capacities and locations of institutionsthat are either to be established or has alreadybeen functioning. Should policies fail to besubstantially detailed, risks deriving from theenvironment of the sector and the organisa-tional system might not be identified, and, con-sequently, such risks might have a strongerimpact. That impact might even be unlimitedor more significant for want of a prudent insti-tutional system based on policies. Due to theinsufficient frequency of reviewing the policiescompared to the pace of changes in the envi-ronment, or due to a lack of harmony betweenin changes of the economic programme and thepolicies, control quality will be damaged.

A concept relating to annual budgetaryincomes and expenditures can be compiledbased on the policies, in accordance with theobjectives of the economic programme. Theobligation to compile an annual budget conceptis required by legislation. Ultimately, the annu-al concept needs to be in harmony with theeconomic programme. The difference betweenthe original estimates of budgetary incomesand expenditures, i.e. the planned deficit, is tobe determined in accordance with the basicprinciples of the financing strategy, while themethod of financing the budgetary deficit is tobe determined in accordance with the conceptof the financing strategy and the medium-termfinancing plan. It is expedient to harmonise theplanned estimates of local tax incomes with theconcept of the local tax policy, and it is expedi-ent for the estimates of operational expendi-tures to be based on the objectives of the poli-cies. It is necessary for the incomes for accu-mulation purposes to be in harmony with theasset policy guidelines. The estimates of expen-ditures for accumulation purposes are to reflectthe priorities of the investment policy. Theannual level planning system – the formulation

of the concept, the preparation of the draftbudget decree, mid-year amendments to thebudget decree, and the preparation of theappropriation accounts – may be regarded asthe lowest, elementary level of the planning-monitoring system. This level's failure toacknowledge the identifiable regulatory andplanning risks indicates a quality type defect ofthe control system, which might query the reli-ability of the whole planning system, and tendsto result in significant control risks. At thesame time, formulating the budget concept is afeedback mechanism testing the harmonisationof different policies and the execution of theeconomic programme. It is a control risk if theprocess of the compilation of the budget failsto indicate significant deviations from theobjectives, or the demand that certain neces-sary changes be made in the economic pro-gramme and the policies due to the scarcity offunds. According to State Audit Office audits,95–96 per cent of municipalities formulatedbudget concepts in the period between 2004and 2006. (The proportion based on a repre-sentative sample was 100 per cent in 2005.)However, the well-groundedness of the con-cept and taking locally generated incomes andwell-known obligations into considerationwere deemed as adequate at 85–87 per cent ofmunicipalities.

THE REGULATORY SYSTEM LINKED TOTHE EXECUTION OF MUNICIPAL BUDGETS

The regulatory elements known as authorisa-tion and segregation of duties in the internation-al audit terminology can be identified in thepractice of Hungarian municipalities, too. Thefinancial control executing operative financingis linked to the execution of the budget as aparticularly important sub-system.

During the operation of authorisation, atransaction is most typically diverted to a high-


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er authorisation level based on its financial size,but the procedures also distinguish sensitiveand complicated events whose occurrencerequires the insertion of a higher authorisationlevel independently of financial sizes.Authorisation is adequate for the risks inherentin the system if it assigns levels of audit proce-dures to the real distribution of the financialsizes of transactions, and if, statistically speak-ing, it determines the medium level of authori-sation correctly. Authorisation is inadequate ifthe levels of authorisation have not been out-lined based on the real distribution of financialtransaction sizes. Authorisation is of inade-quate quality if transactions of complex, sensi-tive types requiring special procedures havebeen evaluated inconsistently with reality, theprocedures fail to filter out genuinely complexor sensitive events, or divert less complex orsensitive events to the special branch. The inad-equacy of authorisation might lead to theoccurrence of type I and type II audit errors ina higher than acceptable quantity, and theremight be some overaudited and underauditedoperational areas. For this reason, the quality ofauthorisation constitutes a high control risk(to be evaluated with a high weighting factor).This control risk area comprises the regulationof the decision making competences of munic-ipalities regarding budget and asset manage-ment issues. The regulatory systems of munic-ipalities have been being audited by the StateAudit Office continuously. According to theirfindings, in 2004 and 2005, 80 per cent, and in2006, 87 per cent of mayor's offices regulatedthe order of decision making relating to budg-etary issues (commitment). They haveobserved an improving tendency regarding theregulatedness of asset management compe-tences, too. In 2004, 90 percent, in 2005, 98 percent, and in 2006, all of the municipalities inthe representative sample outlined decisionmaking competences relating to asset manage-ment, setting them out in regulations.

A chain of audits built on each other may becreated (segregation of duties) if an operationcan only be executed subsequent to the closureof the previous work phase and providing thatits performance has been of an acceptable qual-ity. Audit is genuine if the next work phase istruly separated from the previous one by thesegregation of duties to be performed by dif-ferent people, and if identifiable (documentedand contractual) interests and responsibilitiescan be linked to high quality takeovers betweenwork phases. Segregation can be ensured by thedetailed regulation of processes taking intoconsideration the risks inherent in the system,by the closed, watertight outlining of jobdescriptions in full consistence with the proce-dures, and by determining incompatibilitiesbetween audit functions. The separation ofoperations is inadequate if procedures have notbeen fully regulated as required by the risksinherent in the system, or if job descriptionshave been outlined defectively, or if the incom-patibility of duties has not been regulated.Separation of tasks of an inadequate qualityresults in a significant control risk, the risksinherent in the system can be felt without gen-uine harnessing (abatement). An unacceptablyhigh error ratio may endanger the operation ofthe financial management system, and increas-es the likelihood of incurring losses (nearingthe level of inherent risks). Within the financialmanagement of municipalities, countersigningcontracts and proofs of financial transactions,validating economic transactions, and last butnot least, indeed, quite importantly, verifyingprofessional performances, serving as an inputinto the operative audit process of the budget,belong to this control risk area. The StateAudit Office has been paying special attentionto the verification of professional performanc-es in the course of their audits. Between 2004and 2006, they found an extremely high pro-portion of errors indicating grave problems inconnection with the execution of municipal


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budgets, and the operational reliability of therelating control system. 32 per cent, 44 per centand 42 per cent of municipalities failed to veri-fy professional performances in the threerespective years. From 2007 on, the State AuditOffice has further developed its audit method-ology regarding the systems auditing the exe-cution of municipal budgets. They have beenpaying special attention to this major problem-atic risk area relying on statistical tools, andcarrying out compliance audits serving toenhance the efficiency of the audits.

The risk area relating to financial control isespecially important because of the cash-basedapproach of the budget management of munic-ipalities. Financial control makes it possible tosupervise the financial and financing operationsindispensable for the execution of the budget.Adequate financial control can ensure meetingthe financing demands deriving from theplanned deficit and the different scheduling ofbudgetary incomes and expenditures, provid-ing cash flow for institutions, tracking and col-lecting debts, meeting obligations withoutdelay, managing the cash transactions of thewhole financial management of the municipalsystem (corporate connections, supportedorganisations) and the drawdowns of externalfunds seamlessly. Financial control is consid-ered to be of adequate quality if it executes anannual, constantly updated operative financialplan, and ensures its liquidity finance demandat an optimal cost, sparing its own funds, tak-ing out operational bridging loans. Financialcontrol is of inadequate quality if permanentdisturbances are experienced in its cash flow,and in the course of its meeting obligations, orif a permanent, or gradually increasing opera-tional credit portfolio is created. Municipalitiescontrol financial processes by compiling liquid-ity plans, and allocation fund schedules, byoperating mini treasury systems, by buying andselling securities mid-year, and by drawingdown and repaying operational credit facilities.

The quality of financial control constitutes asignificant control risk, its weakness or the lackof financial control may result in insolvency,which constitutes a danger for the financialmanagement of municipalities, and the cost ofexcess financing may cause significant losses(Vigvári, 2005b).

The regulatory and logical frameworksof the internal and external audits ofmunicipalities

An independent internal audit may be deemedas one of acceptable quality if its activity focus-es on the most important control risks of thefinancial management of a municipality, and ittests the outlining and operation of controlmechanisms adequate for the inherent riskswith acceptable frequency. It is possible toidentify professional audits within the sectors(the educational sector, technical audits ofinvestment projects, etc.) which audit the con-trol systems of the given sector and the profes-sional standard of the activities. However, it isimportant to emphasise that audits of that typecannot replace internal audits – as it is stipulat-ed by the relevant legislation, too. Internalaudits are compulsory to conduct pursuant tothe legislation on municipalities. That legisla-tion stipulates the formal elements of audits,the rights and duties relating to audits, theplanning and execution systems of audits, thecompulsory steps of the realisation process ofauditor findings, and the necessary documenta-tions in detail. The lack or poor quality ofinternal audits constitute serious control risks,no overview or testing are conducted in rela-tion to the control system and there is no reg-ular feedback on necessary adjustments. Theaudits by the State Audit Office have moni-tored and made comments on the impacts ofthe legislation on internal audits introduced in2003, partly based on international models, and


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have promoted its more and more widespreadapplication. 34%, 73% and 87%, i.e. a rapidlygrowing proportion of the regulatory frame-works of the internal audit systems of munici-palities met the amended legislative require-ments in 2004, 2005, and 2006, respectively.Strict compliance regarding issues of content,and the introduction of efficient audit planningand modern audit procedures inevitably requirea long transition period, and according to thefindings of the State Audit Office regarding2006, for instance only half of the municipali-ties had made capacity analyses to support theiraudit plans with, and half of the municipalitieshad met the requirements regarding necessaryqualifications.

The State Audit Office audits municipalities'relations with the central budget in view ofsupports for operational and accumulation pur-poses, linked to the audit of the appropriationaccounts of the different chapters of the centralbudget. These audits are closer to the method-ology of financial audits, but they contain com-pliance elements, and the focus of the audit andits approach are different from that of a munic-ipal audit, the findings are evaluated at bothlocal and national levels based on the method-ology applied internationally by state auditoffices, which differs from audit standardsregarding several points. The essence of themethodology applied by state audit offices isthat special audit procedures are applied usingthe ISA framework, taking into account theconsiderations of the public sector.12 The prac-tical guidelines relating to international auditprocedures necessary for state audit offices areexpected to be fully compiled by 2010.13 Theprofessional committees of INTOSAI areadhering to the basic principles of internation-al auditing procedures while developing aninternational methodology for state auditoffices. They accept the ethical principles ofinternational auditing, and the meticulous, crit-ical professional approach of investigating

veracity and authenticity (professional judge-ment / professional scepticism), and expect stateaudit office evaluation practice based on suffi-cient and appropriate audit evidence.

International audit methodology based onthe COSO report, outlined to assess risks (ISA315 and ISA 330), whose application in thepublic sector is to be prepared by the end of2008, is worth special attention. The interna-tional standard outlined for risk assessmentdetermines an integrated and systematic analy-sis/assessment and audit procedure whichtracks the control environment of the auditobject, analyses the risk assessment procedureapplied by the audit object, the informationsystem based on it, the control mechanism sup-ported by the information system, and themonitoring activity, utilising the top downapproach. One might picture that system as amodel using filters that are able to sense, allevi-ate and transform the impacts of a risky envi-ronment. It is a multi-layer mechanism, and itslayers present increasingly clear pictures as aresult of risk management. The approachapplying the (previously outlined) interpreta-tion of the system, i.e. that auditing, auditingthe public sector, and the audits of state auditoffices conducted in the public sector keep theknowledge regarding the risks of the auditobject gained in the course of the audit activityup-to-date, making early assumptions moreprecise and modifying them in the course of asystematic process of assessment depending onthe reliability of the information tested, is par-ticularly important. Risk assessment is not anoptional activity in the course of the audit, butan essential central element of the audit activi-ty demanding planning, checking and continu-ous assessing (Anerud, 2008).

Audits of the financial management ofmunicipalities, comprising several aspects, arecarried out by the State Audit Office. In theframework of such audits – following the defi-nitions of international practice – the control


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risk areas of the financial management ofmunicipalities are rated through complianceaudits, while a general survey and an assessmentof the economy, efficiency and success of keyfinancial management activities are createdthrough performance audits. According to inter-national auditing practice, outlining the auditmethodology of a large number of territorialunits requires a special approach. It is necessaryto make sure that audit types that easily adjustto changing financial sizes, match audit meth-ods with the characteristics of a territorial unit,provide relevant information concerning thewhole population, and are based on representa-tive samples are outlined (Sepsey, 2006).

A well-organised and regularly tested con-trol mechanism may require and indeed outlinethrough its own regular replies the risk modelof the financial management of municipalitieswhich is sensitive to its external and internalenvironments, and operates effectively, effi-ciently and economically. The model may onlybe approximated by real processes, and thewell-known audit errors (type I and type IIerrors, underaudited and overaudited areas)may give experts plenty to think about. Inpractice, naturally, the issue of who the trap isset for – the mouse or the cat? – may be therein the minds of those operating and examiningthe auditing systems as a standard question.

1 Regarding the growing value of the audit function,see Kovács (ed., 2007) and Vigvári (2008); regardingits bearing on public finance, see Vigvári (2005a).

2 We find exceptions in the British Commonwealthand the United Kingdom, e.g. Gibraltar may conductan independent trade policy, and Scotland has theright to issue banknotes (Forman, 2003).

3 Fiscal leeway may be gained by shaping the opera-tional and accumulation budgets based on carefulplanning, by developing local public services throughproper coordination and optimising their expendi-tures, by taking out credits for the purpose of accu-mulation, by obtaining support for the purpose ofaccumulation, and by rationally shaping local tax pol-icy within the given legislative framework, also rely-ing on an active investment policy, communityinvestment programmes, and the stimulation of pri-vate equity.

4 Theoretically, the leeway of municipalities in view oftheir income policies may range from total autono-my concerning incomes to a total lack of the same.Systems of financing are profoundly influenced byhistorically developed models. They partly dependon the basic model of governance (unitarian, feder-al), and partly on the characteristics of the state taxmonopoly. At the national/federal level of gover-nance we usually find tasks relating to defence, homeaffairs and foreign policy. Education, health care and

law enforcement may be vertically segmented,depending on traditions. Unitarian governance disal-lows local taxation (the French model), whereas fed-eral states leave relatively high amounts of tax at thelevel of the provinces (however, in the Germanmodel, the practice of tax imposition is insignificantat the lowest local level).

5 Their distance from the growth pole, the strength oftheir connection with a given agglomeration, aregional cluster, and the town network, the charac-teristics of their position within the region, and thepresence of the factors relevant for the selection ofthe locations of business premises may differ signifi-cantly. In Hungary, economic spatial structure ischaracterised by the so-called west-east slope(Forman, 2003), and the differences between theposition of the capital city and of the countrysidemay also be regarded as significant.

6 The applicable tax types (property-type and commu-nal-type taxes, tourism tax and local business tax),tax rates and exemptions, and the system ofallowances are outlined by municipal decrees withinthe legislatively created framework.

7 Education is typically such a sector. Locally providedprimary education is a compulsory municipal task inHungary, and ensuring minimum provision and set-ting cost-efficient sizes may cause problems depend-ing on settlement types.

NOTES


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8 Considering sector-related legislation, see Takács(2003), p 13

9 Pursuant to the Amendment of Act III./1993. onSocial Administration and Welfare Benefits, effectiveas of January 1 2005, basic social care, as regulatedearlier, is to be provided by so-called basic social carecentres, whose activities are to include daytime careand child welfare service as well as the basic activitiesregulated earlier (see Sections 57 (4) a to e of theAct). Amending the Act brought about a significantexpansion of the scope of basic services. Sections 57(1) a to j of the Act contain the list of tasks relatingto village caretaker's service and farm caretaker'sservice, social information service, meal service,home help, family support service, emergency signalhome help service, community care facilities, supportservice, street social work, and daytime care.

10 The growing importance of the economic pro-gramme is reflected by the fact that the content ofthe economic programme was regulated in detail inthe amendment of Act LXV./1990 on LocalGovernments, effective as of August 31 2005. Thejustification of the amendment of the Act on LocalGovernments clearly signalled that the Act hadstipulated that municipalities should prepare eco-nomic programmes as early as in 1990; however,most of the municipalities had failed to meet thatstipulation as it was unclear for them what the eco-nomic programme was to contain. The amend-ment of the Act provided guidelines for themunicipalities by determining the objectives, cer-tain professional aspects and the term of the eco-nomic programme. Pursuant to Section 91 (6) ofthe Act on Local Governments, the content of theeconomic programme should cover solutionsrelating to development ideas, the promotion offulfilling the conditions necessary for the creationof new workplaces, the settlement developmentpolicy, the objectives of the tax policy, the provi-sion and the improvement of the standards of dif-ferent public services. In the case of towns, it isalso to cover the investment support policy, andthe objectives of the urban areas management pol-icy. Pursuant to Section 91 (7) of the Act on LocalGovernments, the economic programme shouldbe adopted by the body of representatives within 6

months of their initial meeting if it is for the termof an election mandate. If the existing economicprogramme has been in effect since before the endof the previous mandate, it is to be reviewed by thefreshly elected body of representative within 6months of their initial meeting and to be comple-ment or amended in view of a term at least as longas that lasting until the end of the mandate.Municipalities had to first apply the stipulations ofthe amended Act after the 2006 elections.

11 In this respect, Hungarian municipalities do nottend to use the term policy. Different municipal sec-tors draw up task fulfilment plans, service provisionconcepts, development concepts, and institutedevelopment plans. I have found the introductionof the term policy justified so as to spread interna-tional terminology and to unify those different ter-minologies.

12 International Standards on Auditing (ISA) deter-mine all the important steps from the acceptance ofa task to the compilation of the audit report and theacceptance of the findings through the stages ofplanning and implementation, also describing bestpractice. The standards form a tight logical frame-work from the recommended objectives and termi-nology of an audit (ISA 200) to the methodology ofcompiling auditor's reports (ISA 700), through thedescription of planning procedures (ISA 300). A detailed lecture on the ISA framework and itsapplication in the public sector was presented at theconference on the financial audit methodology ofEuropean state audit offices held in Vilnius, inOctober 2008 (Anerud, 2008).

13 The objective of the current standardisation regard-ing state audit offices is to compile a Practice Note(PN) for each ISA standard. The two together(ISA+PN) are to form the state audit office auditprocedure (ISSAI). The professional developmentproject, whose products compiled at the end of2008 had completed the necessary harmonisationrelating to audit risk management and complianceaudits (ISSAI 1315, 1330, and ISSAI 4100 and 4200)is to continue. The committees in charge of theproject have promised to complete the whole taskby 2010.


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ANERUD, K. (2008): Risk Assessment – Practicalapplication of the INTOSAI Financial AuditGuidelines, EUROSAI Seminar on Financial AuditStandards, October

BÁGER, G. (2006): New Features of the Roles theState Plays in the Globalised World of the 21stCentury, in: Vigvári, A. (ed.) Back to Basics! Studieson the Reform of the Public Finance System, NewMandate Publishing House, Budapest

BODONYI, M. (2003): Financial Audits, in: Nyikos, L.(ed.) Auditing Public Finance 2 PERFEKT, Budapest

FORMAN, B. (2003): EU Structural and Pre-Accession Funds, ETK, Budapest

KASSÓ, ZS. (2006): Do We Need an Act on StateAccounting? Tendencies of the Development of theFinancial Informational System of Public Finance, in:Vigvári, A. (ed.) Back to Basics! Studies on the Reformof the System of Public Finance, New MandatePublishing House, Budapest

KOVÁCS, Á. (2004): Financial Auditing in aChanging Field of Force, PERFEKT, Budapest

KOVÁCS Á. (ed.) (2007): Audit System andMethodology, PERFECT, Budapest

LENGYEL, I. & RECHNITZER, J. (2004): RegionalEconomics (Studia Regionum), Dialóg Campus,Budapest-Pécs

LÓRÁNT, Z. (2007): Financial Managemet at theLocal Level of Public Finance, Analytical Overview ofState Audit Office Experience, Public FinanceQuarterly, Issue 1

MALATINSZKY LOVAS, I. (2003): AuditingPerformance, in: Nyikos L. (ed.) Auditing PublicFinance 2 PERFEKT, Budapest

NYIKOS, L. (2003): Auditing Public Finance.Regulations and Practice in Hungary and the EU, in:Nyikos, L. (ed.) Auditing Public Finance 1 PER-FEKT, Budapest

PORTER, M. E. (1998): Competitive Strategy,Akadémiai Kiadó, Budapest

SEPSEY, T. (2006): The Increasing Importance ofPerformance Audits at Municipalities, (1–2). AuditObserver, Issue 4, 2005, Issue 1, 2006

TAKÁCS, A. (2003): Task-Related Obligation ofMunicipalities, manuscript, State Audit Office, ÖTEI,Miskolc

VAS-EGRI, M. (2005): Marketing Decisions inDeveloped Socities, AULA, Budapest

VIGVÁRI, A. (2005a): Public Finance Issues, KJK-KERSZÖV, Budapest

VIGVÁRI, A. (2005b): Loans Taken Out byMunicipalities, in: Vigvári A. (ed.) Halfway Through.Studies on the Opportunities of Developing theFinancing Systems of Local Municipalities, TÖOSZ-BM/IDEA, Budapest

VIGVÁRI, A. (2008): Financial Taxonomy,Akadémiai Kiadó, Budapest

Summarising Reports of the State Audit Office No.0544, No. 0634, and No. 0726 on the FinancialManagement of Municipalities

LITERATURE


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T

Péter Halmosi

Risks in the local governmentsystem from the stakeholders'point of view

The words 'risk' and 'stakeholder' are businessterms often used nowadays when presenting theproblems of a system. In the past fifteen years ormore, the local government system, put on a newfoundation at the time of the political change, hasundergone several changes that can be clearlytermed as unfavourable today and which are easi-est to grasp in the light of the complexity of the sug-gested reforms.1 The aim of this study is to con-tribute to the discussions on the direction of thelocal government system reform by an analysis of adifferent nature, which has worked in other fields.

Taking the national economic significance ofthe local government sector as a basis, the studyundertakes to present the problems of the chang-ing regulation, the development of the respectiverisks and the stakeholder behaviour patternsclosely related.

THE ROLE OF THE LOCAL GOVERNMENTSECTOR IN THE NATIONAL ECONOMY

After the collapse of the council system, thelocal government system established inHungary seemed to meet the challenges of thetime. With the right of self-government and therelatively large freedom in local affairs granted,some had the temporary feeling, while otherseven the lasting impression, that a significant

problem had been successfully solved. For sucha value judgement to be made, events have to beviewed from several years' perspective, however.

The local government sector has become oneof the basic pillars of the Hungarian economy.Evidence for the latter includes the expenditurerate of the sector to GDP as well as its role inemployment. The reason why public sectorreforms should be started from the side of localgovernments2 is not only that it is here wherethe problems are most serious. The opinion thatlocal governments have become far too impor-tant in the judgement and improvement of thecompetitiveness of Hungary also deserves con-sideration, we believe. (see Table 1)

The sector manages some one third of thenational wealth, the total value of which wasHUF 9 860.9 billion as of December 31, 2005.It implies its significance furthermore that thedecisive rate of basic and public education- aswell as social services-related expenditure isrealised through the sector. Good evidence forthe latter is that about 90 per cent of localexpenditure is related to these welfare servicesrather than to town operational costs. It is thusjustifiable to view the sector as the “engine” ofcompetitiveness, which is not something spe-cific to Hungary, however; the same has beenformulated in several court judgements inGermany, for example.3


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The fact that local governments constituteparts of the state budget is a source of risks, atthe same time – through regulating duties andsources, the central government predeterminesthe situation of local governments. Consideringthe increasingly frequent borrowings and bondissuings by local governments, however, a cer-tain benchmark-phenomenon can also beobserved, i.e. that a creditor or an investor com-pares the local government concerned to thestate as a debtor. This may have both positiveeffects (improvement in the judgement of thestate at the international level, for example) aswell as negative consequences (e.g. underfi-nancing for obligatory duties, inconsistencies inregulations, etc.).

Considering the above we believe that theregulation on the operation of the sector mustalways be given special attention in economicpolicy.

THE SOURCE OF CONFLICTS

According to Ágh (2005), in the 1990's, the cen-tral government treated local governments asconflict containers, due to other prevailingproblems. The phrase refers to the phenome-non that the sector was assigned a growing listof duties which, in retrospect, can be claimednon-local ones, without the necessary financingprovided. Hungary was no champion in this,

either, as it had been a custom also in othercountries in the 1970's to solve central budgetdeficit problems by means of financially unsup-ported decentralisation (Pálné, 2001). The con-flict container-situation can be interpretedalong the following regulation problems.

The Act on Local Governments does notdifferentiate between the rights and responsi-bilities of settlements of different sizes.7

Settlements with a population of under 500inhabitants thus have basically the same dutiesas towns or cities with thousands of inhabitants.

The legislator has left the situation ofcounty local governments unclear. The exclusivesource of income for county local governmentsmay be subsidies, which is especially problemat-ic considering that public duties potentially del-egated by settlement level local governments tocounty local governments are thus to be per-formed under worse economies of scale.

The law does not draw a clear line betweenobligatory and voluntary duties. While guaran-teeing secondary-level education is a dutyobligatory for county local governments, set-tlement local governments also have the rightto perform this duty.

The consequences of these contradictions inthe regulations can be quite precisely estab-lished today. Considering the deterioratingquality of management, the May 2006 report ofthe State Auditing Office (SAO) already men-tioned exhausting local government core assets

Table 1

BASIC CHARACTERISTICS OF THE SIZE OF THE LOCAL GOVERNMENT SECTOR

1991 1993 1995 1997 1999 2001 2002 2003Number of employees of local governments

and their institutions (thousand people)4 ND ND 561.3 544.05 520.5 506.0 496.4 501.4

Number of local government institutions

(on December 31)6 ND ND ND ND 20 705 ND ND 21 154

Number of built-up real estates (pcs) ND ND ND ND 243 573 ND ND 240 815

Number of Associations (pcs) ND ND ND ND 1 646 ND ND 2 142

Source: Dobos–Szelényi (1996–2006), local government balance 1998, 2003


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as a development of serious likelihood. Data ofTable 2 seem to support the prediction of SAO.

Data draw attention to several facts. On theone hand, privatisation incomes had a determi-native role in the GFS-balance in the 1990's;after the absence of these there was consider-able deficit in the budget balance. On the otherhand, local government expenditure within gen-eral government expenditure rose in 1996–2005,which rise was, however, covered, to someextent, by using money reserves. It seems thusthat other sources, too, had a role in ensuringthe operation of the underfinanced system.

Sources were nevertheless insufficient formeeting public duties. This is also well indicat-ed by the fall of expenditure in real terms (seeTable 3).

Even more serious financing problemsappeared at the micro level. Although there isno comprehensive analysis available on theoperation of the almost 3,200 local govern-ments, three important phenomena reflectingthe appearance of problems can be pointed out.

A drastic rise in the legal titles of norma-tive subsidies: while in 1996 there were still 52legal titles, in 2005, there were 143 already.

The appearance of supplementary subsi-dies for underfinanced local governments inthe annual budget acts: there are currentlythree such legal titles, the most significant ofwhich are supplementary subsidies for local

governments underfinanced for reasonsbeyond their control.

The appearance and growth of operationalindebtedness: in the year 2000, 13.9 per cent oflocal governments while, in 2005, 20.3 per centof them already were obliged to take up opera-tional loans (SAO, 2006, p 21). While the rate ofoperational indebtedness within total debt con-stitutes a stable 15 per cent, total debt made uponly 1.4 per cent of public debt in the year 2000but amounted to as high as 2.3 per cent in 2005.

Considering the above it can be established,we believe, that there are serious risks inherentin the inner contradictions of the local govern-ment system. The exploration of these requiresthe survey of literature on risk evaluation.

THE RISKS INHERENT IN THE HUNGARIANLOCAL GOVERNMENT SYSTEM

So as to be able to establish the presence ofactual risks, it is necessary to discuss some the-oretical issues first. When describing the risksof a system, it is important to emphasise theaspect of observation and the subjective-objec-tive nature thereof. The same local governmentis certainly given various evaluations of by tax-paying small enterprises, capital investing bigenterprises, financing credit institutions, ratingagencies, the Auditing Office and, last but not

Table 2

MAJOR FINANCIAL DATA OF THE LOCAL GOVERNMENT SECTOR

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005GFS-balance 48.0 66.5 –8.8 23.0 5.0 1.3 –105.0 –31.7 –16.5 –81.4

Privatisation revenues8 47.4 90.5 19.3 21.9 37.1 11.2 11.6 9.0 8.7 15.6

Operational balance9/GDP (%) +0.69 +0.77 –0.0 +0.20 +0.0 +0.0 –0.62 –0.17 +1.9 +1.8

Local government expenditure/general

government expenditure (%) 25.2 25.6 25.8 25.0 ND 27.0 25.2 25.4 27.8 ND

Growth in GFS-expenditure, compared

to previous year (HUF bn ) 74.9 212.4 206.8 127.0 175.6 251.3 383.5 271.1 156.7 282.4

Growth in spending reserves (HUF bn ) 23.6 ND ND 2.2 14.2 44.5 5.3 12.6 34.8 17.1

Source: Own calculations based on data by Dobos – Szelényi (1996–2006), Illés (2005) and the Ministry of Finance


107

least, the local government concerned itself. Asregards the objective-subjective approach, webelieve that, even though it is economic organi-sations that are examined, it is insufficient toapply an objective approach due to their embed-dedness in the state budget. The most impor-tant reason for the latter is that the regulatoryenvironment may change unexpectedly fromyear to year. Following the methodologicalpractice of North-American rating agencies, itis therefore advisable instead to familiarise withthe situation of the local government observedas closely as possible and to compare it withlocal governments of settlements in a similarsituation.10 Adding dimensions like space andtime to the observations may be of help.

Space, as a dimension, is of double signifi-cance. On the one hand, it provides importantdata on the area of authority of the local gov-ernment concerned, i.e. geographically, regard-ing the microeconomic development level, (e.g.the number of enterprises, their capitalstrength, etc.), the state of infrastructure, etc.On the other hand, the dimension of space

reflects the size of the duties of the local gov-ernment (the number of obligatory and volun-tary duties, the depth of duties, the number ofbeneficiaries, etc.) and the relation thereof tothe micro economy. This thus covers a surveyrelated to the size of the local government itselfas well as that of the settlement concerned,which can be carried out in the case of localauthorities of a similar size only.

The survey along the time dimension takesthe utilisation of the decision alternativesoffered by the laws and regulations, and the“room for action” of the organisation con-cerned as the bases, which, by altering thephrase “expectable control” of Vigvári (2002),can be referred to as the “expectable behav-iour”. During the surveys along the timedimension, the emphasis moves from theshort-term to the medium-term, because ofwhich a failure to meet the indicators observedor to perform the “expectable behaviour” doesnot make it necessary to implement an imme-diate revaluation of the riskiness of the organi-sation observed.

Table 3

CHANGES IN THE LOCAL GOVERNMENT SECTOR EXPENDITURE

Year Nominal change in expenditure (%) Consumer price-index (%) Change in real value (%)1991 118.5 135.0 87.8

1992 133.3 123.0 108.4

1993 120.4 122.5 98.3

1994 125.2 118.8 105.4

1995 106.7 128.2 83.2

1996 114.1 123.6 92.4

1997 124.3 118.3 105.1

1998 118.8 114.3 103.9

1999 109.5 110.0 99.5

2000 111.9 109.8 101.9

2001 115.2 109.2 105.5

2002 120.2 105.3 114.1

2003 110.8 104.7 105.8

2004 106.0 106.8 99.0

2005 110.5 103.6 106.7

Source: Vigvári (2006b)


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So as to get a precise picture of the organisa-tion examined, it is often necessary to furtherrefine the picture acquired through the spaceand time surveys, one way of which is connect-ing the dimensions, thereby making the explo-ration of individual traits possible. The aboveis based on the realisation that, beyond the rel-ative geographical location of the settlementconcerned, its stage of development, to be eval-uated, also contributes to its uniqueness. Intheir reports, international rating agencies dif-ferentiate between what are referred to asmature settlements, the population of whichdoes not grow significantly, and developing set-tlements, in the case of which there is signifi-cant population growth annually. Local govern-ments in the latter category must be preparedfor a future growth in the demand for publicduties, too, i.e. for the need to widen capacity.Therefore, in the case of developing settle-ments, diversion from the expected data, toserve as the basis of evaluation, and from therequirements of “expectable behaviour” is to begreater than in the case of mature settlements(Fitchratings, 2004, p 8).

The above theoretical foundation probablyraises doubts in the reader as regards our knowl-edge of the risks of the Hungarian local govern-ment sector on the basis of the informationavailable. There is a reason for doubt indeedsince the analyses presented are missing in oneaspect or the other even at the macro level, letalone those according to the types of settlement.Since the Hungarian local government systemcovers a relatively high number of local govern-ments, however, from the data and indicatorscalculated on the system as a whole, it is easy tomake conclusions on the presence of risks. Onthe basis of the data and expert opinions on theoperation of the local government system in thepast one and the half decades, the following riskcategories can be specified:

• state budget risks,• risks in the decentralisation of duties,

• financial risks,• asset risks,• management risks.In the presentation of the performance of

the sector above, references were made to therisks related to the state budget and to thedecentralisation of duties, while financial,assets-related and management risks stillrequire some explanation. As a significant con-sequence of the conflict container situation,there has been little information available onthese risks until today.

It is related to the obscurity of financial risksthat, due to the borrowing limit set by the localgovernment act, banks present some of thedeficit financing as if it was liquidity borrow-ing, which latter is unlimited (Vigvári, 2006a).The rise in debt as compared to own revenue ishigher than the debt rate compared to totalexpenditure, thus resulting in worsening bor-rowing ability. The amount of borrowing risesnevertheless, which raises the need to deter-mine the level of borrowings that still allows alocal government to meet its public duty-relat-ed expenditure.11

The presence of assets-related risks is onlyapparent from the SAO reports. The problemis that most local governments do not keep astatement on the assets available for the respec-tive public duties or on whether the conditionof these assets makes meeting the public dutyconcerned possible. It is certainly important tonote that in the case of certain local publicduties – like basic and public education, socialservices – it is probably only the quality ofservices that we can make conclusions on basedon the current methodology. There is thus noinformation on the suitability of the assetsthemselves.

Since local government managements alsoshare the responsibility for the current situa-tion, we believe, it should be examined to whatextent they met the requirements of“expectable behaviour” when making financial


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management decisions. The priority of opera-tional activities to investment activities at set-tlements resulted in efforts to achieve budgetbalance by any means. Whether a local govern-ment achieved this by borrowings, local taxes orby selling tradable assets, depended on how andto what extent they were, while keeping theirown position, able to involve local taxpayers inburden sharing. As theoretical research hasrevealed for almost 50 years, the interests of set-tlements are pushed into the background dur-ing efforts to win over electors. The situation inHungary is most likely to be the same. In viewof this, analysing stakeholders' interests is prob-ably of even higher significance.

LOCAL GOVERNMENT STAKEHOLDERS

In the beginning of this study we noted thatbasically the whole national economy is inter-ested in the operation of local governments.The following can be established as regards thebehaviour of the respective interest groups.

Electors

Electors are taxpayers and the beneficiaries oflocal services at the same time. Theoreticalresearch reveals that taxpayers tend to movefrom settlements with what they find non-

optimal public goods tax combination.12 TheHungarian population is characterised by lowmobility, however, because of which changes in(i.e. the deterioration of) local taxation and thestandard of local services have little influenceon changing residence.13

For the operation of the local government, itcan be regarded as expectable behaviour ofelectors to be actively interested in the electionof local leaders and to check accountability forpublic moneys as well as to control the ade-quate treatment of the assets owned by thelocal government, i.e. the public assets of thelocal community. In the past few years, partlydue to the political dividedness of voters, theseissues have been very much in focus, butrumours have often lacked economic consider-ations. There is low probability for electors'clear-sightedness.

Off-budget organisations performingduties14

The performance of public duties by off-budg-et organisations is also closely related with theconflict container situation. Due to the lack ofindependent decision making opportunity infinancial management and the real fall in rev-enue, local governments have viewed marketsolutions as the omnipotent solutions. Thecontents of the contracts made with organisa-

Table 4

THE VOLUME OF LOCAL GOVERNMENT ASSETS TRANSFERRED FOR OPERATION AND MANAGEMENT CONSIDERING THE SECTOR AS A WHOLE IN 1999–2005

(as of December 31, HUF bn)

1999 2000 2001 2002 2003 2004 2005Assets transferred for operation and management 174.6 399.3 489.5 858.4 1 214.0 1 396.5 1 465.8

Value of local government property assets 2 313.2 3 089.9 3 504.8 6 423.3 9 234.6 9 617.9 9 860.9

Rate of transferred assets compared to local

government property (%) 7.54 12.92 13.96 13.36 13.14 4.52 14.86

Source: Dobos – Szelényi (2000–2004 and 2006) as well as data of the Ministry of Finance


110

tions performing public duties or the risksinvolved therein have been ignored by the cen-tral government.

It can be expected of off-budget organisa-tions to use the transferred local governmentproperty assets and funds in a transparent way.The importance of this can be appreciated con-sidering the volume of property assets trans-ferred for use (see Table 4).

Yet, for every company, it is profitability thatis of primary importance. Although the marketattitude and the base of distribution of admin-istrational costs are wider, local governmentdecisions on public services fees as well as thepotential demands for supplementary subsidiesbecause of the former do not serve the respon-sible management of transferred moneys andproperty assets.

The state

In addition to the aspect of improving thecompetitiveness of Hungary, the state interestin the development of the situation of the statebudget is also significant considering therequirement to meet the Maastricht criteria.The deterioration of the GFS-balance of thelocal government sector indicates that reformsmust not be put off for long since borrowingsof growing significance, with no regard tofinancing ability, have appeared as a social riskin the background already.

So as to guarantee the performance of publicduties, the state must ultimately bear the bur-den of the local indebtedness related to theoperation of local governments. Apparently,indebtedness does not always appear explicitly:the situation caused by the increase in thefinancial obligations outside the budget(exchange rate risks involved in leasing con-tracts and foreign currency loans ) and theassumed deterioration of the transferred prop-erty – due to the lack of local control – cannot

be sustained for long. In the case of invest-ments – the decisive majority of which is likelyto be financed from EU sources in future – itis an extra problem that, under the current reg-ulations, it is the state that is responsible forthe potential repayment of sources.15

The treatment of local governments as con-flict containers thus concealed the real situa-tion apart from the problems on the one handand eased control on the other hand, which, insome cases, could lead to free rider behaviour.

Creditors

For the Hungarian bank sector, local govern-ments count as major clients. In the 1980's, localgovernments issued bonds for the first time asan experiment, through the National SavingsBank OTP. The credit institution that developedinto a bank later on faced serious competitors atthe local government market in the 1990'salready. Since, until 1996, creditors believedthere was state guarantee behind local govern-ment borrowings, in the competition of banks,OTP often lost current account and loan con-tracts to other banks. Another aspect of moralhazard was that, although excessively indebtedlocal governments were not allowed to take uploans under the law, OTP accepted a simple localgovernment statement as verification.

The local government bankruptcy cases afterAct 25 of 1996 took effect, made creditors, too,more careful. The return on claims, sometimesas high as 1–10 per cent, had its effect: the localgovernment sector became a net financer of thebank sector until 2004 (see Table 5).

After 1996, it is what is referred to as the“rule of thumb” under which credit institutionsjudged applications for loans,16 which weremade by local governments for liquidity pur-poses basically, as well as in relation with actu-al investments. It can be formulated as criti-cism of the credit institutions that they failed


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to develop standardised products for local gov-ernments.17

The suspicion occurs that there is “cross-financing” between the various financial prod-ucts offered to local governments. Currentaccount management is basically guaranteedrevenue of low risk for banks, because of whichthey often set irrealistically low conditions tolocal government clients in the case of poten-tial applications for loans.18

So as to meet Basel II regulations, commer-cial banks will assumingly show greater interestin buying local government bonds, which fallinto a lower risk category compared to classicloans. Once they are made interested thus,credit institutions will probably also be inter-ested in sharing their experience as well as inevaluating their local government clients undernew aspects, which has not become generalpractice as yet, however.

Investors

As a result of the expected rise in local govern-ment investments, investors are to be assignedan important role. The criticism raised againstthe new solutions – like PPP, BOT – which alsomake it possible to circumvent the Maastricht

criteria, includes the lack of an adequate legalregulation or local experience on the manage-ment of such contractual relations on the onehand, and the consequence of putting the bur-den of the investments on later generations onthe other hand.20 Since it is the return on theirinvestments that investors primarily keep inmind, with no adequate contracts available, it isnot to be predicted in what condition propertyassets in permanent private management will bereturned to state ownership later on.Considering the state orders or subsidies guar-anteed during the contracts, such construc-tions can be justified only if, after the expira-tion of the contract, the property assets con-cerned are suitable for performing the purposefor which they were produced and their furtheroperation does not involve unjustified extraburden on the state.

Under paragraph 80/A of the LocalGovernment Act which entered into force onJanuary 1, 2007, the core property may beassigned to property management. If a localgovernment assigns its property assets to prop-erty management by appointment, the transferinvolves no VAT payment obligation.Investigations by the State Auditing Officeinto the transfer of water public utility proper-ty have revealed unlawfulness in several cases

Table 5

THE RELATION BETWEEN THE LOCAL GOVERNMENT SECTOR AND THE BANK SECTOR

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2006Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec March Jun

Bank loan 49.9 38.5 30.3 44.4 57.6 73.1 115.1 44.0 182.8 241.5 260.1 293.0

Bank deposit 80.7 86.8 115.8 123.5 148.3 197.5 219.3 211.3 251.9 249.9 256.0 210.7

Net position against

the Hungarian bank

system 30.8 48.3 85.5 79.1 90.7 124.4 104.2 67.3 69.1 –8.4 –4.1 –82.3

Liabilities total19 ND ND ND ND 224.4 231.6 405.4 419.8 533.8 647.6 589.6 ND

70 per cent limit of

own current revenue 136.0 199.9 246.3 292.4 335.0 335.2 438.9 461.9 523.6 556.4 ND ND

Source: Vigvári (2002), Kopányi – Vigvári (2003), Vigvári (2005) and Hungarian National Bank (MNB, 2006)


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and ordered the restoration of the originalstate. As made possible by the widened law,local governments will probably prefer to haveproperty assets of mostly limited tradability,assigned to use by cultural, educational, sports,health and social, etc. institutions, restored orrenovated by private companies, without mak-ing the necessary steps to avoid risks.

CONCLUSION

The behaviour of local government stakehold-ers is the result of the regulatory environmentdetermining the operation of the sector basical-ly. During the economic transition, the nation-al economic significance of the sectorincreased. Since the reforms are likely to have a

catalyst effect on the other subsystems of thestate budget and on the Hungarian economy asa whole, the irresponsible stakeholder behav-iour should be stopped as soon as possible.

As a conclusion of the stakeholder-analysis,stakeholders' interest in clearing the situationof local governments is summarised in Chart 1(ability-inclination-time).

As revealed by the chart – which reflectshigh subjectivity, just like in the case of riskawareness – inclination for improving the situ-ation of the sector has improved in the case ofseveral stakeholders in the past one and a halfdecades or more, but further steps are requiredfor an overall effect. There has been a positiveshift in the inclination of the state, we believe,which will hopefully influence the inclinationof other stakeholders as well.

Chart 1

THE INTEREST OF STAKEHOLDERS OF THE HUNGARIAN LOCAL GOVERNMENT SECTOR IN CLEARING THE SITUATION OF THE SECTOR

Source: own editing

INCLINATION

Low Medium High

Low

Med

ium

High

ABIL

ITY

2 4

3

51

2 3

15

4

Explanation:

1 electors

2 off-budget organisations per-forming duties

3 the state

4 creditors

5 investors

White: 1990

Green: 2007


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NOTES

LITERATURE

1 Cf. Péteri (2005), Pitti (2003), Vigvári (2005), etc.

2 Cf. Vigvári (2006)

3 Public servants, civil servants and other employees(e.g. firefighters, elected officials, not including localgovernment representatives)

4 Data of December 31, 1996

5 Year-end closing data; instead of December 31, 1997,data of December 31, 1998 are presented.

6 For further detail cf. Albers (2004)

7 The only differentiation that exists is between coun-ty- and settlement-level local governments.

8 In 2004 and 2005, this constituted revenues from thesale of shares that local governments had acquiredthrough privatisation primarily.

9 In 2004 and 2005, instead of operational revenues,data reflect total revenues minus accumulation rev-enues, earmarked- and target subsidies.

10 From the relevant Hungarian literature, it is worksof Kozma (2006) and Vigvári (2004) that should benoted.

11 The term used for this in the literature is financialcapacity, which was first used by Gurley and Shaw.The problem is that financial capacity is not easy todetermine even in individual cases. Under a courtjudgement made in Rheinland-Pfalz province,Germany, (Rheinland-Pfalz GemO 103. §,Thüringen KO 63. §), local governments should bebanned from further borrowings if their ability tomeet public duties permanently fails. The piquancy

of the problem is that the above is determined bythe per capita indebtedness indicator.

12 Cf. Tiebout (1956)

13 In further research, it would be interesting to exam-ine population behaviour patterns related to the tax-public services rate, in the view of low mobility.

14 Since the activities are carried out outside the localgovernment budget, such companies as a whole arereferred to as the off-budget sector.

15 Hungary is not alone with the problem. The issue iscurrently dealt with by Germany and Austria, wherethe GDP proportionate deficit framework – andthereby the risk of repayment – is divided upbetween the federal and the province levels.

16 The rates and conditions of loans continued to bedecided on without comprehensive analyses, on thebasis of the rate of local industrial tax revenues andchanges therein basically.

17 Local governments are to start repaying loan capitalduring the term of the loans already, in contrast tothe state, which usually starts repaying at the end ofthe term, using revenues from new loans.

18 Source: a discussion with Péter Kígyós, sales man-ager of Dexia Kredit Hungary.

19 The deadline composition of these is unknown but thedominance of long-term deadlines can be assumed.

20 It was Katalin Botos who called attention to the factthat such constructions may be the bases of futurestate subsidies or orders, the sustainability of whichshould be examined.

ALBERS, H. (2004): Von der Konkursunfähigkeit zurZahlungsunfähigkeit – aktuelle Probleme der kommu-nalen Haushalte, 15. Bad Iburger Gespräche,Kommunale Aufgaben in einem gewandeltenSozialstaat, 10 November 2004, Bad Iburg

ÁGH, A. (2005): Public administration reform andEU-competitiveness: Eliminating conflict containers.In: Vigvári, A. (ed.): Halfway. Studies on the further

development opportunities of local governmentfinancing systems, Timp Kft., Budapest, pp. 15–21

DOBOS, L. – SZELÉNYI, GY. (1996): Browsing amongthe 1995 yearend results of local governments, PublicFinance Quarterly, 1996/9, pp. 659–676

DOBOS, L. – SZELÉNYI, GY. (2006): Yearend accountsof local governments of 2005, Ministry of Finance


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ILLÉS, I. (2005): Local government financing andtaxation in an international comparison, in: Vigvári, A.(ed.): Halfway. Studies on the further developmentopportunities of local government financing systems,Timp Kft., Budapest, pp. 21–46

KOPÁNYI, M. – VIGVÁRI, A. (2003): Economic polit-ical questions related to raising the source absorptioncapacity of the local government sector, Pubic FinanceQuarterly, pp. 1070–1088

KOZMA, G. (2006): The risk categories of local gov-ernment management – through an auditor's eye,unpublished study

PÁLNÉ, K. I. (2001): Regional policy and publicadministration. Budapest-Pécs, Dialóg CampusPublisher

PÉTERI, G. (2005): Regulations on local governmentsources: Ideas and suggestions, in: Vigvári, A. (ed.):Halfway. Studies on the further development opportu-nities of local government financing systems, TimpKft., Budapest, pp. 115–125

PITTI, Z. (2005): The modernisation of local gov-ernment financing. in: Vigvári, A. (ed.): Halfway.Studies on the further development opportunities oflocal government financing systems, Timp Kft.,Budapest, pp. 47–70

TIEBOUT, C. M. (1956): A pure theory of localexpenditures, Journal of Political Economy LXIV. pp.416–424

VIGVÁRI, A. (2002): Public finances, local govern-ment finances, KJK-Kerszöv Publishing House,Budapest

VIGVÁRI, A. (2003): Some questions on the cred-itability and absorption capacity of the local govern-ment sector, Hitelintézeti Szemle, Issue 4, pp. 91–112

VIGVÁRI, A. (2004): Financial System(atic)s, KJK-Kerszöv Publishing House, Budapest

VIGVÁRI, A. (2005): Public finances in Hungary,KJK-Kerszöv Publishing House, Budapest

VIGVÁRI, A. (2006a): “The weakest chain.” Thereform of the local government financing system, In:Vigvári A. (ed. 2006): Back to the Basics! Studies onthe public finance system reform, Új MandátumPublisher, Budapest

VIGVÁRI, A. (2006b): Absorption of sources and thelocal government financial system, Lecture at theNational Notary Conference. Siófok, August 30

Fitchratings (2004b): International Public Finance –Ratings of public sector entities. June/2004,www.fitchratings.com, downloaded on January 30, 2006

Hungarian National Bank (2006): Financial assets ofthe state budget and the components of asset changes,www.mnb.hu, downloaded on August 11, 2006

State Audit Office (2006): Report on state debtmanagement control, May, 2006, www.asz.gov.hu,downloaded on August 14, 2006


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R

Károly Jókay – Katalin Veres-Bocskay

Only in Hungary: experiences with municipaldebt adjustment and suggestedregulatory changesReforming Hungary's government sector seems tobe an unavoidable task. A competitive economydoes not exist without modern public finances.(Kovács, 2006). The State Audit Office outlineda possible path to reform in 2007.1 Local govern-ment (or municipal) reforms play important rolesin these theses. Increased financial discipline ispart of these reforms.2 Municipal reform propos-als to date did not pay much heed to the legalinstitution of municipal debt adjustment. We willattempt to generalize our observations of munici-pal debt adjustment in Hungary, and attempt toshow how slight modifications to the law mayresult in stricter financial discipline in the localgovernment sector.3

Hungary is the only European state – perhapswith the exception of cantonal legislation inSwitzerland – that has a municipal debt adjust-ment process in its statutes that is supervised by acourt-appointed independent bankruptcytrustee.4 In Slovakia, Latvia, Romania, theRussian Federation or Estonia, the Treasury orFinance Ministry, or a state institution, inter-venes directly into the affairs of an insolventmunicipality.

The 1991 Act on Local Self-Government(Act LXV) stated:

• A municipality may be declared to beinsolvent by a county court upon therequest of creditors or suppliers;

• In order to restore solvency, the munici-pality must suspend the financing of allactivities and services that are not servingbasic functions or exercising publicauthority on behalf of the State.

These clauses of the local government lawwere practically impossible to implement overtime. Starting in 1995, more and more munici-palities signaled that their budgets were not inbalance, and have protracted solvency prob-lems. Policymakers decided to regulate thelegal indebtedness of municipalities in severalsteps. On one hand, the local government lawbegan to regulate the maximum debt of munic-ipalities in 1996. Of course, these regulationsdid not apply to debt already on the books, butthey did prevent future financial instability.

In a second step, the Parliament passed the1996 Act on Municipal Debt Adjustment (ActXXV). Experience has shown that local gov-ernments experiencing financial difficultiesneed assistance in making adjustments, andvital public services are in the public interestand may not be degraded. The lawmakers hadthree goals: to restore financial solvency at themunicipal level, to ensure the provision ofmandatory municipal functions, and of course,to satisfy fully, or at least proportionally, theclaims of creditors and suppliers. An addition-al policy goal was to encourage both the


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municipal sector and its business partners toengage in more prudent behavior to preventexcessive debt.

This “Hungaricum” (i.e. Hungarian special-ty) has served to protect both creditors andmunicipalities since 1996. The law is justifiedby the notion that Hungarian municipalitiesare free to engage in business activities, but theState does not guarantee their debts, and makesState funds available only for the provision ofmandatory public services. The 1991 Act onLocal Self-Government (Act LXV) stated thata municipality may be declared to be insolventby a county court upon the request of creditorsor suppliers. And in order to restore solvency,the municipality must suspend the financing ofall activities and services that are not servingbasic functions or exercising public authorityon behalf of the State.

The Debt Adjustment Act's additional posi-tive feature is that it lists in detail all mandatorymunicipal tasks that must be performed evenduring the debt adjustment process, and must befinanced in the emergency budget. This list ofmandatory tasks is difficult to identify in otherHungarian statutes such as the LocalGovernment Act, and the Debt Adjustment Actmakes this list slightly more precise than here tofore.5 The following table 1 below represents 22known cases of municipal “bankruptcy,” withthe case of Nemesgulács being the newest well-documented occurrence.6, 7 We consider theanalysis of these cases to be important, becausesome involved criminal activity and fraud, whileothers demonstrate the weaknesses of the“financial architecture”8 of local government inHungary, and highlight the need for increasedfinancial discipline. The list is not complete,because press accounts do not report all cases,and only a thorough examination of public courtdisclosure documents, such as the EnterpriseGazette, would reveal all occurrences.

The debt adjustment procedure is alwayspreceded by municipal insolvency, defined as an

inability to pay its employees, creditors andsuppliers on time. The debt adjustment lawuses a threshold of 60 days to separate liquidi-ty problems from legal insolvency. These pro-cedures have participants with varying degreesof information and divergent interests.9 Themunicipality represents one side, the bankmanaging the municipality's account the other,with the third side represented by the collectiv-ity of other suppliers and creditors. The munic-ipality has a significant advantage in terms ofinformation.10 The account managing bank hasa distinct advantage over the other players, inthat as a provider of liquidity (before insolven-cy) it can influence the ability of the munici-pality in paying the bank's claims ahead of time.On the other hand, irresponsible lending bybanks can also contribute to insolvency. In thetable above, italics marks those cases where abank was a significant creditor.

GENERAL FEATURES OF OUR EMPIRICALINVESTIGATION

Our analysis examined these cases along the fol-lowing lines: to what extent did the DebtAdjustment Act prevent situation of insolvency,how transparent was the procedure, how couldasset liquidation be prevented, and to whatextent were mandatory municipal services main-tained during the debt adjustment procedure?

Regarding prevention, it is obvious thatmunicipalities do not comply with the law. InDecember 2002, it turned out that a municipal-ity (Dunafalva) was two years late in paying 14invoices, and six months late in paying 18 oth-ers. Upon initiation of the debt adjustmentprocedure in Sata, large numbers of invoicesthat were 60–90 days late were discovered. Weassume that this phenomenon is repeated inmany places in Hungary, but in a cynical man-ner the local assembly ignores its obligationsunder the law, while the creditors do not take


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advantage of their rights under the law (to peti-tion the court to declare the municipality insol-vent after 60 days). We therefore state that thelaw does work in a preventive manner, since theexplicitly irresponsible lending practices haveall but disappeared under the threat of asset liq-uidation by the early 2000s. But in this light, itis obvious that in the absence of any legal sanc-tions and credible enforcement (of the 60 dayrule), and as a result of the patient attitude ofmost creditors, the law is simply not obeyed bythe municipalities. Lastly, the relatively lownumber of formal debt adjustment cases sig-nals, that beyond acting as accomplices, the

creditors and debtor succeed in agreeing at thelast minute, essentially extending the deadlines.The debt adjustment procedures reveal manyunpleasant secrets, and in the majority ofclosed cases the creditor receives only a smallpercentage of its principal, and virtually noneof its interest claims. Thus irresponsible lend-ing has all but ceased, and the causal factorsbehind a growing number of insolvency casesinvolve criminal activity and fraud, as well asimproper refunds of value-added tax and othercentral government funds.

One of the merits of the law is that the pro-cedure is transparent and explicit. Each step is

Table 1

MUNICIPAL DEBT ADJUSTMENT (BANKRUPTCY) CASES IN HUNGARY (1996-2008)

Municipalties Population Amount of Publication Conclusion ResultDebt on Date of Date

(million HUF) Initiation (publication)Atkár 1685 98 25. 10. 2001 1. 8. 2002 agreement

Bakonszeg (I.) 1278 152 22. 8. 1996 23. 7. 1998 liquidation

Bakonszeg (II.) 1278 60 3. 8. 2000 26. 9. 2001 liquidation

Bátorliget 783 79 22. 8. 1996 26. 3. 1997 agreement

Csány 2298 46 15. 8. 1996 3. 4. 1997 agreement

Csepreg 3333 89 15. 4. 1999 27. 4. 2000 liquidation

Domaháza 1082 22 20. 11. 1997 6. 1998 agreement

Dunafalva 1185 69 13. 3. 2003 29. 12. 2005 liquidation

Egerszólát 1107 24 25. 8. 1996 3. 4. 1997 agreement

Felsõmocsolád 559 11. 8. 2005 ?? No data

Forró 2547 163 7. 4. 2005 15. 12. 2005 agreement

Gilvánfa 341 26 21. 9. 2000 liquidation

Kács 654 32 12. 12. 1996 24. 7. 1997 Agreement

Nágocs (I.) 856 123 5. 9. 1996 23. 7. 1998 Agreement

Nágocs (II.) 856 46 21. 9. 2000 9. 5. 2002 LiquidationNemesgulács* 1100 118 21. 6. 2007 28.1. 2008 Agreement

Páty 4998 400 15. 8. 1996 4. 3. 1999 Liquidation

Sáta 1391 55 25. 2. 1999 1. 8. 2002 Liquidation

Somogyfajsz 553 86 29. 7. 1999 13. 9. 2001 Liquidation

Somogyudvarhely 1208 31 5. 3. 1998. 19. 11. 1998 Agreement

Sorokpolány 825 11 1. 4. 1999 30. 12. 1999 Agreement

Sóstófalva 3509 6 21. 1. 1999 31. 12. 1999 Agreement

Nick 29. 6. 2007

Boba 16. 1. 2008

Debt adjustment cases underway (incomplete list): Pilisjászfalu (February 7, 2008), Tiszaderzs (January 7, 2008), Neszmély (August 2008).


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described in detail so that each participantknows what comes next, and what theirresponsibility is. There were no disputes con-cerning procedures in any of the 19+ cases.The trustee and the court have authority andare respected.

The law has proven beyond a shadow of adoubt that the state will under no condition guar-antee the debts of a municipality, or will it assumeresponsibility for their borrowing. The cases todate, of course, involved the smallest of munic-ipalities, so one may ask what will happen if acounty government reaches insolvency, and willthe State step in as a “last resort?”

Vital public services were maintained in eachcase. The trustee, however, was not always in aposition to suggest reforms, budget cuts andreorganization, because these skills do notbelong to his profession. So the most success-ful reorganization plans came about with thefull involvement of the assembly and the man-agement of municipal institutions. In thesecases the trustee simply reviewed the sugges-tions made by the reorganization committee.

The debt adjustment procedures conductedto date gave participating municipalities a cleanslate, i.e. tabula rasa, enabling them, in theory,to continue to borrow for development pur-poses. But a typical municipality that hasundergone debt adjustment is usually in a direeconomic condition, and will have eternal rev-enue shortfalls, and will remain non-creditwor-thy for reasons other than an earlier debtadjustment.

In a significant portion of the cases we exam-ined insolvency came about due to accounting andinternal regulatory shortfalls. In these situations,there were no counter-signatures, no internalcontrols, receipts were missing, and assemblydecisions were astray. As a consequence, unpaidbills accumulated if they were recorded at all,until an outside actor, such as a court order, upsetthe system. By violating the rules of internal con-trolling, accounting and procedural require-

ments, combined with some fraud and counter-feit documents, a bad lending decision that iswell managed may lead to insolvency. The prac-tice of payments to subcontractors withoutcounter-signatures and valid contracts also vio-lates written and informal money managementrules that apply to public officials. If accountingand procedural rules had been obeyed, then per-haps 3–4 insolvency cases would have come tolight sooner, or perhaps would have been pre-vented among the 19 known cases.

Creditors and suppliers behave in a variety ofways. On the one hand they trust municipali-ties and have faith in their willingness to pay.On the other hand, failed work out agreementscan mostly be blamed on the largest creditor,usually a bank, claiming back interest or otherpenalties to preserve the real value of theirclaim. Even in the case of work out agreementsthat never came about, the municipalities wereable to offer 50–70% of the principal claimedby creditors on a cash or deferred paymentbasis. The large creditors, who for years did notexercise their contractual and mortgage rightsor engaged in long law suits, suddenly hard-ened their position during the workout negoti-ations. Because of their interest claims, theywere willing to risk a failure to reach agree-ment, even assuming the risk of court-orderedliquidation of municipal assets. Asset liquida-tion always affects the creditors negatively.Despite this, in our opinion several large credi-tors rejected compromises on an arbitrarybasis. In many cases not all the creditors filedtheir claims who were in the records of themunicipality. For example, there were 72 mil-lion forints of unpaid bills on record inDunafalva, of which 5 million forints werenever claimed by the creditors.

The local assemblies, seemingly naive in cases,cooperated with the court and the trustee ineach bankruptcy procedure. No assembly hadto be threatened with new elections and disso-lution. One source of difficulty was that


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municipal assemblies hoped that the bankrupt-cy trustee would provide them with ideas forfinancial and organizational reforms, and alsomake difficult decisions on their behalf. Basedon official transcripts, the trustees acted withutmost diligence and care when evaluatingemergency budgets and proposed workoutagreements. They could not represent theinterests of the assemblies nor the creditors.Instead, the trustees acted on behalf of thecourt, and in an indirect way, the State. Themain problem with the assemblies was thatthey were not willing to reduce staff levels, toraise local taxes and to concentrate the budgeton only mandatory functions. Furthermore,they tried to head off further difficult decisionsby applying for deficit grants and other statefunds.

Asset liquidation was mostly caused by cred-itors' insistence on unrealistic satisfaction ofinterest claims. If they had exercised theirrights in time, for example, not waiting 5 yearsin the Atkár case, the bank may have recoveredmost of its principal. But during a bankruptcyproceeding all of the interests and principalscome due at once, and in the meantime timesome municipal assets may “disappear.” Assetliquidation means that creditors can recovernone of their interest claims, and receive only1–10% of their principal claims in cash.

It is interesting that in the periods immedi-ately before a bankruptcy filing, in most cases,municipalities had significant financial prob-lems regarding their operational budgets thathad nothing to do with debt. Thus, in themonths before insolvency, the amount ofunpaid bills for operational expenses coulddouble or even treble. In these situations themunicipalities could not stay current on theirinvoices for operational expenses, and sudden-ly, the court order to pay arrives after 4 to 5years of anticipation.

The cases described above lead us to the con-clusion that the municipal Debt Adjustment

Act was only implemented when basic munici-pal functions were endangered from a financialperspective. It is quite striking that with theexception of Nemesgulács, creditors and suppli-ers did not ever initiate debt adjustment proce-dures against a municipality. This is most likelyjustified by the fact that in the beginning cred-itors “believed” that the central budget wouldstep in to pay on behalf of debtor municipali-ties. (This is a reflex that stems from the old“council” days of socialism). Given theirknowledge of the law, the creditors had noincentive to initiate bankruptcy proceedings,because they knew that only a small portion oftheir claims could be paid. They chose to waitfor better times. From the perspective ofmunicipalities, it is “understandable” that theywould delay declaring bankruptcy for as long aspossible, because if the court accepts their peti-tion, they no longer qualify for a host of stategrants. So this “escape route” is truly a lastresort for a municipality.

We present a specific debt adjustment case inthe next section. This example, as we have indi-cated, is unique since it was initiated by a cred-itor. But we feel that in the context of the othercases, this unique event offers the insightfulperspective of a practicing bankruptcy trustee.

The Village of Nemesgulács's DebtAdjustment Procedure

In April 2006, a construction contractor peti-tioned the court to initiate a debt adjustmentprocedure against the Village of Nemesgulács.The company justified its claim by stating thata contract signed in 2002 for building the sec-ond phase of a waste water project that hadbeen modified many times authorized theenterprise to issue an invoice that eventuallywas not paid on time.

The municipality failed to pay this invoice in2004. Almost two years passed between non-


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payment of the invoice and the petition to ini-tiate the debt adjustment process. The debtadjustment law regulates the debt adjustmentprocess only once it has been published by thecourt in the Enterprise Gazette (this took placein June 2007).

Between April 2006 and June 2007, the casewas before the court in the so-called “courtphase” in which the authority of the municipal-ity to act was not yet hindered in any way. Thecourt notified the debtor (municipality) of thepetition in May 2006. The local assembly ques-tioned the legitimacy of the contractor's claim,and referring to problems with guarantees,decided to reject payment of the invoice andeven passed a local resolution to this effect.(With this resolution, the municipality thoughtit solved the problem.)

The municipality did not question the legiti-macy of the contractor's claim in writing in theappropriate manner, thus it should have paid.Of course, the issue of repairs under guaranteeand gaining compensation from the contractorwould have been different question. From theperspective of the debt adjustment procedure,we can state that this “liability” was not dealtwith in the proper legal manner, and this mis-take is the direct cause of Nemesgulacs's bank-ruptcy procedure.

What could the municipality have done dur-ing this period? The lack of communication wasthe most significant problem. Nobody con-ducted any negotiations either with the creditor(the contractor) or with the municipality's bankabout how this relatively small invoice amount-ing to only 2.5% of the village's annual budgetwould be paid. The municipality did not speakwith the contractor, as they were “convincedthat with our council resolution, we declaredthat we did not consider the invoice acceptabledue to problems with the contractor's services.”They made their biggest mistake when theysimply did not even include this invoice in theiraccounts payable. What is even more striking is

that the auditor's certification of the municipal-ity's annual statement did not even hint at thisaccounts payable in 2004, or in 2005 or even2006. Not even the 2006 statement included a ref-erence to the bankruptcy petition that was filedin April of that year.

As the court announced the official startingdate of the procedure on June 21, 2007, severalimportant deadlines and tasks are definedaccording to the law relative to this startingdate. One of the legal consequences of thisstarting date is that the municipality's bankaccount may only be burdened with the coun-tersignature of the trustee. This can be regard-ed as the ultimate instrument in supervising thefinancial activities of the municipality. Theyregarded this as a violation of their freedom tomake decisions, since any cash or bank transac-tion could take place only under the supervi-sion of the trustee.

The municipality's bank refused any furtherlines of credit, so the only sources of revenuethat remained were normative transfers fromthe State, local taxes and some minimal busi-ness income. The law assigns mandatory tasksfor each participant in the process. The mayorand clerk are required to cooperate in briefingthe trustee in full within a short time aboutmunicipal services, financial condition, liabili-ties and institutions.

The Emergency Budget Preparation of the emergency budgets presentsthe first opportunity to examine the financialoperations of the municipality, including how itoperates its institutions and how it performs itsmandatory functions. In Nemesgulács, themayor, clerk, assembly and the newly formeddebt-adjustment committee carried out theirlegal obligations. The trustee's role was to super-vise the legality of the municipality's activities asan operational of the court. It is completely nat-ural that the municipality and the assemblyhoped for and expected the trustee to offer solu-


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tions to their problems, and to solve their finan-cial and liquidity difficulties. The trustee wasexpected to at least provide suggestions.

Based on past experiences and practices, theemergency budget is really the portion of theannual budget that applies to the period inquestion. Their 2007 budget amounted to 295million forints. The first draft emergencybudget for the June 21, 2007 to December 31amounted to 95 million forints. They had totake into account and correct for a school ren-ovation project that began in 2006 using ROP(Regional Operational Program) funds fromthe EU. The municipality succeeded in gettinga 95% grant to cover the 160 million forint pro-ject's costs. The project extended into the 2007calendar year, and as a consequence, the 2007budget showed a 125 million forint construc-tion project in the capital expense category.The emergency budget, of course, could nottake this investment expense into account, sothe corrected 2007 annual budget was reducedto 170 million forints, so the emergency budg-et of 95 million forints would have been a cal-endar-adjusted 55.9% of the original annualbudget.

The village had to break its old habits andseriously rethink how it delivered mandatoryservices and how it accounted for its costs. TheDebt Adjustment Act (Act XXV of 1996) liststhe mandatory tasks of municipalities in anappendix. The municipality may only fundactivities that appear on that list. The emer-gency budget calls for self-discipline in thedelivery of services and in the exercise of pub-lic authority functions. The debtor has toacknowledge that even during a debt adjust-ment procedure, the insolvent municipalitymust deliver the mandatory functions listed inthe law, even though it has limited capability toincrease revenues.

Why can't a municipality increase its rev-enues? The largest portion of the municipality'srevenues consists of indicator-based normative

transfers that are fortunately not affected bythe initiation of the debt adjustment process.These funds arrive month after month, provid-ing constant liquidity. In theory, the municipal-ity could increase its tax-like revenues, but inpractice, it cannot increase local taxes during abudget year. So during the 210 days that the lawallows for this phase, it is practically not possi-ble to increase revenues based on local taxes.

The municipality had to be shocked into therealization that community burden sharingdoes not mean that the municipality finances,organizes and delivers certain services entirelyat its own expense. Instead, the purpose oflocal taxes is to co-finance such activities. Forexample, in Nemesgulács the municipality paidthe cost of household solid waste removal.Though the law treats the sanitation of publicareas, solid waste collection and annual “springcleaning” of large household waste items asrequired tasks, it does not specify how costsshould be borne. The members of the debtadjustment committee thought that all publicsanitation costs were covered by the communaltax (essentially a poll tax), and thus the popula-tion had “paid for” all forms of waste manage-ment. During the debt adjustment process, thelocal assembly decided to impose a waste haul-ing fee to be paid by each household, whichmeant the local budget could save about 3 mil-lion forints per year.

After a thorough review, the followingexpenditure reductions were identified.

Fine arts instruction in the elementaryschool were reduced to be in line with the max-imum amount paid by the state normative.

Assembly members' honoraria were elimi-nated.

All capital investment projects wereremoved from the budget.

Material and supply expenses were reducedin the budgets of municipal institutions.

The public library was temporarily closedduring the debt adjustment procedure.


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The costs of the shared notary (clerk) dis-trict were reevaluated.

Nemesgulács operates a shared notary(clerk's) office with the neighboring village ofKáptalantóti. The state finances 28% of theshared office, with the balance of costs splitbetween the two villages. But costs were notshared on proportional basis. Nemesgulácswith 68% of the population of the notary dis-trict paid for more than 80% of the costs notcovered by state funds, the other village withnearly a third of the population paid for only20% of the costs. How did this happen? Theanswer was quite surprising. When the districtwas created, Káptalantóti was engaged in a cap-ital investment project and did not have anyadditional funds. So the two villages agreed tothis disproportional cost-sharing.

This problem could not be dealt with duringthe debt adjustment process, and given theshort deadlines that apply to creation of theemergency budget, and that the whole proce-dure happens within one budget year, theassembly could not make decisions or pass res-olutions within the constraints of the legisla-tive cycle. Recognition of the problem offeredanother set of ideas for the assembly's planningof future budgets.

Creditors' Claims Article 15 of the law regulates how creditorsmay file their claims upon initiation of the debtadjustment process. The trustee records allclaims submitted with 60 days of publication ofthe court's initiation of the debt adjustmentprocess. The trustee examines the claims andconfirms them within 15 days. The trusteeaccepts and confirms these claims, but does notnecessarily rank order them. This is an impor-tant aspect, since the trustee compares theclaims to the municipalities' own records,budget statements and other documents within15 days, but the trustee cannot rank order theclaims of creditors relative to each other. It is

important to note that while there still is aflicker of hope for a work out agreement with-out forced liquidation, the committee and thetrustee are in a flexible position to offer com-promises to satisfy creditor claims.

Article 20 of the debt adjustment law allowsthe trustee to propose groupings of creditorsby date, amount or any other reasonable indi-cator, all in the interest of reaching a work outagreement. The usual rank ordering using incorporate liquidations only comes into play ifthere is no agreement and the court has toorder liquidation.

In a corporate bankruptcy situation, claimssubmitted beyond the 60 day deadline are reject-ed and the creditor loses his legal rights to com-pensation. In the case of municipal debt adjust-ment, claims submitted beyond the 60 day dead-line are simply acknowledged, but may only beacted upon 2 years after the original debt adjust-ment had been declared closed by the court andpublished in the Enterprise Gazette.

Since the municipality “will not go out ofbusiness,” the creditors still have an opportuni-ty to act upon their claims in a later period. Butbased upon the experience of debt adjustmentsto date, municipalities finish these debt adjust-ment procedures with little cash and nosaleable assets whatsoever.

In our opinion, given the multi-step and com-prehensive communication requirements of thelaw (daily newspaper, local media outlet, writtennotice), it may be justified to reject claims thatare submitted beyond the 60 day deadline. In thecase of Nemesgulács, creditors had an opportu-nity to submit claims to the trustee until mid-August 2007. The court recognized and credi-tors submitted a total of 118 million forints ofprincipal and accumulated interest in claims.

How to get out of this situation? In order to identify resources available, onemust evaluate all of the municipality's assets.When examining the municipality's assets, one


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must take core property into account separate-ly, as it is protected under law if used to per-form mandatory functions. Assets available tosatisfy claims must be identified and listed sep-arately. There could be situations in whichassets that are classified as being non-nego-tiable or partially negotiable have to be reclassi-fied by the assembly in order to reach a com-promise with the creditors.

After examining the real estate assets inNemesgulacs's balance sheet, it became appar-ent that despite owning real estate withinincorporated and unincorporated areas, thoseassets that are negotiable and have market valueare rather limited in scope. Of course, even if aplot is negotiable, it may not have market valuedue to weak demand. Sales of these assets aremade more difficult by the very short statutorydeadlines made available during the procedure.While negotiating the work out agreement, itbecame obvious that we did not have enoughtime to conduct sales of real estate. So we hadto adjust the work out agreement to allow theusefulness and the future retail value of theseassets to be increased.

A proposed compromise The next important step after passage of theemergency budget and review of negotiableassets is to produce a draft work out agree-ment. The municipality must also outline itsreorganization plan that will enable it to oper-ate rationally over the long run. A successfullong term strategy enables the municipality tooffer a credible and well-founded compromiseto the creditors.

The assembly had been planning a new resi-dential zone that would consist of 27 construc-tion plots. Past budgets had been balanced bygradual sales of these construction plots. Weare talking about empty land that has not yetbeen incorporated, and changing their statusfrom farmland to construction land had beenpermitted already. But the actual reclassifica-

tion had not taken place due to excessive legalcosts that the municipality was not able toafford. This land was to be provided with waterand other infrastructure, and the municipalitysubmitted an application for funding to theCentral-Transdanubian Regional DevelopmentCouncil. The council approved a 10 millionforint grant for this purpose in May 2007.

At that point in time, of course, the RegionalDevelopment Council did not know about thedebt adjustment filing that had taken place inApril. This initial joy had turned to hopeless-ness rather quickly. It was obvious that addingcommunal infrastructure would increase themarket value of this land, as well as increase thechances of finding buyers. During contractnegotiations, it became apparent that a munici-pality that is undergoing debt adjustment is noteligible to receive such grant support. It wasnot possible to conclude the debt adjustmentprocedure during the 90 days that were avail-able to negotiate the contract with theDevelopment Council. Besides problems withthis deadline, the municipality also faced thechallenge of coming up with an amount ofmoney for cost sharing. During debt adjust-ment, and until acceptance of the work outagreement, the municipality is allowed only tospend funds for mandatory tasks, and couldnot therefore set aside funds for the cost shar-ing required by the grant described above.

Our preliminary calculations and estima-tions indicated that sales of 8 to 9 plots wouldhave generated the cost sharing amount, whilethe remaining 18-19 plots would have beenenough to satisfy almost all of the creditors'demands. While it would have taken muchlonger, it would have been beneficial for thecreditors if the construction land could havebeen prepared and sold, and a large portion ofclaims could also have been satisfied. Theassembly accepted the reorganization plan andthe proposed work out agreement inNovember 2007.


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Article 20 of the debt adjustment law allowsthe designation of three groups of creditors. Wemust mention an important precedent. The ele-mentary school had been refurbished with anEU grant starting in 2006, with the acceptanceof the finished project taking place in May 2007.Unfortunately, the financial closing had nottaken place by that time due to the start of thedebt adjustment process. The municipalityreceived ex post facto financing of 95% of theproject's cost in grant form. It became obvious,if the municipality did not pay its 5% cost share,that the entire grant amount would be lost, andthe municipality would have to pay for theentire project by itself. Instead of an 8 millionforint cost sharing payment, the entire projectcost of 81 million forints would have to be paid.So those contractors who finished the schoolproject had to be in a priority category by them-selves. If they were fully satisfied, then the 120million forints of claims could be reduced to 45million very quickly. The municipality's bankguaranteed its overdraft loan to the municipali-ty with a mortgage on municipal real estate. Wehad to take this claim into account as well, sinceif there were no agreement and the court liqui-dated assets, the law gives a priority to thoseholding mortgages over all other claimants withthe exception of salaries and related benefits.The account managing bank submitted a claimof 20 million forints of principal and variableinterest supported by a mortgage. We had to putthe bank into its own priority category for thisreason. Only the “small creditors” remained.Ironically, the creditor, that is the constructioncontractor who initiated the debt adjustmentprocedure in the first place found itself in thealso ran, “everyone else” category of creditors.This group included mostly those firms whosupported the mandatory functions of themunicipality with goods and services. Theirclaims amounted to 18 million forints.

The creditors ultimately fell into one ofthese three categories:

Group 1: The creditor whose claim was sup-ported by a mortgage (the account manage-ment bank).

Group 2: Creditors related to the EU-fundedschool reconstruction project that was finishedas the procedure was initiated by the court.

Group 3: All others including the originalpetitioner, the construction company.

The municipality made the following com-mitments in the work out agreement:

The municipality transferred 2 millionforints immediately to the bank, and asked thebank (in group 1) to allow it to pay the con-tractors on the EU project first by late-February, 2008. This meant that a creditor inthe first group essentially yielded its rights tothe contractors in the second group.

The bank in group 1 was offered a mortgageon those negotiable plots that were to be soldin future. This way the bank was assured that itwould eventually be paid in full.

With the bank's agreement, the creditors ingroup 2 were immediately paid 8 millionforints, that is the 5% cost sharing amount.This made it possible to financially close theROP supported school renovation project. TheState Treasury could then pay the balance, i.e.95%, to the contractors directly. Creditors ingroup 2 received 100% of their claims.

Creditors in group 3 would be paid as theconstruction plots were sold.

All the details of the work out plan, over-sight procedures and deadlines were recordedin the transcript of the work out negotiations.With the new mortgages on the unsold con-struction land, the bank in group 1 essentiallywas assured of being paid before “all others” ingroup 3.

Work out negotiations Work out negotiations took place onDecember 18, 2007. The invitations sent to thecreditors included a statement that they couldsign if they could not attend or did not want to


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attend. We asked the creditors to send a state-ment ahead of time if they agreed with the pro-posed work out document. This was done inorder to assure a quorum in terms of number ofattendees as well as representation of a suffi-cient percentage of total claims.

Eighteen creditors took part in the debtadjustment procedure. Six attended the workout negotiations, and an additional six sentwritten notices of their agreement with theproposed compromise. This meant that over99% of the total claims were represented. Evenwithin the creditor categories, the overwhelm-ing majority of claims were represented.

Article 24 of the debt adjustment law lists themandatory, formal contents of a work outagreement, but it details neither deadlines norenforcement methods. This is left up to the par-ties concerned. It is obvious that if the partiesreach this stage in the debt adjustment process,that it is in their mutual interest to sign anagreement that cannot be disputed later andthat such an agreement guarantees the restora-tion of a balanced budget along with the satis-faction of creditor claims. The law practicallydraws attention to the need for the creditors toretain someone to monitor implementation ofthe agreement. Such monitoring is in the inter-est of both the debtor and the creditors.

The creditors who took part in the work outnegotiation asked the bank to monitor imple-mentation of the agreement. The bank, ofcourse, can track the flow of funds through themunicipality's accounts, and can place proceedsfrom land sales into a separate debt serviceaccount which it controls. With such oversight,the bank has significant influence over the wayin which the agreement is executed by themunicipality. The court did not examine thecontents of the work out agreement, it onlychecked for formal compliance, as well asdetermined that the creditors who signed itwere authorized to sign in the first place. Thecourt does not consider whether the agreement

is in the interest of the parties concerned, nordoes it analyze the effect the agreement has onthe municipality's creditworthiness. The courtdecision ending the debt adjustment process inNemesgulács was published in January 2008.

The debt adjustment procedure executed inNemesgulács is unique among all the rest ofthese procedures so far in Hungary in that itwas the first case in which a creditor petitionedthe court to declare the municipality insolventand subject to an adjustment procedure.

Participant motivations and interests

We would like to summarize the duties, rights,tasks, interests and responsibilities of the par-ticipants by referring to some of the key eventsthat took place.

The municipality is the main stakeholderinvolved. Even though the law states veryspecifically under what conditions the mayor,even without assembly authorization, is obli-gated to petition the court to initiate the debtadjustment procedure, this only happens ifbasic mandatory tasks become endangered dueto financial problems. If we took the time tothoroughly examine Hungary's more than3,000 municipalities, then we can say withabsolute certainty that 80% of them haveunpaid invoices that are more than 60 daysoverdue. Despite this, they do not act in accor-dance with the law. Why should they? Theywould cause great difficulties for themselves,since up until insolvency they could use cur-rent revenues to pay the most importantinvoices and simply “stockpile” the rest of theirunpaid bills somewhere in short term debt inthe best case. In the worst case, these invoicesdo not ever appear in the books of the munici-pality and lay dormant until a vendor wins alawsuit. They only took the step of petitioningthe court, if they could no longer stay currentin financing mandatory tasks.


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We would like to take a detour to discuss thebank as a special type of creditor. The financialinstitution providing constant project andshort term liquidity lending is the least inter-ested in initiating a debt adjustment procedure.As long as the municipality behaves “normally”and offers solid mortgages to guarantee its bor-rowing, the bank has much formal and informalleverage over its behavior. But initiation of adebt adjustment procedure significantly hin-ders the bank's influence, not to mention theinterest and handling charges it may have tosacrifice in the meantime. Table 2 below repre-sents the cash available to Nemesgulács duringvarious phases of the procedure.

Table 2

CASH(In HUF)

June 21, 2007 1 839 653

Oct. 31, 2007 13 930 494

Dec. 18, 2007 19 293 451

Dec. 31, 2007 27 103 726

Feb. 15, 2008 14 425 878

After the emergency budget was prepared, itwas determined that the municipality qualifiesfor deficit financing grants from the Ministryof Local Government and RegionalDevelopment. So the municipality receivedgrants totaling 12 million forints in Novemberand December 2007. These funds by definitionare to be used only for financing mandatorytasks, so they could play no role in the workout agreement. The numbers speak for them-selves even without the deficit grants. Thismunicipality used its full overdraft facility of20 million forints during the debt adjustmentprocess, and was able to pay all of its invoiceson a current basis. In addition, it could also setaside funds in a reserve account.

When formulating the emergency budget,we only looked at the financial aspects of pro-viding mandatory services.11 For example, we

did not review the number of teachersemployed at the local school from a technicalperspective nor did we suggest an optimal fac-ulty size. We did not question the optimal wayof delivering primary health care or its humanresources needs. Of course, these servicedelivery options contain hidden reserves ofsavings.

The assembly learned the most during theadjustment process. Perhaps their perspectivehas changed in that serving the public is impor-tant, but all must bear a portion of the cost.One must not be deluded into proposingdream-like capital investment projects thatexceed the financial capacities of the locality,especially taking into account inefficienciesthat are not sustainable. One must not onlytake into account the current budget, and per-haps next year's budget, but should instead alsocalculate the impact of long term financialcommitments.

GENERAL LESSONS LEARNT AND POLICY PROPOSALS

The cases we have examined suggest several gen-eral lessons learnt that would help us createstricter financial discipline at the local govern-ment level. An important lesson is that suppliersand creditors alike do not consider it in theirinterest under current conditions to petition thecourt for debt adjustment proceedings against amunicipality. A study written in late 2007 con-firms12 that businesses do not blame municipal-ities for their unpaid accounts receivable. At thesame time, it may be worthwhile to revisit thisquestion in the light of numerous EU-fundedprojects. The example from Nemesgulács is alsoexemplary from this perspective.

Public administrative offices (located at firstat the county level, then regional level) were inmany cases quite familiar with the hazardousfinancial situation of municipalities and with


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their unprofessional conduct. But their author-ity only extends to determining the formallegality of municipal decisions and local legisla-tion. They cannot use their wealth of experi-ence to warn municipalities if they detect irre-sponsible financial management. The StateAudit Office does not have the capacity toaudit the most endangered type of municipali-ty on a constant basis. Prevention of financialdifficulties is an important aspect, thus it isworthwhile to redesign the entire system ofinternal and external controls at the municipallevel. Our case study demonstrates that eventhe presence of an annual compliance audit inits current form could not detect Nemes-gulacs's financial difficulties.

The town clerk (chief administrator, notary)plays a key role in either preventing or helpingto cause insolvency. Their current legal status isfull of contradictions and they are subject to thewhims of the elected officials. Municipalitiesacting on short-term political motivations didindeed engage in capital projects that had noconnection whatsoever with mandatory munic-ipal functions. The investment boom stimulat-ed by “free” EU funds has multiplied thispotential source of danger.

Changing tax rules and instable interpreta-tions of tax regulations led to two municipaldebt adjustment procedures caused by valueadded tax refunds that were later deemed illegalby the tax office. Most of the debt adjustmentprocedures happened owing to illegal andfraudulent activity. A common feature of alldebt adjusted municipalities is that their stan-dard operating procedures were faulty, had veryweak or non-existent internal controls, andlacked proper professional staff in the financialarea. These cases all pointed to the generalweakness of the public finance informationsystem. Cash-based bookkeeping, as well asviolation of basic bookkeeping rules made itpossible to avoid paying bills 60, 120 days, oreven years late, without these invoices showing

up in the books. Contingent liabilities and offthe books accounts payable simply does notshow up in the budgeting and accounting sys-tem.12 The current financial risks of largemunicipalities simply do not appear in theState's public finance information system.

In several cases, the State Audit Office hadpreviously audited municipalities and issuedwarnings about their problems that with timewill lead to insolvency and other difficulties. Wemay conclude overall that the debt adjustmentlaw provides an adequate framework to conductbankruptcy procedures. But disobeying the lawdoes not lead to any appropriate sanctions. Theprocedure is best suited for settling the claimsof creditors and is to be recommended. Afterthe court initiates the procedure by publishingits announcement in the public record, all debtscome due simultaneously. This means that allsuppliers and employees get in line with the restof the creditors. In about half of the cases so far,it was unpaid vendor and supplier invoices, andnot loan payments nor foreclosure againstmortgages that led to legal liens and forced pay-ments being applied against the municipalities.These legal actions finally convinced the munic-ipalities to obey the law and to petition for debtadjustment by first asking the court to declarethem insolvent. For this reason we propose thatthe law be made stricter with sanctions for non-reporting. This stricter approach may have apositive effect on financial discipline at the localgovernment level.

We find it to be most important that wide-spread violation of the law be punished withsanctions of some sort. Creditors and suppliersare not required by the law to initiate theseprocedures. On the other hand, mayors arerequired to announce their insolvency to thecourt if invoices are not paid within 60 days (insome cases 90). In all cases, the municipalityrepeatedly violated this provision of the law.Internal controls, independent audits, the StateAudit Office, the regional office of the State


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Treasury nor the Public Administration Officereported these violations. The sanctions thatdo exist in the law (Article 5 § (4)) are noteffective, because there is no one to enforce thelaw, nor does the State have any capacity tomonitor and detect these violations. The Statealso does not have a real time database onmunicipal budget execution. The law currentlyonly sanctions the mayor with potential finesfor non-cooperation with the court. It wouldmake sense to extend financial responsibility tothe members of the assembly and to the non-voting members of committees. For this rea-son, we propose that the debt adjustment lawcontain sanctions if a municipality does not payan acknowledged invoice within 60 days, andhence violates Articles 4 and 5 of the law. Alsoneeded would be public financial reports thatcontain explicit information on payment histo-ries, that is, the municipality is not in violationof this law. This could be similar to the audi-tor's statement, except that in the final annualaccounts of a municipality the mayor andnotary would have to certify that the munici-pality did not violate the debt limit clause ofthe Law on Local Government (Article 88) andis in compliance with Articles 4 and 5 of theDebt Adjustment Act.

A portion of the creditors and suppliers arenot fully aware of the rights that they have inthe debt adjustment law. But the exact oppositemay also be true, in that they know what willhappen during one of these procedures, wherethey stand a good chance of losing a good por-tion of the their claims of principal and perhapsall of their interest claims. They opt to choosea long cycle of lawsuits under civil law, that willbring a certain judgment and collection actionin their favor. So they choose to “wait” for themunicipality to pay. One could imagine arequirement that beyond a certain thresholdthe creditor be required to initiate a debtadjustment proceeding against a municipality.This raises constitutional issues, since it vio-lates equality before the law, in that in com-mercial bankruptcy the creditor is neverrequired to initiate a proceeding.

To solve the problem of asymmetric infor-mation, there is a need for an accessible, up todate, and credible database on municipal debtand other obligations. This could solve theproblem, assuming that the entire publicfinance system, including the central budgetand municipalities, were thoroughly modern-ized from the perspective of accounting,reporting and budgeting.14

1 For more information, see Csapodi (2007).

2 We agree with Vigvári's assertion in 2007, that thisis the key issue in Hungary under current condi-tions.

3 Act on Municipal Debt Adjustment (Act XXV of1996). Available in English at www.igeconsul-ting.com

4 The United States' first Federal municipal bankrupt-cy law is Chapter 9 of the Federal Bankruptcy Code,passed only in 1978. South Africa uses a central gov-ernment administrative procedure until the forcedsale of assets, when the court steps in.

5 For a detailed critique of Hungary's municipal sys-tem and the local government law, see Pálné (2008).

6 See Jókay et al (2004).

7 One of the authors served as the bankruptcy trusteein this case.

8 See Vigvári (2005)

9 Vigvári (2005) pointed out the problem of asym-metric information in the public finance systemand the role it plays.

10 Based on local regulations, the mayor or clerk

NOTES


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could monopolize this function. In practice, theassembly's budget committee or finance commit-tee could be in the dark entirely.

11 In an ideal situation, a complex reorganization ofthe municipality could take place in the context ofthe emergency budget.

12 The survey took place at the end of 2007 on behalf

of the Ministry of Economics. Its purpose was toinvestigate the cause of late payments in the privatesector, and the private sector's relationship withmunicipalities was a sub-topic.

13 For details see Hegedûs–Tönkõ (2007).

14 A possible road map is detailed in Közigazgatás-fejlesztési Füzetek 5. (2001)

CSAPODI, P. (2007): “A közpénzügyi szabályozástéziseinek legfontosabb üzenetei” (The most impor-tant messages of our public finance reforms theses)in Hungarian, Public Finance Quarterly (2007),Number 2

HEGEDÛS, J. – TÖNKÕ, A. (2006): “Az önkor-mányzati gazdasági társaságok szerepe a helyi önkor-mányzatok vagyongazdálkodásában: a feltételeskötelezettségvállalás (“contingent liability”) prob-lémája.” (The role of municipal corporations in localasset management: the problem of contingent liabil-ties) In: Vigvári, András (editor)(2007): A családiezüst. Tanulmányok az önkormányzati vagyon-gazdálkodás témakörébõl. (The family silver. Studiesin the topic of municipal asset management)Publications on public administration. COMPLEXPublishers, pp. 67–94

JÓKAY, K. – OSVÁTH, L. – SÓVÁGÓ, GY. –SZMETANA, GY. (2004): “Az önkormányzati adóssá-grendezések oknyomozása 1996–2003”. (“Investi-gating the cause of municipal debt adjustment: Study onBehalf of the State Audit Office of Hungary”.) Availableat: www.ige.hu,

JÓKAY, K. – SZEPESI, G. – SZMETANA, GY.:“Municipal Bankruptcy Framework and DebtManagement Experiences 1996–2000,” in Kopanyi,Mihály-Deborah Wetzel, and Samir El Daher, edi-tors, Intergovernmental Finance in Hungary: ADecade of Experience 1990–2000, (Budapest andWashington: The World Bank and the LocalGovernment and Public Service Reform Initiative,Open Society Institute, 2004).

KOVÁCS, Á. (2006): “Competitiveness andModernisation of Public Finances. SelectingScenarios in Hungary”. OECD Journal onBudgeting. Vol. 6, No. 3

LÓRÁNT, Z. – SOMOGYINÉ LEGÉNY, M. – BUKVA,A. (2002): “Az önkormányzatok költségvetési kap-csolatai 1991–2001 között az Állami Számvevõszékellenõrzései tükrében.” (Municipal Ties to the StateBudget between 1991 and 2001 in light of audits bythe Audit Office,”) published in MagyarKözigazgatás (Hungarian Public Administration),Number 6, pp. 360–370

PÁLNÉ KOVÁCS, I. (2008): Helyi kormányzásMagyarországon. (Local Governance in Hungary),Dialóg Campus, Budapest–Pécs

VIGVÁRI, A. (2002): Közpénzügyek, önkormányza-ti pénzügyek. (Public and municipal finance-a text-book), published by KJK-KERSZÖV

VIGVÁRI, A. (2005): Közpénzügyeink (Our publicfinances- a textbook) published by KJK-KERSZÖVBusiness Publishing Kft.

VIGVÁRI, A. (2006): “A közpénzügyi reformokmegvalósításának egy lehetséges útja.” (“A possibleroute to implementing public finance reforms inHungary”) Public Finance Quarterly, Vol. LI, Number2, pp. 127–146

“2008-the year of municipal bankruptcies?” A con-ference organized by Local Monitoring Institute andIGE Consulting Limited. Materials available inHungarian at: www.onkormanyzaticsod.hu, For infor-mation in English see www.igeconsulting.com

Working papers on public administration develop-ment 5 (2001.): “A helyi önkormányzatok pénzügyirendszere. Az önkormányzati adósságregiszter.” (“Aproposed registry of municipal debts” -study preparedfor the World Bank and Office of the Prime Minister)(The Prime Minister's Office, Cabinet General Secretariatfor Public Administration and Regional Policy, The WorldBank, Hungarian Institute of Economics).

LITERATURE


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I

Barnabás Reke

The controlling backgroundof the financial managementof municipalities

In the study, the controlling activities that affectthe financial management of the municipalitieswere examined on the basis of the deep interviewsand questionnaire-based surveys conducted withthe staff members of the municipalities and theirinstitutions. The purpose of the fact-findingresearch was to assess the extent to which theapplication of controlling gained ground in theevolution of the financial management of muni-cipalities in 2005–2007. The purpose of the inves-tigation is to lay the foundations for a controllingmodel which may contribute to the future expedi-ence, efficiency and profitability of the financialmanagement of the municipalities.

From among the number of conclusions drawnfrom the investigation, it should be highlightedthat the answers to the questionnaire confirm thelevel of controlling knowledge of those who par-ticipated in the survey. The respondents primari-ly expect the application of controlling to improvethe effectiveness of financial management and thetransparency of the budget. Many accept the con-clusion that measuring the performance of publicservices could reduce the dissatisfaction of societywith public services. It is a general opinion thatby developing efficiency and effectiveness calcula-tions, the economic decisions could be better sup-ported by cost data, as opposed to the current jus-tifications mostly relying on income- andexpense-based data.

THE PURPOSE OF CONTROLLING ACTIVITIES, THE CONTROLLINGAPPROACH

In the budgetary organizations, including themunicipalities and the institutions controlledby them, the management of public funds hasoutstanding importance. The purpose of cont-rolling work is to meet the requirements ofbeing efficient,1 effective,2 and profitable3 inthe context of managing public funds.

The importance of controlling was realizedby the organizations of the private sectordecades ago. They spent large sums of moneyon making the feedback process as efficient aspossible. Unfortunately, this approach wasincorporated into the financial management ofthe public sector, the municipalities and theirinstitutions with significant delay, thus givingway to less efficient and often extravagantfinancing, to the lower and more beaurocraticstandards of task performance.

The practical application of controllingshould not lack a kind of controlling approachof the management, which had better be basedon a certain model developed by the manage-ment. In Table 1, we have shown a possible,recommended controlling model.

By applying the controlling approach at thebudgetary organizations:


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• besides the traditional function ofaccounting [as regulated by Act C of 2000and government decree No. 49/2000. (XII.24.)], management accounting and cont-rolling receive ever more significant roles,

• in planning, future is transformed into thepresent and this is also represented in theaccounting records as appropriations,rather than “extrapolating the figures ofthe past into the future”,

• in controlling, the person-oriented direc-tion is replaced by a process-orientedapproach,

• the static system of information isreplaced by dynamic information.

The responsibilities of controlling are thefollowing:

• to get familiar, in due time, with thoseopportunities, risks and obstacles that arerelated to the performance of the tasks,

• to establish the tactical/strategic pointsthat serve development and adjustment tothe external requirements, by this, kind ofsupporting the activities performed by themanagement.

The point of controlling, besides the identi-fication of the threats of financial managementand the assessment of the risks6, is to select,supervise and document those critical points ofthe regulation where prevention can be imple-mented in the most efficient way possible.

EMPIRICAL RESEARCH, THE METHODOLOGY OF RESEARCH

The selected research method was greatly influ-enced by the fact that the information techno-logical and methodological bases that wouldallow the practical introduction of applyingpublic service controlling are not yet availablefor the municipalities and their institutions inthe period under review. Accordingly, theresearch work is definitely of the explorativetype.

The exploration and evaluation of the control-ling applications used in the financial manage-ment of the municipalities and their institutionsas one of the independent sub-systems of thepublic finances system have been defined as a

Table 1

CONTROLLING MODEL

Source: own edition

EXAMINING THE CONDITIONS OF SUSTAINABLE GROWTH RATE

STRATEGIC CONTROLLINGIn a regional environment5: based on the examina-

tion of the equilibrium, with the typical technical

tasks and/or partial indicators, with mathematical

modeling of multiple variables

ToolsOPERATIVE CONTROLLINGWithin the technical tasks: by using a method that

is based on using the technical tasks or indicators

that characterize the activities

STRATEGIC CONTROLLINGStatic approach: by relying on the method based on

the balance sheet of the financial statements

MethodologyOPERATIVE CONTROLLINGDynamic approach: by relying on the method of

“profitability”

STRATEGIC CONTROLLINGIn the long term: increasing assets by raising

shareholder's equity

Owner's needOPERATIVE CONTROLLINGIn the short term: “profitability”4 should be realized

in the form of as many financial assets as possible


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fundamental objective. This means that it is theapplication of a management tool, i.e. public sec-tor controlling by the municipalities and theirinstitutions that is examined by the research. Theform of the research is usually a questionnaire-based survey and the analysis of documents, it isan explorative, interpretative analysis.

QUESTIONNAIRE-BASED SURVEY AT THEMUNICIPALITIES AND THEIR INSTITUTIONS

The questionnaire-based survey was conductedon an 80-element sample, comprising thefinancial organizations of the municipalitiesand their institutions. The sample was com-piled on the basis of random representativity.In the composition of the sample elements, thestarting point was to assess the level of cont-rolling-related knowledge of the financialexperts and their subordinates who directlycontrol and execute financial management andwho fulfill financial positions at the municipa-lities and their institutions.

The questionnaire used in the research con-tains five groups of questions.

In the first set of questions, controlling asthe level of knowledge of the new method ofensuring efficient financial management wasassessed. I have assessed the respondents'source of knowledge as to the application ofcontrolling, their intentions to participate incontrolling training programs in the future, aswell as their needs for the practical applicationof controlling, in nominal scales of “yes or no”.The opportunities for the qualitative improve-ment of the efficiency of financial managementwere examined in 10 groups of questions, on anordinal, five-grade Likert-scale.

The second group of questions containsthe examinations related to the statements as tothe need to apply controlling by the municipa-lities/institutions by relying on the five-gradeordinal Likert-scale.

The third group of questions deals withthe target hierarchical examination of the costcalculation practices applied by the municipali-ties/insitutions.

The fourth group of questions analyzesthe system of technical tasks performed by themunicipalities/insitutions and the issue of thelevel of computerization of the IT system oftheir financial management.

The fifth group of questions maps the si-tuation in the planning system of the munici-palities/insitutions by applying various “yes orno” nominal scales and a 5-grade ordinalLikert-scale, through qualifying the currentlyapplied planning practices.

The sixth group of questions tests thequestions of reporting and the accounting ofassets on a “yes or no” nominal scale at thefinancial organizations of the municipalities/institutions.

I have coded the completed questionnairesby using the Statistica 6.0 program package, byrelying on which I have developed a statisticaldatabase, in order to perform a further mathe-matical statistical analysis of the question-naires. I have characterized the variables mea-sured on the nominal scale by their frequencies,while those measured on the ordinal scale bythe position indicators, i.e. by the middle value(arithmetic mean). By using these, as a start, Igave a description of the individual groups ofvariables in each case. Let us now see the out-come of the questionnaire-based survey.

CONTROLLING AS A NEW METHOD OF ENSURING EFFICIENT FINANCIAL MANAGEMENT

In the group of questions called “Controllingas a new method of ensuring efficient financialmanagement”, in the questions of the firstgroup of the questionnaire, the respondentsdescribed whether they had ever heard of cont-


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rolling, and if so, from what source. Based onthe responses, Table 2 contains the level of eachrespondent's controlling knowledge, expressedas a percentage. A very high proportion of therespondents (90 percent) had already heard ofcontrolling as a new method of ensuring effi-cient financial management before the surveyhad was conducted. The high rate of familiaritycan be assessed as a favorable piece of informa-tion.

Table 2

THE RESPONDENTS' LEVEL OF FAMILIARITYWITH CONTROLLING

Responses Frequency PercentNo 8 10

Yes 72 90

Total 80 100

Then I went on with the examination byassessing the distribution of controlling know-ledge by the various sources, as illustrated inTable 3. It is also worth observing how, fromwhich source the respondents were informedof this method. From among the individualsources, colleagues were mentioned mostoften, which means that most of the respon-dents heard of controlling from their col-leagues or acquaintances. Besides this, technicaljournals were also mentioned frequently. Bytaking the specific nature of the question, aswell as the respondents into account, we canstate that the technical journals also have a sig-nificant information-carrying role.

Table 3

SOURCES OF CONTROLLING-RELATEDKNOWLEDGE (%)

Yes NoScientific conference 22 78

In a scientific journal 28 72

TV/radio 12 88

In a technical journal 48 52

From colleagues 56 44

It turns out from the answers to the questionwhether they had earlier participated in anorganized controlling training session that 34percent of the respondents had already takenpart in some organized training or furthertraining program on controlling before the sur-vey. A further 76 percent of the respondentsdid not yet attend a controlling course but as itturns out from the data indicated in Table 4,they would very probably, or definitely takepart if the opportunity arose. The distributionof the responses among the predefined indivi-dual categories is shown by Table 4.

Table 4

INTENTIONS TO TAKE PART IN ORGANIZEDCONTROLLING TRAINING (%)

Definitely 44

Probably yes 34

It depends on the circumstances 16

I do not yet know 4

No 2

Total 100

As an answer to the question whether theywould like to apply controlling methods andtechniques in their everyday work, 97 percentof the respondents said yes, they would like touse controlling as a method. All in all, it can beconcluded that the attitude of the respondentsto controlling indicates a positive approach, onthe basis of their preliminary knowledge.

As regards the sub-points of the question“How do you think the application of control-ling methods and techniques would help thefinancial management of the municipalities andthe institutions controlled by them?”, therespondents answered questions related to theapplicability of the controlling methods. Theanswers to the questions could be scored fromone to five, where five scores express absoluteagreement, and so on. The value ranking devel-oped from the scores given as answers repre-sents the attitudes of the respondents to the


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individual controlling methods and techniques.This is illustrated by the average values of Table5. It can be concluded that the respondentsmostly expect controlling to improve the effi-ciency of the financial management of the insti-tutions and the transparency of the budget.Based on their preliminary knowledge of con-trolling and their presumptions, they think thatan approach of financial management which isoriented at technical tasks/programs may effi-ciently support financial management withinthe institutional framework. The respondentsagree on that controlling would improve trans-parency and controllability in the case of theprocess of performing technical tasks by themunicipalities and their institutions as a servicearea.

Table 5

PRIORITY OF TASKS TO BE SOLVED BY THEAPPLICATION OF CONTROLLING

Description of the tasks to be solved AverageImprovement of the efficiency of financial management 4.3

Program-oriented planning 3.9

Transparency, controllability 3.9

Encouraging effect of performance measurement 3.8

Resource- and process-oriented approach 3.7

Employment of a controlling expert 3.7

Supporting the control activities of the management 3.5

Addition of a controlling module to the IT system 3.3

Incentive for providing quality public services

(technical task) 3.1

The measurement of public service performance

would enhance the satisfaction of society 2.8

There is also agreement on that, similarly tothe corporate sector, the introduction of up-to-date management tools would greatly sup-port the job of the decision-makers in mana-ging the financial processes of the municipali-ties and their institutions as well. This is exact-ly because of this that the overwhelmingmajority of the respondents would happilyemploy a controller in the area that they mana-

ge, if they had the opportunity. However,fewer of the respondents (but the averagevalue of 2.8 is still significant) think that themeasurement of public service performancewould increase the satisfaction of society withthe public services.

To sum up, through evaluating the answers,it can be stated that the respondents agreedwith the statement according to which cont-rolling improves the efficiency of the financialmanagement of the municipalities and theirinstitutions, it greatly contributes to trans-parency, controllability and program-orientedplanning. Besides these correlations, it is wellvisible that the respondents also agree withthe idea of setting up a controlling organiza-tion and the employment of a controller. It isyet another interesting correlation that thosewho think that controlling would encouragethe activities of those taking part in the finan-cial management of the municipalities andtheir institutions and would contribute to themore profitable performance of public (tech-nical) tasks, also accept the conclusion thatthe measurement of performance couldenhance social satisfaction with the publicservices.

THE NECESSITY OF APPLYING CONTROLLING

In the second part of the questionnaire, thenecessity of the practical application of cont-rolling was examined. The statements reflectthe opinions of the financial managers andthose reporting to them at the financial institu-tions and they deal with the presentation of theproblematic areas of enforcing financial effi-ciency. In the first lines of Table 6, you can readthe statements on the most problematic areas.Agreement or disagreement with the state-ments is well visible from the average values, inthe ascending order of the variables.


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Table 6

PRIORITY RANKING OF THE STATEMENTSPROVING THE NECESSITY OF CONTROLLING

Statements proving the necessity of controlling AverageWell-founded financial decisions, from the

aspect of efficiency 4.7

Existence of an independent controlling organization 4.4

Lack of management knowledge related to controlling 3.7

The information content of deviation analysis

is satisfactory 3.6

The institutions that perform the technical tasks

determine the need 3.5

Lack of management knowledge on the information

advantages of controlling 3.5

The system of technical tasks fails to ensure

transparency 3.5

Comparison of performing the appropriations 3.4

Centralized (so-called Treasury type) form of financial

management 3.3

The information content of deviation analysis is

satisfactory 2.7

Independence of financial organizations performing

technical tasks 2.1

The lack of well-founded financial decisionsfrom an efficiency aspect was indicated as themost problematic area. The respondents thinkthat the existence of an independent control-ling organization would greatly improve theassessment of the previous statement. Theavailability of the appropriate details of thetechnical tasks would provide a transparentbudget, which seems to be supported by the 3.6average of the statement “The informationcontent of deviation analysis is satisfactory”and the 3.5 average value of “The system oftechnical tasks fails to ensure transparency”.

RENEWING THE METHOD OF COST CALCULATION

In the first part of the third group of questionsof the questionnaire, the 9 targets to be reached

in connection with the usability of controllingwithin the municipality institutions weredefined as target deficits (see Table 7). As theindividual elements as targets are statementswith absolutely different contents, it is a ques-tion how important these targets (targetdeficits) are for the respondents. If we deter-mine the order of frequency, a priority rankingof the targets is determined by the individualaverage values for the individual answers. I haveset up the order of the targets on the basis ofthe average scores. The ranking of the targetsrepresents how important change is regarded inthe area in question.

Table 7

THE NEED FOR RENEWING THE METHODS OFCOST CALCULATION EXPRESSED AS THE

AVERAGE OF RELEVANCE VALUES

Variables related to cost calculation AverageCost calculation as an effectiveness control 4.7

Cost calculation as an efficiency control 4.5

Regular comparison of appropriations and

cashflow figures 4.2

Application of a cost calculation that provides

a basis for the appropriations 3.9

Application of total cost calculation 3.3

Cost calculation in determining the optimum

decisions 3.1

Making up for missing cost data 3.1

Cost calculation in evaluating the performance

of the organizational units 2.6

Determining unit (specific) costs 2.5

It is obvious that the areas that need changethe most, i.e. cost calculation as an effective-ness control and cost calculation as an effi-ciency control are waiting to be implemented.This need is in harmony with the spirit of gov-ernment decree No. 193/2003. The respon-dents relatively underestimated the making upfor missing cost data, although this is of spe-cial importance, as in the lack of such data, thecalculated performance indicators are distort-


136

ed, and the decision-makers have not got suf-ficient information for making the right deci-sions.

Based on the answers to the questions aimedat assessing the general financial information,which are in the second part of the third groupof questions, Table 8 answers the question onwhat financial management methods are usedby the individual respondents for managing theeconomic processes.

It turns out from Table 8 that calculationsare performed by relying on the traditionaltools in the majority of budgetary institutions.It exerts a negative impact on improving theefficiency of financial management that,according to 66 percent of the respondents, inthese organizations, no cost calculations orcost analyses are prepared. Furthermore, thecosts are not broken down according to techni-cal tasks, as stated by 76 percent of the respon-dents. 79 percent of the respondents say thatno preliminary financial analyses are applied,and 91 percent are not aware of the significanceof break-even point cost (expense) calculation.

Table 8

DISTRIBUTION OF RESPONSES TO QUES-TIONS TOUCHING UPON GENERAL FINANCIAL

INFORMATION (%)

Yes NoUse of norms 76 24

Application of unit cost calculation 68 32

Application of project budgeting 58 42

Preliminary provision of funds 55 45

Cost calculation on the unit level 34 66

Calculation of costs of technical tasks 24 76

Performance of preliminary fin.anal. 21 79

Application of break-even point analysis 9 91

It can be assessed as a positive phenomenonthat the significance of norms is still high foreach of the technical branches, which is provenby the 76 percent evaluation, as well as the 68percent application of unit cost calculation.

THE SYSTEM OF TECHNICAL TASKS ANDTHE RELEVANT IT SYSTEM

From the answers to the questions on the sys-tem and IT system of the technical tasks, itturned out that there is a considerable diffe-rence of opinion between the institutional andprogram-oriented approaches to technicaltasks.

Table 9

THE FUTURE METHOD OF THE REGISTRA-TION OF TECHNICAL TASKS (%)

Registry orientation CasesProgram-oriented 36

Institution-oriented 64

Total 100

According to the data shown in Table 9, 36percent of the respondents think that thetechnical tasks should be treated by using amuch more program-oriented approach.However, two thirds, i.e. 64 percent of therespondents would continue to work in thetraditional framework. By examining thechoice between a program- and an institu-tion-oriented approach more in depth, we canconclude that the financial managers thinkmore in terms of a program-orientedapproach, while the managers responsible forcontrolling the performance of the technicaltasks continue to think in terms of an institu-tion-oriented structure.

Examining the issues of the efficiency of theinformation flow, its automization and the levelof the available IT infrastructure, it can be con-cluded from the responses that the IT supply ofthe organizations, as well as the efficiency of theinformation flow are both good. 72 percent ofthe respondents work on a PC linked to someIT system, by which level it is already possible toensure efficient IT support for the performanceof up-to-date controlling activities.


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THE SYSTEM OF PLANNING AS ONE OF THE FUNDAMENTAL PILLARS OF CONTROLLING

In this part of the questionnaire, I wished toassess the status of the practice of planning, byrelying on the statements referring to the cur-rent status of the planning of the municipalitiesand their institutions, in a five-grade scale. Thestatements in Table 10 focus on the weakpoints of planning, and the discrepancies thatshould be corrected. By qualifiying the state-ments, we are also able to measure the respon-dents' abilities to identify problems, i.e. to whatextent they are aware of the issues that areregarded as problems by the questionnaire.From the relevance averages generated fromthe answers to the questions, it can be conclu-ded how important the solution of the problemin question is regarded by the respondents, andwhich are those areas where changes are themost urgent.

Table 10

EVALUATION OF THE CURRENT PLANNINGSYSTEM

Statements AverageThere is no harmony between short- and

long-term plans 4.7

Use of basis-approach procedures in practice 4.4

There is a traditional annual budgetary

planning system 4.3

The connection btwn the resource planning

model and PIR is not satisfactory 3.9

The significance of technical task-based

plans is low 3.8

The level of integration of the IT system is

inappropriate 3.6

The values exceeding 3.5 measured on thescale of 1–5 are strong enough for us to claimthat the significant majority of the respondentsagree with the statements and observationsrelated to budgetary planning. In line with the

strength of agreement, it seems to be timely torenew the current practice of planning by deve-loping and introducing a new planning system.In the future, the harmony between short- andlong-term plans should be established and theexisting, traditional, basis-approach planningsystem should be transformed.

In Table 11, the financial planning habits ofthe senior and mid-level managers of the bud-getary organizations under review, as well asthose of the executive organizations thereofwere assessed.

Table 11

PLANNING HABITS, PLANNING PRACTICE (%)

Yes NoAnnual budget planning 100 0.00

Preparation of liquidity plan 77 23

Preparation of other plans 67 33

Preparation of procurement plan 65 35

Planning of refurbishments 59 41

Planning of maintenance 55 45

Cash-flow planning 22 78

Strategic planning 18 82

82 percent of the respondents do not prepareany strategic plans, they focus on annual bud-getary planning. The planning of liquidity andthe required funds already shows a much betterpicture, with its 77 percent value. The prepara-tion of cash-flow plans shows a very modest 22percent rate. As regards the procurement,refurbishment, maintenance and other plans,the planning practices of municipalities andtheir institutions show a balanced positive situ-ation. Accordingly, the practices of strategicplanning and cash-flow planning should bestrengthened in the future. In the course of thedeep interviews, the respondents regard thenecessity of strategic planning and cash-flowplanning as important for the future and theydo not think that strategic planning is replace-able by the application of the three-year rollingplanning method.


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THE PRACTICE OF ACTUAL-BUDGETANALYSIS IN MUNICIPALITY BUDGETS

This group of questions of the questionnairewas aimed at mapping the use of controllingmethods and techniques applied in the courseof preparing the budgetary reports. The yesand no answers in Table 12 refer to which plans,in what form and how are applied by the indi-vidual organizations. Apart from the struc-tured manner of the comparison of budget andactual figures, as well as the budget report, allthe variables show an unfavorable picture onthe reporting tasks on the level of the organi-zational units. There is a significant backlog inthe applicability of the controlling method inthe accounting settlements by technical tasks,as well as in the area of analyzing indicators,reporting, planning and analysis by technicaltasks and the expense owners. The analysis ofindicators, which can be regarded as a tradi-tional controlling tool, is not applied by asmany as 75 percent of the respondents whenevaluating the reports, by which they deprivethemselves of a very important tool of analysis.The reason for this may be found in the under-developed reporting practices applied by themunicipalities and their institutions, as well asthe inappropriate level of IT support.

Table 12

USE OF CONTROLLING METHODS IN THE REPORTS OF THE BUDGETARY

ORGANIZATIONS (%)

Yes NoComparison of budget and actual figures 95 5

Deviation analysis on a cause and effect basis 44 56

Agreement of report and plan structures 78 22

Accounting settlements by technical tasks 35 65

Use of indicators 49 51

Analysis of indicators 25 75

The annual financial plans are comprehensive 50 50

Detailed planning of technical tasks 43 57

Detailed planning of expense owners 25 75

SUMMARY

The answers to the questionnaire largely sup-port the controlling-related technical know-ledge of the respondents who took part in thesurvey. Based on the answers given to the ques-tions asked in the questionnaire, the respon-dents mainly expect controlling to improve theefficency of financial management and thetransparency of the budget. If they had theopportunity, the overwhelming majority of therespondents would be happy to employ a cont-roller in their respective areas. The respondentsthink that the development and introduction ofa controlling system were indispensable tasksin order to increase the efficiency of financialmanagement and improve the performance ofthe technical tasks. The respondents think thata program-oriented financial approach wouldbe able to give efficient help to financial man-agement. A high number of the respondentsaccept the statement that the measurement ofperformances could improve the satisfaction ofsociety with the standards of public services.

The majority of the respondents think thatby the application of the management infor-mation system (MIS), the budgetary institu-tions have started using the opportunitiesprovided by the modern information society,from which the widespread use of integratedcontrolling software and monitoring systemsis not so far away. The development of a cont-rolling thinking would trigger the applicationof modern cost accounting within the organi-zations, the clearer presentation of technicaltasks and project costs, better-founded finan-cial calculations and would at the same timecontribute to the quality performance of theorganization's planning, financial managementand reporting tasks. By developing efficiencyand effectiveness calculations, the financialdecisions could be better supported by costdata, as opposed to the current justificationsmostly based on income and expense figures.


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By the application of an up-to-date, integra-ted management information system, it wouldbecome possible to ensure consistency

between the mandatory tasks, services and theavailable resources.

1 Economic efficiency: from government decree No.193/2003 (XI. 26): the optimization of the costs ofthe resources used for performing a certain activity,by ensuring appropritate quality.

2 Effectiveness: the correlation between the products,services and other deliverables produced in thecourse of a certain activity, as well as the funds usedfor their production.

3 Profitability: the extent to which the objectives of acertain activity are achieved, the correlation betweenthe intended and actual effects of the activity.

4 Profitability, in this sense, is related to the evolutionof the monetary and appropriation reserves, and thecashflow result of the potential entrepreneurial acti-vity.

5 Regional environment: in this sense, it may include,for example, those institutions of the regional

municipalities, the municipalities of the settlements,the small regions, the regions, etc. which performspecific tasks and manage their finances from thebudget.

6 Risk assessment includes the estimation of risks,as well as the communication and managementthereof.•Estimation of risks: it may ensure that the criteria

and guidelines that contribute to the safety offinancial management rest on more solid, scienti-fic foundations,

•Communication of risks: here it means theexchange of risk-related information and opinionsbetween those performing risk estimation, riskmanagers and other affected parties,

•Management of risks: the activities whereby thealternative decisions are considered in view ofthe risk estimation, and if necessary, the appro-priate regulatory options are selected andapplied.

BODNÁR, V. (2001): Mire irányítják a vezetõkfigyelmét a controlling rendszerek? (What do control-ling systems call managers' attention to?), the journal'Kontrolling', issue 1

CSILLAG, I. (2001): Közpénzek, átláthatóság, pénzü-gyi fegyelem – Konferencia a költségvetésrõl,Pénzügykutató Részvénytársaság, (Public funds, trans-parency, financial discipline – conference on the bud-get, Pénzügykutató Részvénytársaság, i.e. FinancialResearch Plc.), Közgazdasági Szemle, issue 10

KÖRMENDI, L. – TÓTH, A.: (1996): Controlling ahazai vállalkozások gyakorlatában (Controlling in thepractice of Hungarian companies), TUDEX KiadóKFT, 1. edition, Budapest, pp. 19, 20 and 150

LÕKÖS, L. – REKE, B.: (2006): A gazdaságosság,hatékonyság és eredményesség kérdésköre a

közpénzen finanszírozott oktatásban, (The questionsof efficiency, effectiveness and profitability in educa-tion financed from public funds), Conference on theproduction of raw food materials, NYME-MÉK(Western Hungarian University-Hungarian Chamberof Architects), Óvár Science Day No. XXXI,Mosonmagyaróvár, October 5

REKE, B. (1995): Korszerû törvényekhez korszerûközgazdasági-elemzõ módszereket (Modern eco-nomic analysis methods for modern laws), Számvitelés könyvvizsgálat, year 37, issue 11, pp. 477–485

REKE, B. (1997): Többváltozós elemzési módszerekhasznosításának lehetõségei a vezetõi controllingmunkában (The opportunities for using analysismethods with multiple variables in management cont-rolling activities) , Social science journal Polvax, issue 2,pp. 13–27

NOTES

LITERATURE

SUPERVISION AND AUDIT

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T

Pál Csapodi

Advisory activities in theState Audit Office

The history of financial control and audit embracesseveral hundred years. It goes back to the earlyChinese empires as well as to the ancient Greekcity-states. The history of state financial audit canhistorically be divided into three main periods:from the early communities until the French revo-lution, from the French revolution until and a fewyears after World War Two and finally from then onuntil our time. We must however add that this divi-sion is evidently not “fine-tuned”.

The first appearances of advanced parliamen-tary financial audit were about 250–300 yearsago in contemporary Europe, primarily inGermany, Belgium and in some other countries.

The first traces of Hungarian public accountsand accountability, i.e. state audit, can be found inroyal treasury accounts and records. The oldestdocument dates from 1528. Public funds auditbecame a reality in Hungary after the Compromiseof 1867. The State Audit Office was founded in1870.1

My paper is not aimed at tracing the progress ofaudits performed by audit institutions, nor does itwant to analyse the activity of the supreme finan-cial audit organisation of the Hungarian state, theState Audit Office (SAO), established (re-estab-lished) on January 1, 1990. Rather, my studyintends to demonstrate that the focuses of SAOaudits are gradually being shifted from the tradi-tional computation, i.e. checking the mathemati-

cal accuracy of figures, to performance audits,programme evaluations which are also suitablefor economic analyses, and by summarising theexperience of individual audits and by the “tar-geted” processing of research results, financialaudit leads to an advisory activity that orientspublic opinion. While the reports prepared aboutaudits, which rely on stringent professional rulesand methodological requirements, continue to bea priority, the advisory activity together with thereports enables the supreme national audit insti-tutions – in view of the current challenges – tohelp Parliaments exercise their legislative andcontrol functions and to contribute to theenhancement of the operational efficiency of thepublic sector and public finances.

My essay offers an insight into how the abovepractice of the State Audit Office is developed,but it is not aimed at evaluating the content andanalysing the impacts of the various recommen-dations and written compilations made withinthe framework of the advisory activity. It couldprobably be the subject of a separate paper.

STRATEGIES OF THE STATE AUDIT OFFICE

As determined by legal obligations, based on theestablished internal decision-making mecha-nism, the president of the State Audit Office


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(SAO) may take decisions – in the average ofseveral years – on one-third of the utilisation ofthe audit capacity. Decision-making requiresstrategic direction and planning. The function ofSAO's strategy is to define – generally for a par-liamentary cycle – the major directions andinternal division of work in the audit activity andthe opportunities for the efficient utilisation ofthe resources required for carrying out the tasks.The key principle is that audits and reports arealways trying to find the causes behind the facts,and the background correlations in respect ofthe area, topic or project under review and toexplore the possibilities of improvement.

The first attempt to summarise and analysethe lessons that go beyond the findings of aspecific audit – in a formalised way – was inSAO's strategy published in year 2002. Namely,the management identified a number of areaswithin the public sector and the national econ-omy on which thematic audits should befocused. The aim was to analyse and evaluatethe operation of the given areas through SAOaudits by relying on the experience gained fromthematic audits in medium run.2

With this strategic problem solving, i.e.efforts aimed at summarising and analysing, theStrategy for year 2002 has opened a new chap-ter in SAO audits in Hungary. It has laid thefoundation for advisory activity by formulatingthe following strategic objective of priorityimportance: “…by applying appropriate auditmethods and techniques, and cooperating fromtime to time with partner audit institutions andresearch institutes, the audit office forms acomprehensive, evaluating opinion on the util-isation of public funds and public property”.3

The above basically refers to an activity –without using the actual term – which is todayusually regarded professional opinion orient-ing, as advisory activity.

Below is a quote from SAO Strategy 2006-2010 and from the regulation included in therevised SAO Audit Manual which contains the

audit methodology rules of SAO based on theabove Strategy, a regulation which now has thestatus of Audit Principles and Standards “…the mission of the SAO is to serve the secure,balanced and efficient operation of publicfinances, to support its development, tostrengthen the transparency of processes relat-ed to public funds, and the accountability ofmanaging public funds and public property.The SAO audit facilitates Parliament to exer-cise its budgetary right and to fulfil its legisla-tive and control function. It participates active-ly in the domestic and international area of theaudit profession and contributes to improvethe standard of audit culture.”4

The professional regulation, the AuditManual, makes it also clear that the audits,findings, conclusions and proposals are utilisedby the National Assembly (Parliament), thegovernment, ministries, local governments andgenerally by the audited organisations.5

The necessity and possibility of shaping pro-fessional opinion, of advisory activity, directlyderive from the salient strategic objectives andtasks which were defined by the managementof SAO – in conformity with its legal obliga-tion and in line with its mission – as a part ofthe strategy for 2006–2010 in force. Its corner-stone is that audits and the advisory activityshould promote the renewal of the system ofpublic finances in every possible way and withevery possible method, and by doing so, con-tribute to put the national economy on a sus-tainable development and growth path withsound financing.6

In order to accomplish the key objectives –reads the strategy document – SAO develops itsadvisory services, intensifies the analysing andassessment work directed at certain key areasand neuralgic points of public finances (in thisrespect, the content of the previous strategyremains the same, it “directly” carries on withit), and by doing so, it also strengthens its advi-sory function in formulating an opinion on


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budget planning with special attention to thesecurity and feasibility of the budget.7 I prompt-ly add that the systematic arrangement andanalysis of information were performed in thisspirit in cooperation between SAO and itsresearch institute, and as a result, we could pub-lish the theses which summarise the principlesof the renewal of the public finance system.

INTOSAI, THE ORGANISATION HARMO-NISING PROFESSIONAL DEVELOPMENT

In the “world of audit institutions” the mostimportant documents that are relevant eventoday and which deal with the statutes, prob-lem solving and concrete audit activity oforganisations state – sometimes only indirectly– demonstrate that in addition to audits con-ducted on the basis of consistently strictmethodological rules, the position and func-tion of the supreme audit institutions withinthe state structure and the utilisation of theiractivities can and should be interpreted in abroader horizon.

Thus the Lima Declaration, which is alsoconsidered as the “constitution” of audit insti-tutions, was adopted at the INTOSAICongress in the Peruvian capital in the autumnof 1977, defines the prurpose of the audit itselfas a part of the regulatory system. It deducesfrom the above that the audit institutions mayhelp the work of Parliaments, the executionand improvement of administrative activitieswith professional consultation and expert opin-ions, in other words, with advisory activity.8

The INTOSAI-standard (ISSAI 100) con-cerning the basic principles of governmentauditing lays down that the audit institutionsmay also provide useful information to deci-sion-makers based on their activities that bystrict definition do not qualify as auditing.With this the regulation practically outlines theframework of advisory activity.9

The general standards of government audit-ing and the standards of ethic significance(ISSAI 200) state that a degree of co-operationbetween the SAI and government is desirable incertain areas and the SAI should give advice togovernment. In terms of giving advice the reg-ulation (back then) only mentions such mat-ters as financial statements and accountingstandards and policies. As a result of consider-able reforms and new challenges in the (world)economy that had surfaced since then, not onlythe focuses of SAO audits but – depending onthe latter – the possible scope of the content ofthe advisory activity have also changed andbroadened. At the same time, the direction ofthe standards continues to be clear and impor-tant from the aspect of safeguarding the inde-pendence of audit institutions.10

It would deserve a more detailed analysishow the concepts, proposed solutions and ini-tiatives for expanding the professional scopeand content of SAO audits and for stimulatingits development at the level of INTOSAI, anorganisation dedicated to harmonise and devel-op the professional activity of supreme auditinstitutions. In the following pages I will onlygive an outline of the main direction of thechange.

The Washington Accords, adopted at theXIV INTOSAI Congress in 1992, representeda significant step in the development of theprofessional approach and professional philos-ophy behind the activity of INTOSAI, theworld organisation of supreme audit institu-tions. As opposed to the former practice, thenew goal set was now that instead of merelydescribing and examining, audits shouldattempt to improve and help and should try toinfluence the financial management of the stateand, in addition to detecting faults, they shouldmake proposals on how to eliminate them.11

It was at the XVII Congress at Seoul in theautumn of 2001 that increased emphasis wasplaced on the advisory role – directly and con-


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cretely – for the first time at the highest level ofINTOSAI. As regards the role of audit institu-tions in administrative reforms, it was statedthat INTOSAI (its Congress and professionalorganisations) were increasingly addressingissues related to the political and administrativeorganisation of the state and other similar top-ics instead of the questions that were tradition-ally focused on in the past. The identity of thesupreme audit institutions changes and renew,and as a consequence, audit institutions mustassume an advisory role in the implementationof reforms by using their professional experi-ence.12

The conference held in Washington in thespring of 2006, which was a significant step in theprofessional convergence process of the WorldBank and INTOSAI, shows the new focuses ofthe activity of audit institutions and their inter-national organisation and the significance ofmodern performance audits that go beyond tra-ditional arithmetical controls and regularityaudits. It was stressed at the conference that theprofessional relationship of the two world organ-isations is based on the responsibility demon-strated by both systems of institutions in theefficient utilisation of public funds, in goodfinancial management and governance.13

It is considered as a milestone in the morethan fifty-year history of INTOSAI that, forthe first time, a middle-range strategic plan wasadopted, aimed at developing the internationalorganisation, at the XVIII INTOSAI Congressorganised in Budapest in October 2004. Theplan was devised to develop the world organi-sation in the light of the macroeconomic andsocial challenges. At the latest event, the XIXCongress, which was held in Mexico City onNovember 2007 and was dominated by theevolving trend of modernization, tasks werespecified in connection with the expandingadvisory role and the independence of supremeaudit institutions, and the new structured sys-tem of audit methodology rules.

Decision was made at the Congress that theindividual audit types and their interrelationshould be redefined in view of the economicand social changes. One of the most importanttasks is to clarify how to make the relation andinteraction between performance audits andprogram evaluation more intensive based onthe assumption that program evaluation can beviewed as a particular branch of program-cen-tred, system-oriented performance audit.14

ADVISORY ACTIVITY AT FOREIGN PARTNER ORGANISATIONS

Adjustment to the changing needs and newchallenges of the world is illustrated by the factthat there is an increasing number of exampleseven in the activity of foreign partner organisa-tions for the utilisation of the capability ofSAO audits to reveal and analyse facts and, asits particular form, for the gaining ground ofthe professional opinion-orienting consultingand advisory role.

Building on studying the professional litera-ture and various documents, and on short pro-fessional exchange of experience or on the les-sons of conferences, we can only draw the con-tours of typical solutions as we have no empir-ical evidence. We have no information on howthese consultations and advisory activity“work” in practice abroad and how efficientthey are. But the mere fact that such activityhas become a practice in several countries – inaddition to those mentioned below, e.g. inBelgium, Denmark, France, Russia, Slovenia,Turkey – speaks for itself.

The function and objective of our mostimportant professional co-operation partnerour British sister organisation, the NationalAudit Office (NAO) are lively described by itsvision and key strategic principle which is nomore, no less than “helping the nation spendwisely”.


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The NAO has been consistently promotingthe economic initiatives of the central govern-ment aimed at reforms for years. In these seriesof initiatives, mention is to be made of theNAO's participation in the programme, enti-tled Modernising government, which was pub-lished by the Prime Minister in the autumn of1999 . The aim of the programme was to betterorganise, manage and operate, in other words,modernise the large community supply sys-tems, education, health and justice. The Britishsister organisation issued a declaration on sup-porting the programme and tried to foster itsimplementation with its audits and advice.

In his paper published in the Public FinanceQuarterly, the president of the NAO explainedthat they take part in the efforts of the BetterRegulation Commission in an organised man-ner. The Commission provides independentadvice to government. The NAO has given andis giving advice with the purpose of improvingthe information background for the budget,modernising budget accounting and renewingthe related management and direction activity.Its report titled the “Progress in improving gov-ernment efficiency” describes the possibilities ofimproving efficiency. The President also stressedthat the NAO is making an effort to meet itslegal obligations and its mission summarised inthe above slogan in an increasing number offields, through performance audits carried out inthe British public sector and with continuousadvisory activity based on these audits.15

The active influencing, advisory role of theGerman partner organisation in developingbudgetary chapters and the budget of min-istries has been dominant since the 1969reform of the Federal Budget Principles Act.The German audit office takes part in thebudgetary negotiations of the Federal Ministryof Finance and the ministries. It has alsobecome a general practice that opinions areprovided on laws affecting public finances in anorganised manner.

In addition – and this is a peculiar featureand fairly important one for our theme – thepresident of the audit office is (not automati-cally, but apparently always) assigned to thepost of Federal commissioner for the efficien-cy in administration (Bundesbeauftragte fürWirtschaftlichkeit in der Verwaltung). Thecommissioner endeavours to promote theorganised and efficient performance of federalgovernment administrative duties throughexpert opinions and proposals made explicitlyin the form of giving advice. He has no separatestaff, but relies on the professional capacity ofthe audit institution and on his audit experi-ence.16 This special assignment and advisoryrole are also treated in the professional litera-ture dealing with the statute and operation ofthe German partner organisation primarilyfrom the perspective of legal administration.17

In Finland the supreme audit institutioncomprises an Advisory Board set up as stipulat-ed by law. Its members are government offi-cials, MPs, leading members of local govern-ment associations, well-known economicexperts and leading officials of the supremegovernment control organisation.

The audit institution of Norway has made ita general practice to continuously summariseand evaluate audit experience, and building onsuch experience, it makes recommendations tocontribute to the operation of the financial sys-tem as an external advisory organisation.

It is also part of the work of such a – geo-graphically – distant partner organisation as theAudit Office of New Zealand to provide adviceto financial government and to give answers tovarious central and local administrative organi-sations in consultation questions affecting pub-lic funds.

And looking at our neighbours, we can seethat the supreme audit institution of Austria –in line with its strategic principles – lays specialemphasis to on co-operating with its auditeesin the spirit of trust, as well as conducts con-


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sultation in connection with its audits. Its workof expressing expert opinion on draft laws isalso of an advisory nature.

The activity of the US Audit Office has fromthe very first been built on professional analy-sis and evaluations in well-defined themes. Itsprimary “output” is providing expert opinionand advice at the request of the Congress andits member.

This brief insight into the practice of partnerorganisations serves as an illustration withoutaiming at providing a full picture, but it canundoubtedly demonstrate that beyond the tra-ditional audit function, the range of activitiesperformed by foreign audit institutions isbecoming more and more diverse and they aremaking more and more extensive use of theirprofessional capacities. Today the supremestate audit institutions do not only producereports on individual audits – carried out byapplying international standards – but they alsosummarise their experience to contribute tothe work of legislators and (financial) govern-ment through defining well-specified (nation-al) economic issues and revealing correlationsthat may have an impact on the above and bygiving advice that shapes opinion and by pro-viding expert opinion on legal provisions.

ADJUSTING TO THE NEW TASKS – COMMUNICATING THE CHANGES

Although it deserves special attention how thelegal obligations and rights of the financial andeconomic audit organisation of Parliamenthave almost continuously broadened alwaysrapidly and considerably adjusting to econom-ic changes, its detailed description would how-ever go beyond the confines of my paper.

In addition to auditing, counter-signatoryand reporting rights and obligations, the SAOhas been assigned with particular duties thatcannot be classified as advisory activity. But

these duties are to some extent similar to it tothe extent inasmuch as they assist the work ofother organisations that relying on SAO's inde-pendence and on its objective, professionalactivity. We can mention, for example, that thepresident of the State Audit Office expresses anopinion on the proposal made for the auditor ofthe National Bank of Hungary, he makes pro-posal for the chairman of the supervisory boardof the Hungarian State Holding company, forauditors of separate state funds and – underspecific conditions – for the chairmen of state-owned companies.

I do not go into details of SAO's scope ofduties. I merely indicate that the adjustment tonew challenges and the broadened range ofduties have been accompanied with a moderni-sation of the organisation and work organisa-tion. The professional regulatory system andthe audit methodology have also improved andhave been enriched with the applicable ele-ments of the so-called best (leading) interna-tional practice.

The background work facilitating the adjust-ment and the preparation of the president's deci-sions of strategic importance have been suppor-ted and are supported by the President'sAdvisory Board with the help of external expertsthrough professional workshop discussions andadvisory activity. The Methodology Committeehas fulfilled and fulfils similar professional selec-tion, assessment and advisory functions.

Based on the recognitions gained in thecourse of the ongoing transformation anddevelopment as well as on the experience ofcarrying out new tasks, the professionaldebates and exchange of ideas within SAO havetaught the organisation a number of lessonsand contributed toward formulating new ques-tions and future tasks. The above is traceable inthe communication and professional publica-tions of the changes.

One of the most comprehensive, systematis-ing publications is Árpád Kovács's already cited


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textbook with a title which speaks for itself:“Financial Control and Audit in a ChangingEnvironment”. A professional “forerunner” ofthe work is the collection of theses presentedby the president of SAO for obtaining univer-sity habilitation. The novelty of the book isthat Kovács treats audit experience as a meansof self-learning in the society and finds itimportant to develop SAO's advisory role andthus to strengthen the service character ofSAO audits even with a view to clearly inter-preting audit experience.18

Following the theses, when analysing SAOstrategy 2002 and 2006 in his habilitation pres-entation, the president of the audit officeunderlined that there was a need for SAOaudits that facilitate the transparent andaccountable utilisation of public funds andstate assets. In order to accomplish that – heconfirmed – SAO undertakes advisory, finan-cial and scientific research role and, by makinguse of its active involvement in the internation-al audit community, it and contributes toenhancing the efficiency of the domestic finan-cial audit system.19

There is a long list of official functions aswell as various professional events, confer-ences, round-table discussions organised withthe contribution of SAO, where SAO's leadingexperts and/or president spoke about thechanging and growing role and, none the less,about the responsibility of SAO audits and theadvisory function that goes beyond individualaudits just at the time when in the middle ofour decade the analysing, evaluating and advi-sory roles considerably strengthened in SAO'swork.

It is important to mention, for instance, thecontribution made by the president of SAO inthe parliamentary debate of the 2005 budgetarybill on October 29, 2004. He referred to thefact that an increasing number of Europeanaudit offices form an opinion, in some form orother, about the soundness of budgetary bills

and that the Hungarian SAO's work of provid-ing opinion – in line with its relating legal obli-gation – is advisory activity. In the frameworkof this work SAO makes an attempt to pointout more extensive international economiccorrelations, trends by formulating its opinionin a broadened perspective.20

The different presentation and contributionscan be followed closely at annual conferencesof financial experts and leading officials andalso at unique events such as the Conference ofYoung Researchers.

At the so-called Financial Summit in August2006, the president of SAO put the responsi-bility of the organisation in the limelight. Basedon this responsibility the SAO should provideadvice to Parliament for situation analysis anddecisions by relying on and going beyonddirect audit findings.21

The president was analysing this subject areaat the Conference of Young Researchers indi-cating that although specific policy issues felloutside the scope of SAO, audit results arestudied in a wider context and published with-in the framework of giving advice in line withinternational practice.22

Based on the above description which is cit-ing examples rather than aiming at providing afull picture, it should be clear now that theAudit Office's activity is characterised by abroadening horizon and its advisory activity isjustifiably gaining ground. This feature is aproper adjustment to the mainstream activityof the Audit Office in which the modernisationof audit activity has become dominant. This isunderlined by the Preface to the revised AuditManual's second edition written by the presi-dent of SAO: “The new forces that are shapingthe economy and the society as well as the var-ious mechanisms that impact them compel usto gradually shift the focuses of SAO's activity.Instead of accounting-based audits and focus-ing on organisations and their reports andrecords, there will be an increasing need for


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audits and analyses in the future which provideassistance for parliamentary decisions and forlegislative and audit functions in the course ofpreparing and approving various developmentplans and programmes.”23

FACTS AND DATA ABOUT SAO'S ADVISORY ACTIVITY

In the recent years – as the saying goes now –theory has been translated into daily practiceand the new emphases of SAO's activities havebecome prevalent in its every day work.

This new trend is also facilitated by SAO'smanagement whose members were and areaware of the fact that the broader SAO's scopeof audit activity and the more intensive its par-liamentary contacts are (and in both aspectsthe SAO of Hungary is among the “pioneers”in international comparison), the greater com-petence it will have in planning its own tasksfor years to come with a view to the public andthe national economy as a whole. This compe-tence also involves the use of those elements ofSAO's capacity which are not primarily deter-mined by law provisions.

The professional, organisational and institu-tional development of SAO is reflected in itsstrategic approach, in its consistently con-structed planning system based on planningcirculars and guidelines and above all in itswork focusing on audits, advisory activity anddeveloping domestic and international profes-sional relations. The success of the above workhas been recognised and appreciated in a num-ber of parliamentary resolutions.

Below an attempt will be made to illustrate themost important actions and results of the StateAudit Office as well as the advisory activity ofSAO's Research and Development Institute, aresearch centre closely associated with SAO. Theillustration is based on facts, data and initiativesrather than on an extensive analysis.

It is very important to repeatedly emphasisethat the analyses, evaluations and studies pro-duced as a result of SAO's advisory activity areby no means audit reports, despite the fact thatthese analyses and studies rely – to a largeextent – on the result of audits. The aboveanalyses, evaluations and studies are producedon the basis of different criteria, their focusesare also different from audits, and they oftencontain various excerpts from professional lit-erature, research results and (last but not theleast in an increasing proportion) from theproducts of SAO's research institute.

It is also important to stress that the auditexperience of the very first years was already suit-able for thematic analyses and systematisation. A200-page publication, titled “The State AuditOffice reports”, was issued already in 1994, a doc-ument which dealt with the initial experience ofaudit activity. The publication discussed the expe-rience of audit activity and the recommendationsin the form of analytical studies closely linkedwith each other. These studies already in 1994revealed and recognised facts, data and correla-tions that supported the need to revise andreform public finances and outlined some of thenecessary measures. This was the first really sig-nificant tangible opinion-orienting advisory“product” of SAO in today's sense of the term.24

It is a known fact that the report on SAO'sactivities in the preceding year is submitted toParliament for debate, assessment and adop-tion. The parliamentary resolution on SAO'sactivity identifies the future direction to be fol-lowed and specifies the new tasks. In the recentyears Parliament's resolution called for enhanc-ing the professional content of audit activity,for further developing the related methodologyand, by doing so. By doing so, it also called foran activity which can facilitate the modernisa-tion of public finances, for broadening thecompliance testing of final accounts and formodern performance audits, research and ana-lytical work and advisory activity.25


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What do the facts indicate ?

As a result of the parliamentary resolutionadopted in 2005, SAO's advisory activity hasbecome increasingly extensive and meaning-ful in content. This is partly explained bySAO's acceptance of a pioneering role inwhich, in addition to more thorough-goingand target-oriented audits, focus was gradual-ly shifted in SAO's professional profile to thepublic domain by using the studies of theResearch and Development Institute concen-trating on the financial issues of the publicfinances.

In the autumn of 2005 – under the auspicesof SAO – a renewed, joint issue of the PublicFinance Quarterly was published for the firsttime in English. This professional journal onpublic finances with a tradition of 50 yearscontinues to play an important role, it pro-vides a credible overview about the financialsystem and – in the context of the most signif-icant financial correlations – it provides infor-mation about the way the public sector and thenational economy operate, about their mainfeatures, about efforts aimed at catching upand planning the future as well as about theprofessional debates connected with the abovesubjects.

In addition to implementing the tasks speci-fied in parliamentary resolutions on SAO'sactivities, the State Audit Office's advisoryactivity has become a continuous one in therecent years. This activity is conducted in closeco-operation with SAO's research institute andwith other domestic and foreign research cen-tres and by broadening the professional con-tacts with Hungarian higher education institu-tions. As also pointed out by Gusztáv Báger ina recent publication of the research institute'sdirector, the various analytical works and stud-ies produced in the framework of SAO's advi-sory activity are frequently used in SAO's rela-tionship with universities, they often serve as a

basis of training programmes, and they are reg-ularly studied in PhD courses very much in linewith the strategic aspirations.26

The professional basis of a system-orientedperformance audit was laid down by mod-ernising the professional regulation and bypublishing SAO's renewed Audit Manual andby relying on the well-established routine workof professional audits. The methodology (themethodological guidelines) related to perform-ance audit has also been completed.

SAO has had an important contribution tothe research and analytical work conducted onstate reform, and it has also participated in theactivities of various national committees set upto combat corruption.

One of the significant advisory works waspublished in January 2004 when at the requestof the Prime Minister, SAO produced a studytitled “Opinions and Recommendations forpreparing the Government's austerity meas-ures”, a study-based series of recommendationswith professional argumentation.27

Later, in 2006, an analytical work was pre-pared at the request of the chairman of theState Reform Committee by systematising themost essential observations and conclusions ofaudit reports. It primarily attempted to identi-fy the operational problems of large communi-ty supply systems and the causes behind them.The compilation attached to the study forinformation purposes contained the recom-mendations of the SAO audits conductedbetween 2003 and 2006 concerning the abovetheme as well as answers of those addressed bythe recommendations.

Another of the significant advisory workswas the professional opinion provided by SAO,at the request of the government, about theworking document of the updated convergenceprogramme of September 2006. The expertopinion was also largely built on the audit expe-rience which was incorporated in the concreteassessment. SAO formed its opinion by August


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28 about the working document received onAugust 25, which opinion was taken intoaccount by those competent in drawing up thedocument titled the “Convergence Programmeof Hungary 2005-2009”. The publication writ-ten on the basis of the expert opinion appearedin the Public Finance Quarterly.28

At the request of the chairman ofParliament, SAO has prepared a survey aboutthe remuneration and benefits of MPs in thecontext of international comparison and aboutthe related recording and accounting issues.The survey, compiled with the aim of givingadvice, was closed with recommendations.

A brief assessment was prepared in 2007about the transformation of the healthcare sys-tem, based on audit experience relating to thehealthcare system, at the request of thePresident of the Republic of Hungary, to pro-vide him with the necessary information.

OPINION-ORIENTING PROFESSIONAL ADVISORY ACTIVITY – HOW TO CONTINUE?

Based on the above, the question is what is thefuture direction of SAO's advisory activity andwhat is the role of the decisive participation ofSAO's research institute in it?

On January 1, 2001, the Research andDevelopment Institute of SAO was established(as a legal successor of the Training andMethodological Institute of SAO) in line withthe strategic objective to place an increasinglystrong emphasis on the State Audit Office'sresearch and advisory role.29

The research and advisory activity designedto assist the parliamentary work of MPs isbased on the rich activity experience andknowledge accumulated in the course of SAO'saudit activity. By making good use of suchknowledge and experience and by utilising themost up-to-date domestic and international

research results, 2 or 3 comprehensive summa-ry studies were published annually by the insti-tute in the past seven years, these assessmentstudies with the research activity behind themare closely linked with the objectives of SAO'sstrategy relating to advisory work.30

The studies provided an analysis of certainareas of the economy, dealt with their opera-tions and concentrated on the decisive eco-nomic processes. In the past two years a num-ber of studies have also been published by theinstitute on public finances and on the ques-tion of how public finances can be mod-ernised.

One of the important milestones in the his-tory of the institute is the autumn of 2007when, at the request of SAO's president, anassessment study was produced on certain cor-relations of the 2008 budgetary bill and on itsmacroeconomic soundness.31 In addition to asummary review and assessment of economicgrowth prospects and budgetary processes, thestudy highlighted in a few selected areas of keyimportance, some of the possible risks in theconditions of the budgetary bill, and it alsodemonstrated the impacts of the planned meas-ures. The professional debates conducted bythe experts of the study also pointed out thatmacroeconomic risk assessment is always animportant and inevitable method in order toformulate an expert opinion about the budget-ary bill, such risk assessment provide decision-makers with sufficient information to payattention to (economic) correlations and criti-cal points that may jeopardise the accomplish-ment of the budgetary objectives specified inthe budgetary bill.

In 2008 the institute produced two furtherassessment studies as a logical continuation ofits earlier work.32

In May 2008, certain correlations of the 2009budgetary bill were analysed by SAO'sresearchers with a focus on how much macro-economic room for manoeuvre planning may


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have. Based on the available knowledge in thattime, this study also contained a risk andimpact analysis of the possible factors that mayexpectedly influence the budget. The study wasa unique one, because in such an early phase ofbudgetary planning usually neither the govern-ment nor the research institute is ready to pub-lish microeconomic analyses which can serve asa background material for professional debateand reconciliation of interests before drawingup the budgetary bill.

In October, the effects of the internationalfinancial crisis made it clear that the macroeco-nomic path which had served as a basis of theoriginal 2009 budget proposal submitted by thegovernment to Parliament was no longer feasi-ble. The study published by the Research andDevelopment Institute in October also con-tained a macroeconomic path which no longerpredicted any tangible economic growth. Thisstudy was distributed among MPs who directlyutilised the statements and conclusions pre-pared by the researchers with an advisory pur-pose in the course of the parliamentary debateof the 2009 budgetary bill.

As a consequence of the financial crisis, thegovernment submitted a revised budgetary billwhich in its second version contained a motionfor amendment aimed at adjusting the macro-economic path. Comments to the revisedbudgetary bill were made not only by SAO inconcrete observations but – in a supplement ofSAO's document – the budgetary forecast wasalso commented by the Research andDevelopment Institute in the form of a riskassessment with the specific aim to assist thework of MPs.

A number of different forums, such as theAdvisory Board of the President, the confer-ence convened by the general secretary andby the president have recently reviewed thepossible new opportunities generated by thesuccessful research activity of the institute.By making use of such opportunities, the

intellectual capacity of the researchers can beutilised in a more “task-oriented” way in thefuture, an approach which can furtherstrengthen the advisory activity through thecontinuous co-operation between the insti-tute and SAO.

In line with the objectives of SAO's strategyaccording to which it “ strengthens its advisoryfunction in providing an opinion on budgetplanning, with special attention to the securityand feasibility of the budget”. Accordingly,there is every reason to conclude that in thecoming few years the core activities of theinstitute will centre around the preparation andplanning of the budget as well as around anassistance work designed to renew the regula-tion of public finances. The above objectivesrepresent priorities in the present strategy inforce. In order to accomplish these goals, SAOdeveloped a compilation of studies titled “TheTheses on the Regulation of Public Finances”and submitted it to Parliament in April 200733.This document and a separate analysis dealingwith the key messages of the same documentwere later published in the Public FinanceQuarterly.34

In addition to the senior staff members ofSAO, the institute's researchers have alsoplayed a decisive role in formulating the theses.They have also participated in the repeated –but unfortunately often interrupted – effortsaimed at modernising the regulation of publicfinances. (In 2007, in this subject area the insti-tute published a study titled “State Reform, theReform of Public Finances: InternationalTrends and Domestic Challenges”.)

The possible future research priorities ofthe institute may include the following analy-ses: how can the public sector influenceHungary's competitiveness and what are thedefining factors of the public sector's compet-itiveness. Closely linked to these questions,SAO's future evaluations will cover the per-formance and efficiency of large community


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supply and distribution systems, subjects thatare also included in SAO's important strategicobjectives. The list of the Research andDevelopment Institute's studies clearlydemonstrates that the institute has also pro-duced studies with a valuable research work inthis subject area.

Finally, when the priorities of the institute'sactivities are set, there is certainly a need totake into account the important fact that thestrategy highlights the significance of combat-ing corruption and revealing the causes andrisks of corruption. This is also one of the sub-ject areas in which the institute has done con-siderable research work for years, and in theyears 2007 and 2008, together with the DutchSAO the institute conducted a successful“twinning light” programme. There is everyreason to expect that the institute will deal withcorruption as a priority in the future. SAO'smanagement has recently made a decision thatit will submit a tender bid to the NationalDevelopment Agency for a development proj-ect addressing anti-corruption as a continua-tion of the twinning light programme.According to a preliminary concept, the insti-tute will also be involved in the programme asa professional participant, the programme willoffer an opportunity to utilise the results of theHungarian-Dutch programme by helping otherparticipants, such as the ministries and otherorganisations financed by the state budget to

assess an reveal corruption risks and to preparea policy line on integrity.

* * *

The title of the study assessing the professionalprogress of the US State Audit Office is self-explanatory: The Evolution of the GeneralAccounting Office: From Voucher Audits toProgram Evaluations.35 In my comprehensivestudy I made an attempt to take a road similar tothe concept represented by the above quoted title,while focusing on the progress of the advisoryactivity of the State Audit Office. An attempt wasalso made to draw the readers' attention to thisimportant development path of SAO's modernisa-tion of its activity. It was also my intention todemonstrate that State Audit Offices in the world– and the SAO of Hungary specifically – no longerlimit their activities to traditional audit activity, afunction aimed at detecting faults and at initiatingpossible sanction. Increasingly, they are also deal-ing with risk analyses which usually concentrateon various aspects that may jeopardise the opera-tion of public finances. Today, they also conductaudits, assessments and professional opinion-ori-enting advisory work which can effectively assistparliamentary decisions and the solution of prob-lems related to public finances. Depending on thevarious impacts and correlations reflected in theeconomic and social developments and in theworld economy, SAOs increasingly also con-tribute to optimising leadership decisions.

1 For the different periods of financial audit seeBenjamin Geist's Introduction (1995) in: Studies inState Audit, page 1. One of the important Germanliterary sources on the several hundred-year historyof European audit institutions available to us comesfrom the German audit office: Bundesrechnungshof(1964). Of the Hungarian works, two specialisedtextbooks needs to be mentioned: Árpád Kovács(2003/c) and László Nyikos (2001)

2 A new element in SAO's activity is – according to thedocument – is that audit themes are selected withinits range of possibilities so as to provide a compre-hensive picture within the framework of a separateanalysis about the specific processes in a given area,about typical problems and changes and the reasonsbehind them by using the reports prepared on certainareas of the national economy during 3-4 years. StateAudit Office (2002), page 9

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3 State Audit Office (2002), page 6

4 State Audit Office (2006), pages 4 and 8 and StateAudit Office (2008), Manual 4, page 6

5 The same document points out that in addition tothe above, SAO's research institute prepares variousstudies by analysing and summarising its audit expe-rience and by using various research results, sourcesof professional literature and statistics, etc. Thesestudies are used in the course of conducting profes-sional opinion-orienting advisory activity as well asin the parliamentary and government work and theycan also be accessed by other users, universities,domestic and foreign research institutes. State AuditOffice (2008), Book 5, page 114

6 The main strategic objectives and key tasks includethe following: SAO initiates and assists the renewalof the procedures applicable to the operation, plan-ning, accounting and control of public finances, and,linked to it, the elaboration of a full and consistent(re)regulation of the financial management of stateassets. It calls for performance audits that facilitatethe more efficient operation of large communitysupply systems, as well as for comprehensive analy-ses and assessment relying on them. In addition, itdetects the risk factors related to the relationship ofpublic finances and the private economy and to theirnew investment and development cooperation, itassesses the degree of regulation of projects that areunder construction and the efficiency of the appliedfinancial arrangements. It also investigates the causesof corruption as well as areas and processes whichrepresent increased risk. State Audit Office (2006),page 6


8 “The concept and establishment of audit is inherentin public financial administration as the manage-ment of public funds represents a trust. Audit is notan end in itself but an indispensable part of a regula-tory system whose aim is to reveal deviations fromaccepted standards and violations of the principlesof legality, efficiency, effectiveness and economy offinancial management early enough to make it pos-sible to take corrective action in individual cases, tomake those accountable accept responsibility, toobtain compensation, or to take steps to prevent –or at least render more difficult – such breaches.”(Lima Declaration, Section 1 – INTOSAI ISSAI 1,traslated by Malatinszkyné dr. Irén Lovas andZoltán Gidai, 1999). Furthermore: “When neces-sary, Supreme Audit Institutions may provide

Parliament and the administration with their profes-sional knowledge in the form of expert opinions,including comments on draft laws and other finan-cial regulations. The administrative authorities shallbear the sole responsibility for accepting or rejectingsuch expert opinions; moreover, this additional taskmust not anticipate the future audit findings of theSupreme Audit Institution and must not interferewith the effectiveness of its audit.” (LimaDeclaration, Section 12)

9 “Supreme audit institutions often carry out activitiesthat by strict definition do not qualify as auditing,but which contribute to better government”….“These non-audit activities provide valuable informa-tion to decision-makers and should be of consistent-ly high quality.”

10 “A degree of co-operation between the supremeaudit institution and the executive is desirable insome areas. The supreme audit institution should beready to advise the executive in such matters asaccounting standards and the form of financialstatements. The supreme audit institution mustensure that in giving such advise it avoids anyexplicit or implied commitment that would impairthe independent exercise of its audit mandate .”


12 Árpád Kovács (2003/c), page 237

13 Gusztáv Báger (2006), page 248


15 Bourn, Sir John (2006)

16 Based on a long tradition dating from the era of theWeimar Republic, the prevailing president of theGerman Federal Audit Office (German acronym:BRH) fulfils the post of Federal Commissioner forthe efficiency in administration (in German:Bundesbeauftragte für Wirtschaftlichkeit in derVerwaltung, acronym: BWV). Delegating this posi-tion of the federal commissioner to the president ofthe Federal Audit Office is, in principle, not auto-matic (as it is a separate function), but this is thegeneral practice. Every time a new president isappointed as head of the BRH, the person is simul-taneously assigned to the BWV-post. The BWV endeavours to encourage more efficientperformance of federal duties with its advisoryactivity through proposals, expert opinions andstatements. On top of the federal public administra-


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tion sector, it may also deal with separated stateassets and with federal enterprises. The BWV maycarry out a given advisory assignment upon therequest of the federal government, a federal minis-ter, any “part” of the federal executive (Bundestag,Bundesrat) or at his own decision. Ministers areobliged to inform the BWV of any organisational orother measure of financial significance, unless theyhad already done it towards the BRH according to aspecific legal regulation. The BWV may order data collection after prior noti-fication is received from a competent ministry. Theorganisation affected by the data collection isobliged to assist the work. Before the BWV submitsthe prepared documents to organisations other thanthe government, the Bundestag and the Bundesrat,he must obtain approval from the competent min-istry whose professional area the information, datacollection results concern . (This limitation is inharmony with the limited access to a number ofBRH audit reports.)The salient part of BWV-documents represents 14volumes published so far within an independentseries of publication. The last five volumes are enti-tled as follows: 1 Allocation and utilisation of feder-al subsidies directed outside the federal sector andserving public duties; 2 Federal motorways –Planning, Construction, Operation; 3 Federal sub-sidies for overground construction projects; 4.Problems in implementing tax taws; 5 Involvementof external experts in federal public administration.Apart from the volumes published in the series,there are more, generally shorter BWV papers (afew-page statements, etc.). The BWV documentshave no unified structures – as they are of differentlength, type and purpose. The structural solutionsapplied are in any case similar to those of the BRHthematic reports which likewise have no uniformstructure.

17 Fuchs, Arthur (1966)

18 It reads in thesis number 7: “…the activity ofsupreme audit institutions, the publicity of theiraudit experience and their communication to thepublic constitute an essential part of the self-learn-ing process of the society. An audit result consistsnot only in revealing concrete irregularities, enforc-ing the proper utilisation of public funds, but also inreinforcing society's awareness of standards andnorms. Therefore, I regard it an important questionthat SAO audit findings should be utilised widelyand the advisory and service character of SAOshould be strengthened.” Árpád Kovács (2003/a),page 27

19 Árpád Kovács (2003/b), page 18

20 The message of the parliamentary contribution wasthat “…the State Audit Office gives an opinion onthe soundness of the budgetary bill in accordancewith its legal obligation. Fifteen years ago when theorganisation was set up this activity of SAO repre-sented a unique legal stipulation. Today similar con-cepts and recommendations are requested from theaudit office in most countries of the EuropeanUnion. The above opinion, however, does not formany judgement on political, economic policy deci-sions, so as Mr Minister has pointed out it avoidsthe questions of “why” and “what to do”, instead itattempts to focus on the risks connected with thetoolbox of implementation, and usually highlightsthe question of “how to do”. Thus, in its advisoryactivity also encouraged by Parliament, the AuditOffice does not qualify economic policy decisions.But for the first time as a result of the encourage-ment, SAO will address the main international eco-nomic correlations and trends in some detail thatshould receive somewhat more attention than in thepast, and should form its opinion on the budget in abroadening horizon based on sound theoreticalfoundation.”

21 In his presentation titled “Reform and Control”delivered at the Financial Summit of August 2006,the president of SAO highlighted that it is not theduty of supreme state audit institutions to judge theeconomic policy and fiscal policy of prevailing gov-ernments. It is however very much the duty of auditinstitutions to examine the sound foundation ofactions aimed at implementing the above policies,the risks associated with the sustainability of theprocesses leading to the goals and the related dis-crepancies. It is also their responsibility to tell to thepublic what conclusions they have made, what risksthey envisage, where they regard corrections neces-sary and, moreover, they should give advice andmethods to situation analysis and to decisions onselecting development paths based on but pointingbeyond direct audit findings in certain cases bydirecting attention to the relevant economic corre-lations and macroeconomic trends. Árpád Kovács(2006/a)

22 At the Conference of Young Researchers,Gödöllõ, October 2006, Árpád Kovács dweltupon the following: “… due to our legal statusdefined in the Constitution, it falls outside ourscope of activity to conduct policy analysis of theeconomic policy and fiscal policy of the govern-ment and measures designed to contribute


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towards their implementation. At the same time,we do feel responsible and assume responsibilityfor forming an opinion – based on the audits – onthe sound foundation of actions aimed at imple-menting the economic and fiscal policy and forcalling the attention to the risks of the measuresaimed at accomplishing our goals and to the nec-essary corrections. This becomes possible becauseour audit experience is not only published in offi-cial reports issued by the audit office which areaccessible to anyone on our homepage. We try tosystematise, analyse and publish the most impor-tant lessons of the audits taking also account ofwider economic correlations. This is usuallyreferred to as SAO advisory activity in interna-tional practice. It is naturally the de facto auditsand the reports issued by the audit office that rep-resent our main products through which we meetout legal obligation. On top of about 50–70 offi-cial audit reports, advisory activity is gaining moreand more ground in keeping with internationaltrends and the recommendations of INTOSAI.”Árpád Kovács (2006/b)

23 State Audit Office (2008) pages IX-X

24 The Preface written by the president is basicallyabout an advisory publication: “… Our publication,first of all, intends to facilitate the difficult andresponsible work of MPs by providing informationand raising awareness. It is especially important,because there are a number of new MPs in the cur-rent parliamentary cycle who have rarely or have notcome across with the reports of the State AuditOffice. This is exactly why our message is oftengeared at spreading information, which also servesthe purpose of orienting the readers' opinion.” StateAudit Office (1994), page III

25 The above can be demonstrated by ParliamentaryResolution 43/2005(V. 26.) according to whichParliament considers it necessary that “... withinits advisory activity the State Audit Office (…)should continue its summarising and analyticalwork which is published in studies focused on cer-tain groups of problems, and it should issue an up-to-date financial journal.”In its Resolution 47/2006 (X. 27.) “Parliamentagrees with the objectives of SAO's Strategy 2006-2010 and in line with them it promotes that (…)through its audits (SAO) should specifically assistin the modernisation of public administration andthe efficient operation of public finances.” In its Resolution 41/2007 (V. 23.), the supreme leg-islative body “calls SAO to use its tools to help the

research and analytical work conducted within theframework of the government reform.”In its latest resolution – Res. 72/2008 (VI. 10.) –Parliament ratified the objectives laid down inSAO's Strategy 2006–2010 and set forth that “…theorganisation should continue its advisory activityand make it a regular practice, and should apply – indeveloping audit activity – high priority system-ori-ented performance audits which are also suitable forthe economic assessment of professional pro-grammes”

26 “…the studies and analytical background materialscan also be well utilised in the sense that they serveas a basis for university training programmes, theyprompt new research in PhD courses and variousresearch institutes, and provide points of referencewhich are also assisted by the growing number ofSAO publications in professional periodicals.”Gusztáv Báger (2008), page 120

27 In conclusion of the document – on page 23 – theState Audit Office underlined that “…those high-lighted to the government affect in their entirety theoverall system of public finances and public assets.Although a part of these does not result in immedi-ate savings, we are nevertheless convinced that theirfavourable impacts can be quantified even in theshort run. The above, however, makes it necessaryto devise a uniform government action plan and toimplement it consistently.”

28 Árpád Kovács (2006): Observations about the con-vergence programme, Public Finance Quarterly,Number 4

29 According to the Deed of Foundation “ The basictask of the Institute is to support SAO in fulfillingits legal obligations, and improving external auditfunction through performing scientific researchactivity, while paying special attention to settingstrategic objectives, as well as to its advisory roleprovided to the National Assembly and the (finan-cial) government.”

30 This is illustrated by the a list – in a chronologicalorder – of the most important studies published bythe institute since 2003: •Ten years' of impatient care – components of a

possible therapy •The operation and control of the non-profit sector•Privatisation in Hungary•Medicine consumption and financing and the audit

experience of the State Audit Office in the recentyears.


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•The transformation of higher education, the mod-ernisation of financing

•From research to innovation – the present state ofD+R activity, certain aspects of its efficiency andfinancing in Hungary

•Environmentally conscious economic manage-ment and sustainable development in the light ofregulation and audit experience

•State reform, the reform of public finances:International trends and domsetic challenges

•International and domestic experience in connec-tion with PPP

•The competitiveness of the public sector and theeconomy

•An evaluation study about certain correlations ofthe macroeconomic soundness of the 2008 budget bill

•The costs of the tourism-related studies of theBalaton Region, their justification and utilisationin the 17 years since the change of the politicalsystem

•A comprehensive and exploratory study about thedegree and efficiency of support granted to

improve and develop the conditions of the Gypsypopulation in Hungary since the change of thepolitical system

•An evaluation study about certain correlations ofthe macroeconomic room for manoeuvre in the2009 budget planning

31 The Research and Development Institute of SAO(2008/a)

32 The Research and Development Institute of SAO(2008/b, (2008/c)

33 State Audit Office (2007)

34 Pál Csapodi (2007)

35 Even the expressive title of the comprehensivestudy about the history and professional progress ofthe US Audit Office alludes to its evolution fromvoucher audits accounts to programme evaluation,which shows the development direction and con-tent of the American sister organisation.

BÁGER, G. (2006): Új hangsúlyok a Világbank és aszámvevõszékek kapcsolatában (New focuses in therelationship of the World Bank and the supreme auditinstitutions), Public Finance Quarterly, Number 2

BÁGER, G. (2008): Az Állami Számvevõszék aközpénzek szolgálatában (The State Audit Office inthe service of public finances), in: Báger, Gusztáv –Bod, Péter Ákos (edit.): Gazdasági kormányzás(Economic Governance), Aula, Budapest

BOURN, SIR J. (2006) The external auditor's role inregulation, Public Finance Quarterly, Number 3

CSAPODI, P. (2007) A közpénzügyi szabályozástéziseinek legfontosabb üzenetei The key messages onthe regulation of public finances, Public FinanceQuarterly, Number 2

FUCHS, A. (1966): Wesen und Wirken derKontrolle; J.C.B. Mohr (Paul Siebeck) Tübingen

GEIST, B. (1995) Introduction, in: Friedberg, A.,Geist, B., Mizrahi, N., Sharkansky, I. (szerk.): Studiesin State Audit, State of Israel, State Comptroller's Office,Jerusalem

HAVENS, H. S. (1990): The Evolution of the GeneralAccounting Office: From Voucher Audits to ProgramEvaluations, US GAO, History Program

KOVÁCS, Á. (2003/a): Tézisek – Pénzügyiellenõrzés változó erõtérben, (Theses – Financial auditin a changing environment), Manuscript, August

KOVÁCS, Á. (2003/b): Habilitation presentation – Apénzügyi ellenõrzés hatékony mûködése, mintversenyképességi tényezõ (The efficient function offinancial audit as a factor of competitiveness),Manuscript, October

KOVÁCS, Á. (2003/c): Pénzügyi ellenõrzés változóerõtérben (Financial audit in a changing environment),Perfekt, Gazdasági Tanácsadó, Oktató és Kiadó Rt.(Perfect Economic Consulting, Training and PublishingCo.), Budapest

KOVÁCS, Á. (2006/a): Reform és ellenõrzés,(Reform and control), presentation at the FinancialSummit IV, Budapest, August 28

KOVÁCS, Á. (2006/b): Az Állami Számvevõszék és atudomány (The State Audit Office and the science),

LITERATURE


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presentation at the Conference of Young Researchers,Gödöllõ, October 2

KOVÁCS, Á. (2006/c): Observations about the con-vergence programme, Public Finance Quarterly,Number 4

NYIKOS, L. (2001): A közpénzek ellenõrzése,Perfekt, Gazdasági Tanácsadó, Oktató és Kiadó Rt. (TheControl of public finances, Perfect Economic Consulting,Training and Publishing Co.),, Budapest

Állami Számvevõszék (State Audit Office) (1994):Állami Számvevõszék jelenti …. (The State AuditOffice reports…..), Manuscript, Budapest

Állami Számvevõszék (State Audit Office) (2002):Stratégia (Strategy), Manuscript, Budapest

Állami Számvevõszék (State Audit Office) (2006):Stratégia (Strategy), Manuscript, Budapest

Állami Számvevõszék (State Audit Office): (2007)A közpénzügyek szabályozásának tézisei (Theses onthe Regulation of Public Finances) – bilingual publica-tion, April, Budapest

Állami Számvevõszék (State Audit Office) (2008):Az Állami Számvevõszék Ellenõrzési Kézikönyve(The Audit Manual of the State Audit Office),Budapest

ÁSZ Fejlesztési és Módszertani Intézet (2008/a):Értékelõ tanulmány a 2008. évi költségvetési törvény-javaslat makrogazdasági megalapozottságának néhányösszefüggésérõl, (SAO Research and Development

Institute (2008/a): Evaluation study about certain cor-relations of the macroeconomic soundness of the 2008budgetary bill), February, Budapest

ÁSZ Fejlesztési és Módszertani Intézet (2008/b):Értékelõ tanulmány a 2009. évi költségvetési tervezésmakrogazdasági mozgásterének néhány összefüg-gésérõl (SAO Research and Development Institute(2008/b): Evaluation study about certain correlationsof the macroeconomic room for manoeuvre of the2009 budget planning), May, Budapest

ÁSZ Fejlesztési és Módszertani Intézet (2008/c)A 2009. évi költségvetés makrogazdasági kock-ázatainak elemzése (SAO Research and Develop-ment Institute (2008/c) An analysis of the macro-economic risks of the 2009 budget), October,Budapest

Bundesrechnungshof (1964): 250 Jahre Rechnung-sprüfung; Frankfurt am Main, 1964

INTOSAI: ISSAI 1 Lima Declaration

INTOSAI: ISSAI 100, Basic Principles inGovernment Auditing

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INTOSAI (2007): XIX. INTOSAI, MexicoAccords, INTOSAI 2007 Secretariat, Mexico

Modernising Government Secretariat, CabinetOffice (1999): Modernising government, London


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I

László Nyikos

The legal and professionalregulation of the financialcontrol of local governmentsin some EU member statesIn Europe the concept of local government isinterpreted much more widely than it is generallyunderstood among financial auditors. InHungary this definition is mostly associated withthe local and nationality governments and onlyrarely extends to the idea that non-governmentalagencies, chambers and non-profit organisationsalso operate on the basis of the principle of localgovernment.

This study focuses only on local governments.It does not aim to describe the development of thecurrent situation in Hungary or to analyse orcriticise the effective legislation or the existingaudit practices. Here we shall describe the legalregulations applicable to the audit of local gov-ernments in some European countries.

The selection is not representative. We shall notdescribe the solutions of Southern Europeancountries (Spain, Portugal, Italy and Greece)and France or Belgium which operate with court-type audit offices. Those Member States have alsobeen left out from the study, the financial auditexperiences of which can only be studied indirect-ly through an intermediary language (Visegrádcountries, Baltic States, Scandinavian countries,Balkan States). Experience shows that due to thedifferences in the professional terminology of thelatter countries, misunderstandings occur fre-quently even if there is no need for an intermedi-ary language for understanding.

Of the 'remaining' European countries, wehave focused our attention on Austria andGermany because of our common roots and his-toric relations as well as the United Kingdom inrelation to the SAO-NAO twinning co-opera-tion. The selected countries have different publicadministration structures and different profes-sional traditions. The culture of their public lifehas a hundred years of advantage compared toHungary. The need of the population and taxpay-ers for accountability, transparency and demo-cratic requirements of publicity differs from theHungarian needs. This is because we have notmanaged to eliminate the disadvantages causedby the socialist diversion of forty years since thesystemic change. (It is not an exaggeration to talkabout further decline.) The author understandsthat there are no automatic recipes. However, wealways must, may and should learn from others.

TIMELINESS AND IMPORTANCE OF THEPROBLEM IN HUNGARY

In Hungary, the external (independent) auditof the efficiency and cash management of localgovernments were referred under the sphere ofcompetence and tasks of the Audit Office onlyafter the systemic change. The model, which iscurrently described in the effective legislation


158

and is applied in the actual practice, did nothave any history in Hungary. Until the periodof socialism, control fell under the competenceof the Minister of Interior, while the Minister ofFinance and the Minister of Interior were joint-ly responsible for the accounting regulations.The counties, towns, large and small villageswere accountable for their operation to theagencies of executive power. The accountingactivities were performed in a regulated, hierar-chy-based system: village (town) prefecturate,district administrator, county sub-prefect andminister of interior. The audit offices formedthe central component of the control system.They had a pyramid structure. The chief auditoffice of the Ministry of Interior was at the topof the pyramid, and the chief audit office of theMinistry of Finance held the highest positionin the country. The financial control 'philoso-phy' based on the audit offices, which could bedescribed as the government internal using thecurrent terminology, reflected the Hegelianconcept whereby the officer at a higher level ofthe hierarchy controls the officer subordinatedto him and each officer has a high degree ofmorale.

The current political decision-makers, mediaworkers, scientific and professional publicopinion builders know practically nothing ofthe role of the one-time audit offices inaccounting and administration processes orfinancial control.1 They did not understandvery well either that the activities of theaccountancy offices were audited by the auditoffice as an independent and external agency orthat the accountancy offices sent their state-ments of the use of public funds to the auditoffice monthly.

The (Supreme) State Audit Office, whichoperated for 80 years, did not have any tasksconcerning the cash management or operationof the local governments. During the 'socialistcontrol' (more specifically, so-called 'councilcontrol') period which lasted for four decades

of the party state, Hungary did not have anaudit office at all. When the current State AuditOffice (SAO) was established, no local govern-ments had existed yet; the system of councilsas effective with its own control hierarchy,where each level was tightly controlled by theparty. When the Act on the audit office waspassed, the last Parliament of the party statewas satisfied to declare in this respect that SAO'controls (…) the use of transfers from the statebudget at the local councils …'2. Rephrasing thesame thing according to the current defini-tions, this involved only a compliance audit.This means that originally Parliament expectedits newly established audit office to controlonly whether or not the villages and townsused the public funds allocated from the statebudget for the same purposes as they were des-ignated by the central administrative agencies.

The legislator did not clarify the professionalcontents or frequency of the audits to be per-formed by the State Audit Office, or whetheror not it 'merely' gave competence to the newinstitution, originally identified as the 'highestagency of state control' or it also involved (annu-ally) repetitive tasks with regard to all localmunicipalities, for the performance of whichthe SAO would have both professional andpolitical responsibility, either at the start (whenthe SAO was established), or ever since. Agood six months after the approval of the Acton the State Audit Office, when the Act onlocal governments was passed, the first freelyelected Parliament announced the still validrule according to which 'the operation of localgovernments is controlled by the State AuditOffice'. This declaration was made without clar-ifying the meaning of operation or the inten-tions and targets of the audits. Did Parliamentgive an opportunity to SAO or did it impose a(regular) obligation on it?

It is a fact that in 1990 the SAO could notget hold of any 'historical handholds', proce-dures or special methods for coping with the


159

audit of the finances of local governments, thenumber of which doubled after the dissolutionof the councils. It could not have adopted theformer state audit practice (i.e., the govern-ment audit methods and procedures) even if itwanted to. However, currently there is a dualexternal financial control system in the local gov-ernment segment of the budget which is expen-sive and neither of its components was proper-ly established. The functions of neither thestate audit nor the accounting audit are clear.The budget Act imposes an obligation on larg-er local governments to employ a private audi-tor, but it does not say anything about the auditof the financial statements of small local gov-ernments (more than 2,000 settlements). Forformal logical aspects, the legislator expects asolution from SAO in the latter area.According to a provision of the effectiveBudget Act stating that 'the State Audit Officeperforms the tasks of the external financial controlof the budget' also suggests that the 'highestfinancial control agency' should be obliged toenter this no one's land. And there is more!Considering that pursuant to the law the audi-tor of a larger local government is employedand paid by the local government, we can hard-ly talk about the independence of the auditor.In Hungary, the number of local governmentsin a tense (or clearly hopeless) financial situa-tion is increasing. Changes are absolutely nec-essary and should not be postponed in severalareas. With regard to the independent financialcontrol of the Hungarian local governments,

•the (annual) financial statements of (small)local governments should also be auditedby an external financial auditor, for whichactive co-operation with the HungarianChamber of Auditors (HCA) is absolutelynecessary;3

•procedures need to be developed for thecomplex assessment of the operation of thelocal governments and they must beapplied in the audits of the State Audit

Office with the purpose of assisting thelocal governments;

•the independent external audit agencyshould prepare quantified, transparent,comparable and user-friendly assessmentsand evaluations which should also be pub-lished on the internet.

LEGISLATION AND PRACTICE IN AUSTRIA

Federation (national) legislation

Austria's settlement structure is similar to thatof Hungary. Apart from the similarity of therelatively even geographic situation of residen-tial communities (Gemeinschaften), villagesand towns (Gemeinden), another factor sup-porting a useful comparison with theHungarian conditions is that, compared toNorthern Europe, in our Western neighbourcountry many settlements have local govern-ments too.

Multi-tier regulations cover the independent(external) financial control of public funds(Gebarungskontrolle). The top (federal) levelcontains the Austrian Audit Office (Österre-ichischer Rechnungshof- ÖRH), which will cele-brate its 250th anniversary in a few years.According to the Constitution, its competencehas covered the second level of public adminis-tration, the provinces (Länder) and also par-tially the third level: communities of at least20,000 residents and local associations(Gemeindeverbände), and their foundations,funds and institutions since 1929.4 This catego-ry includes 23 towns and the capital city, i.e., 1 per cent of the total local governments (seeTable 1). The competent mayors present thefinal accounts of their towns to the audit officefor audit by the end of March each year and,simultaneously, the statements are also pre-sented to the provincial government for infor-mation. ÖRH notifies the mayor of the audit


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findings, who takes his position and thenreports the actions taken to the audit officewithin three months. ÖRH also notifies thecompetent provincial government and the fed-eral government on the declarations of themayors and informs the council of the auditedtown (Gemeinderat), and simultaneously theprovincial and federal governments in an offi-cial communication (Bericht) on the financialyear by the end of the subsequent year. Then italso discloses its communication (report).ÖRH also audits those enterprises in which theparticipation of local governments in charge ofmore than 20,000 residents is higher than 50per cent of the registered capital and companiesthat are operated by the local governmentsthemselves or take part in their operation. Theaudit office may also audit the finances of localgovernments in villages with less than 20,000residents, but such audits can only be conduct-ed upon a specific request of the provincial gov-ernments. This is why within the federal auditoffice organisation, operating with approxi-mately 300 employees and divided into five sec-tions and 35 units, only one unit (AbteilungGemeindeverwaltung, Gemeindeverbände) isdedicated to the financial control of local gov-ernments. (Consequently, despite our commonhistorical roots, there are fundamental differ-ences between ÖRH and SAO in terms ofrights, interpretation of tasks and organisation-al structure.)5

The types of control of public funds, declaredalso in constitution, have developed in a historicprocess for hundreds of years. At the begin-ning, the inspections only focused on the issuewhether or not the accounts and statementsreconciled. These days, apart from the mathe-matical accuracy (ziffernmäßige Richtigkeit) theprofessional contents of audit (Ordnung-smäßigkeit) also include compliance with theeffective legislation and the review of economy,(Sparsamkeit), efficiency (Wirtschaftlichkeit)and practicality (Zweckmäßigkeit). As the

Austrian Constitution contains rather detailedprovisions on issues concerning the State AuditOffice, the Act on ÖRH practically onlyrepeats or supplements the declarations of theConstitution with regard to local govern-ments.6 The Austrian Government does nothave any financial control tasks at federal levelconcerning the local governments. Only theprovincial governments and ÖRH are compe-tent in this field.

Table 1

BREAKDOWN OF THE NUMBER OF SETTLE-MENTS BY SIZE CATEGORIES

(as of 1 January 2005)

number of residents number of settlements– 500 173

501 – 1000 426

1001 – 2500 1 131

2501 – 5000 412

5001 – 10 000 144

10 001 – 20 000 49

20 001 – 50 000 15

50 001 – 500 000 8

capital cyti 1Austria 2 359

Source: Schmid, J.: Die Stellung der österreichischer Gemeinden ineiner reformierten Bundesverfassung

Doctoral thesis on the constitutional law. RechtswisswnschaftlicheUniversität Vienna, January 2006, p. 12

Legislation at provincial level

Austria is a federal state; it consists of nineindependent provinces (Bundesland). With theexception of one, each province (and also thecapital city) has its constitution. The majorityof the provinces revised their constitutions inthe 1980s and 1990s in order to comply withthe requirements of our current age and declarethe basic human rights at the highest possiblelevel. The constitutions mention the financialcontrol of local governments which is not theresponsibility of the audit offices in terms of thefinancial statements.


161

The federal constitution authorises theprovinces to control the finances of their localgovernments in terms of economy, efficiencyand practicality (überprüft). The provinces havevarious financial control institutions(Landeskontrolleinrichtungen), the organisa-tional structure and independence from thepublic administration system of the province ofwhich are regulated differently by the variousprovincial parliaments.

A descriptive document prepared for EURO-

RAI7 classifies the provincial control agencies

into two large groups.

•The first category contains central or provincial

public administrative agencies. E.g., in the

province of Vorarlberg, which contains 96 set-

tlements, the number of residents is below

20,000 in 93 villages. The regular financial con-

trol in this category (regelmäßige Überprüfung)

is exercised by the office of the provincial gov-

ernment, and three towns are controlled by

ÖRH. The competent unit of the office

(Abteilung Gebarungskontrolle) reviews the

financial statements of all villages and local gov-

ernment associations (Rechnungsabschlüsse)

annually, and is entitled to issue resolutions of

approval with regard to them, as a supervisory

authority. Such activities of the office are audit-

ed by the Provincial Audit Office (Landes-

rechnungshof – LRH) as an external independ-

ent auditor. [In the spring of 2006, e.g., LRH

prepared a detailed report for the provincial

parliament and government evaluating its

audits conducted between 2001 and 2005. In

this period, the audited government office

inspected 89 villages. With regard to its activi-

ties, the audit office concluded, in terms of

quantity, among others, that each village was

audited every five years. In terms of the contents

of the audits, the conclusion was that they were

dominated by the classic types of financial con-

trol, i.e., compliance and regulatory aspects

(Rechtmäßigkeit und Ordnungsmäßigkeit.)]8

The federal capital (which is not only a local

government but also a province) has a control

office (Kontrollamt) established in 1920

instead of an audit office. This office is con-

trolled by a director and controls the manage-

ment of the capital city as well as all the eco-

nomic organisations in which the local govern-

ment is the majority owner in a structure of four

departments at present. In addition, it also

audits the management of public funds by the

local public administrative agencies and foun-

dations and funds with legal entity, owned by

the local government of the capital city. Such

audits are also distinguished according to math-

ematical accuracy, regularity, economy, efficien-

cy and practicality.9 Consequently, there is no

difference between the types of audits conducted

by the audit offices and other types of control-

ling institutions. The control office integrated

into public administration operates within the

magistrate subordinated to the mayor. It reports

to the control committee of the capital city

(Kontrollausschuß). The procedure, by which

its executive officer is appointed (for five years)

and recalled by the council of the capital city

(Gemeinderat) based on the mayor's proposal,

provides a quasi parliamentary feature to this

office.

•The second category contains the institutions

directly reporting to the provincial parliament

(Landtag). There are two types of such institu-

tions, the individual organisational units par-

liament (audit offices) and the control commit-

tees of parliament (Kontrollausschüsse) which

operate with the control offices.

With the exception of Vienna, there are auditoffices in each province. They report only totheir own respective parliament, and cannot beinstructed by the head of the province(Landeshauptmann). The annual regular auditof the financial statements of villages and towns isnot included among their responsibilities. Thistask is performed by the offices, departments


162

and rapporteurs of the government apparatus.The audit offices occasionally audit the activi-ties of the latter parties. In Burgenland, e.g., theexternal audit of public funds falls under thecompetence of a nine-member parliamentarycontrol committee (Landeskontrollausschuß),which has its sessions quarterly. The tasks ofthe audit office established in 2002 are regulat-ed in detail in the Constitution of Burgenland.The financial control of local governments islimited to an expert opinion on the managementof public funds of the local governments (andlocal government associations) by the auditoffice based on an order of the provincial gov-ernment (Auftrag)10. (In Burgenland province,there are only two auditors in the audit officeassigned to this field and only one of themdeals with the audit of local governments inpart of his time; more specifically, it is not evenan audit activity, only the preparation of anexpert opinion.)

The legislation of the specific provincesallows for different interpretation, which hasan impact on the degree of independence of thecontrolling organisations from the executivepower agencies. One of the issues in the con-stitutional reform disputes for several years11 ishow to draw a clear borderline of the account-ability of local governments between an auditby an audit office (Gebarungskontrolle nach Artdes Rechnungshofes) and the supervisory con-trol (Gebarungskontrolle im Rahmen derGemeindeaufsicht).12

The financial control agencies prepare anannual report (Tätigkeitsbericht) on theiractivities, which is submitted to the provincialparliament and government. The ex officioaudits are described in individual reports(Einzelberichte), addressed to the same author-ities. The special reports are submitted to par-liament as well as other agencies that sentinquiries concerning those reports or requestedthem. The reports on the audits of local gov-ernments in villages and towns, performed

upon orders, are sent only to the provincialgovernment and the mayor concerned for thepurpose of presenting them to the local council(village or town). The mayor must notify thesupervisory agencies of all the actions taken.

The various control agencies meet annually for

the purpose of exchanging their experiences. They

co-ordinate their activities with the audits of

ÖRH. There are opinions according to which the

audits requested by the provincial governments

may create a disadvantageous situation for the

audited local government, because it depicts a

worse picture about it that it should deserve.

(E.g., in Upper Austria, where there are 445 local

governments, the audit office conducts on average

60 audits each year upon request.) The local and

provincial interests are stressed contrary to the

federal interests which, obviously, the ÖRH is

trying to enforce. (The vehemence is striking,

with which the chairman of the Austrian Audit

Office proposes referring the competence of inde-

pendent financial audit of small towns, villages

and small communities into the competence of

the Federal Audit Office in the new Constitution

which is currently being drafted. This solution

would generate significant additional tasks for

ÖRH.)

The tasks of the audit offices contain theclassic types of the control of public fund man-agement in the province (Landesgebarung), i.e.,they focus on mathematical accuracy (rechne-rische Richtigkeit) and compliance. However, theso-called 'modern' audit types are also present(efficiency, economy and practicality criteria).The principle of economy means that the low-est amount of public funds should be used forachieving a specific result, but it is only desir-able if the lower expense does not underminethe quality (Minimalprinzip). The principle ofefficiency (Wirtschaftlichkeitsprinzip) reflectsthe relationship between the resources used andthe result achieved (Erfolg): have the public


163

funds been used successfully? Consequently, weshould aim at the highest possible result at a spe-cific cost (Maximalprinzip). The principle ofefficiency also involves economy. It is measuredwith external and internal comparative calcula-tions, cost benefit analyses (Kosten-Nutzen-Analysen), especially with regard to capitalinvestments. The principle of practicalityexpresses whether or not the set target has beenachieved and whether or not due considerationwas applied to choose the most favourableoption to spend the required resources (moneyand time) as well as whether or not all tasks wereperformed that could have or had to be per-formed or were allowed to be performed. Theeffective legislation does not provide for the fre-quency of the external financial control.

The audit offices are entitled to audit foun-dations, funds and institutions that are part ofprovincial administration as well as enterprisesand institutions (Überprüfung), in which theprovince is financially interested and which areoperated by the provincial government eitheralone or together with other parties. In addi-tion, any private individual and legal entitymanaging the assets of the province and forwhom/which the provincial governmentassumed a guarantee, may also be audited. Thescope of the audit also covers public low bodiesmanaging provincial claims and provincialreceivables and subsidies (Gebarung öffentlich-rechtlicher Körperschaften), and finally, uponthe order of the provincial government or thehead of government, the finances of local gov-ernments and local government associations(Gemeinden und Gemeindeverbänden). Thelegal regulations applicable to the preparationof final accounts and financial control of localgovernments are contained in the so-called'municipality law'.13

The purpose of the audits is to concludewhether or not the public funds were managedin accordance with the applicable regulations(zahlenmäßig korrekt), accurately, economical-

ly, efficiently and practically. The audit officescan make proposals not only for the elimina-tion of insufficiencies, but they can also sug-gest opportunities for decreasing or eliminat-ing tasks, generating new revenues or increas-ing the existing revenues. An audit in progressmay cover the full range of public fund man-agement or any part thereof; it may give a reli-able picture of the management of funds, ormay also be performed based on random selec-tion (stichprobenweise). Special audits(Sonderprüfungen) are performed according tothe criteria of the order or request.

The so-called permanent (regular), ex offi-cio audits (laufende Prüfungen) are distin-guished from the special audits. All decisionsabout the first category audits are made by thehead of the audit office (control office), or thehead of the financial control committee(Obmann) defining whether or not an auditshould be a complex audit or should onlyfocus on a specific area or should be per-formed based on random selection. Someprovinces prepare an annual audit plan, whichis also presented to the provincial parliament.The nature of any special audit is defined inthe order or request.

According to the Act on the audit office of

Salzburg province, special audits may be 'ordered'

(Kontrollaufträge) based on a parliament resolu-

tion, upon the request of at least one third of the

MPs or upon the request of the financial control

committee of the parliament. Requests

(Kontrollersuchen) may also be received from

the governor or the government of the province.

According to the Styrian Act on the audit office,

those capital investment projects where the total

cost of implementation is 2‰ higher than the

effective appropriation, an audit must be con-

ducted upon the request of the provincial govern-

ment. The audit office prepares an expert opinion

for the provincial government on each audited

project. The audit criteria include compliance


164

with the cost appropriations and deadlines,

implementation of the project according to the

plans and compliance with the regulations (stan-

dards) for the equipment.

LEGISLATION AND PRACTICE IN GERMANY

The audit of local governments of theEuropean country with the highest population(generating the highest GDP) depends on thehistorical structure of its public administration.The federal audit office at the top (Bund) ofChart 1 (Bundesrechnungshof – BRH) does notexercise any financial control over the localgovernments at all.14 The second level consistsof thirteen provinces (Flächenland), which arealso regional (district) local governments(Regierungsbezirk), as well as three city states(Stadtstaat). The provinces and the formerHansa cities (Hamburg, Bremen and Berlin)are the federal states forming the country

(Bundesländer). The settlements (Gemeinden)constitute the third level of public administra-tion. The towns have different positions,because part of them (in total 116) are 'countyboroughs' (Kreisfreie Städte), but the majorityof them are 'integrated into' a provincial dis-trict. Statutory supervision over the minor set-tlements is exercised by the provincial offices,while the larger ones are 'exempt' from anysuperior official supervision (AmtsfreieGemeinden).

The settlement structure of Germany (seeTable 2) is similar to the Hungarian structurewith the very significant difference that theaverage number of residents in the settlementsis much higher than in Hungary: on averagethere are 7,000 residents in each settlement. Inthe German financial control terminology,there is a distinction between a 'local audit'(örtliche Prüfung) and 'external audit'(überörtliche Prüfung). The audits in the firstcategory are performed by the audit offices ofthe towns.

Chart 1

LEVELS OF PUBLIC ADMINISTRATION IN GERMANY

Source: Wikipedia

Federation

Federal provinces

(Regional district governments)

Provincial boroughs

(Offices)

Settlements under the bor-oughs

(controlled by the offices)

Settlements outside theboroughs

(not controlled by theoffices)

Towns outside the boroughs

City states


165

Regulation at provincial level

The legal regulations of each province definethe concept (villages and towns are the basisand members of the state as a regional govern-ment of citizens, it promotes the welfare of itsresidents, it performs the tasks imposed on itby the province and the federal state; it definesthe rights and obligations of the citizens totake part in local administration), its legal sta-tus, and scope of operation of a settlement.Apart from a lot of other issues, the legal regu-lations provide for the method of qualificationinto a town district (Stadtkreise) or large town(Große Kreisstädte) and lay down the rules ofasset and fund management (Sondervermögen,Treuhandvermögen) accounting and the annualreport. They also contain requirements for theinternal audit and disclosure.15

The law on local governments of almost each

province of Germany declares the need for a spe-

cial audit of the finances of the local governments

(Kassenprüfung) by an independent external

audit agency. This primarily assumes accounting

(bookkeeping) and taxation issues. This external

control-type audit is not directly defined by law.

It may be considered as one subtype of the com-

pliance audit (Ordnungsmäßigkeit). As it is well

known, a compliance audit does not only focus

on the accuracy of bookkeeping (buchhalterische

Korrektheit), but also on general compliance

with the law (ganz allgemeine Rechtmäßigkeit).

It also checks whether or not public administra-

tion performs its tasks in accordance with the reg-

ulations and in an up-to-date fashion, whether or

not it respects the basic principles and essential

and formal requirements. The principle whereby

the important matters must be managed properly

has a priority (materieller Richtigkeit).16 Any

matter is important if it had or may have a finan-

cial impact. The so-called Kassenprüfung also

checks the accuracy of bookkeeping based on ran-

dom selection. The report on these issues is the

Table 2

NUMBER AND POPULATION OF THE SETTLEMENTS IN THE PROVINCES

Province Settlement of which towns average number of residentsRheinland-Pfalz 2,306 123 1,758

Bayern 2,056 315 6,076

Schleswig-Holstein 1,119 64 2,533

Baden-Württemberg 1,108 311 9,692

Niedersachsen 1,022 164 7,811

Sachsen-Anhalt 1,016 121 2,403

Thüringen 968 127 2,388

Mecklenburg-Vorpommern 849 84 1,995

Sachsen 497 178 8,551

Hessen 426 189 14,261

Brandenburg 420 112 6,066

Nordrhein-Westfalen 396 268 45,527

Saarland 52 17 20,061

Bremen 2 2 331,990

Hamburg 1 1 11,754,182

Berlin 1 1 3,404,037

Deutschland 12,239 2,077 6,726

Source: Wikipedia


166

basis for the exemption of the managers of the

audited organisation from their economic liabili-

ty. During the audit of bookkeeping, the follow-

ing questions need to be answered: Are the rev-

enue and expense documents available? Are the

documents classified in a timely order? Are

inventories kept in accordance with the regula-

tions? Do the contracts and resolutions exist for

the lawful wage and remuneration payments?

Were there any unnecessary expenses (e.g., default

interest)? Was the most favourable bid chosen in

public procurements? etc.

All provinces (including also the three citystates) have an audit office, but only some ofthem are directly responsible for controllingthe financial reports of the local governments.The audit offices are autonomous both withregard to the federation and BRH. Accordingto scientific research, the variable instrumentsused in the external independent financial con-trol forming part of their activities, can be clas-sified into five categories.17

The first group contains provinces (SaarRegion, Brandenburg, Lower Saxony until2005) applying the so-called integrated author-ity solution (integrierte Behördenlösung). Inthese provinces a separate office is responsiblefor the external audit (Gemeindeprüfungsamt,Kommunales Prüfungsamt). This officebelongs to the Ministry of Interior or the dis-trict government or the provincial counciloffice). The independent audits performed bythis office constitute a public task, one of thecomponents of the legal supervisory system ofthe state. In this context, its primary objectiveis to support the state supervision (staatlicheKommunalaufsicht) over the local govern-ments. German experts also describe this typeof external audit as (traditional) complianceaudit, concentrating on compliance with thepublic regulations (Rechtmäßigkeitsprüfung) forthe management of local governments.However, the activities of the offices also

reflect attempts for economic audits, such asfor example with regard to the counties(Landkreisen) and large towns (kreisfreieStädte) based on comparative indicators.18

The second group contains provincesapplying the institutional solution (Anstalts-lösung). In these provinces a separate publiclaw institution assumes the tasks of the stateand performs independent financial audits inlocal governments. They are supervised by theMinistry of Interior as the highest supervisoryauthority. The institution (Gemeinde- oderKommunalprüfungsanstalt) is financed with thecontributions of the audited local governmentsand the collected audit fees. The institutionsmay also provide consultation services in rela-tion to the regular audits for a special fee. Thissolution also focuses on supporting statesupervision. It also supports comparisons with-in the province and specialisation of the audi-tors. The institute is managed by a Board ofDirectors, which is chaired by a chairman. Thechairman is appointed by the Minister ofInterior for eight years. The members areelected for five years from the representativesof the association of local governments. Theaudits are limited to compliance audits(Ordnungsmäßigkeitsprüfung). This is explain-ed by the rights of the settlements19 to have alocal government, expressed in the constitu-tion, and that the financial control of the localgovernment is a partial function of state super-vision. (At the same time, we must also notethat the German Budget Act declares the prin-ciples of economy and efficiency.) The legisla-tion of Baden-Württemberg, Lower Saxonyand Northern Rhine Westphalia belongs to thiscategory.

For example in Baden-Württemberg towns must

establish an audit office (Rechnungsprü-

fungsamt), reporting directly to the mayor. In

smaller settlements the supervisory authority

(Rechtsaufsichtsbehörde), while in settlements


167

with more than 4,000 settlements a legally inde-

pendent state control institution (Gemeindeprü-

fungsanstalt) performs the external audit (externe

Revision der Kommunen. (This institute for

example had a staff of 160 employees in 2006 and

audited 1,503 financial statements. In addition,

it also audited the accounts of l98 towns and vil-

lages, 717 associations of local governments and

133 foundation reports. It also audited the

accounts of 226 construction projects and 14 hos-

pitals and prepared 92 so-called Kassenprüfung.

It provided consultancy services on organisation,

efficiency and special professional issues in 250

cases.)20 Both audit agencies report to the

Ministry of Interior. Neither of them has a right

to impose any sanction. During the quarterly

audits the external audit agencies rely on the

results of the 'local' audits related to the annual

accounts and the final accounts.

The third group applies a board-type solu-tion. There is only one province, Bavaria, inthis group, where this model has existed since1919. In this model the independent financialcontrol and state supervision are strongly sepa-rated from each other. The first function is per-formed by an association (BayerischerKommunaler Prüfungsverband), subordinatedonly to the law and reporting to the BavarianMinister of Interior. The association is led by adirector and has a provincial committee andpresidium. It is financed with contributionsand expert fees. (The hourly audit fees are pub-lished on the website of the association.) Theprovincial law on local governments covers theexternal financial audit (überörtlicheRechnungs- und Kassenprüfungen)21. The asso-ciation performs such audits as an authorityonly in the member local governments. Uponthe members' request efficiency audits may alsobe performed in such local governments andexpert opinions may be prepared or consultan-cy services may also be provided. The booksand financial reports of those local govern-

ments that are not members of the associationare audited by the public offices of the provin-cial council (staatliche Rechnungsprüfungs-stellen der Landratsämter).

The Bavarian local governments prepare consol-

idated financial statements, while their own com-

panies and hospitals apply the same accounting

principles as the businesses (kaufmännisches

Rechnungswesen). Technical contents of the

external audits, conducted every four years:

•Review of the fundamental rules of the fund

management of local governments and compli-

ance with the budget;

•Review of incoming and outgoing payments,

incomes and expenditures, revenues and costs,

the consolidated annual report and variation of

assets

•Compliance, efficiency and economy principles;

•Did the expenditures (including the insignifi-

cant staff and pocket expenses) lead to any

result?

The fourth group contains only thoseprovinces which chose the so-called classicaudit office solution (klassische Rechnungs-hoflösung). Part of their activities is the audit ofthe overall economic operation and budget ofthe local governments and their associations.The member of the audit office, responsible forthis task, is also a member of the board of audi-tors, therefore he also has an influence on theaudit findings related to the provincial budget.(It is well-known that the German FederalAudit Office operates as a board adopting itsaudit findings in the form of decisions made byauditor colleagues.) The provincial auditoffices operating with the classic model are partof the supervisory system operated by both thestate and local governments (Überwachungs-system – see Chart 2). They are primarilyresponsible for regulatory (compliance) andefficiency-type audits. This group containsSaxony, Mecklenburg-Forepomerany, Rhine-


168

Pfalz, Schleswig-Holstein and Sachsen-Anhaltprovinces.

In the provinces (Hessen, Thüringen)forming the fifth group the competent externalauditor is the audit office, but, compared to theprevious group, these provinces chose a modi-fied audit office solution. The most importantfeature of this solution is that the law gives theright to the president of the audit office toaudit the local governments. In this modeltherefore the audit findings are not establishedin the form of decisions of audit colleagues.The decisions are made by the president of theaudit office. He can designate the members ofhis own staff to perform audits or may alsoemploy auditors, audit companies or any othersuitable third parties for audits. Consequently,the audits are not performed by public servants(Prüfungsbeamte) therefore, this solution isalso described as de-regulation, de-nationalisa-tion or outsourcing, because the audit officedoes not directly audit the annual reports ofthe local governments.22 The law does not pre-scribe annual frequency for this task. LRH per-forms comparative audits in unspecific topics.

In Germany the federal audit office is not

authorised to audit local government, onlypart of the provincial audit offices audit thefinancial statements of the local governments.However, there is no audit vacuum in legisla-tion. There is independent financial controlover each local government at every 4–5 yearsinstead of a yearly audit. Wherever it is not theresponsibility of the audit office, it falls underthe competence of the Ministry of Interiorwith the exception of Bavaria. In six provincesthe audit offices directly audit bookkeepingand reporting, and in two provinces thisresponsibility is assigned to an external auditoror audit company. All this makes it possiblethat the law authorises the president of theaudit office and not the office itself to conductthe audits. One example for this is provinceHessen, the audit office of which 'outsourced'the audit type investigations, and it conductscomparative analyses. (See Chart 3) The auditoffices also perform performance audits, infact they prefer it to the 'classic' complianceaudits. Some laws state that the audit officemay leave certain accounts un-audited.Consequently, the Hessen audit office per-forms multi-lateral structural audits of the cer-

Chart 2

SUPERVISORY SYSTEM OF THE GERMAN VILLAGES AND TOWNS

KOMMUNALES ÜBERWACHUNGSSYSTEM

State supervisionInternal audit

Interme RevisionControlling

Financial controlRechnungsprüfung

'Local' (independent) Örtliche Prüfung External ('upper')Überörtiche prüfung

ministry institutional professional boardaudit office

Rechungshof

Classic model (external public auditor – Prüfer) Modified model (könyvvizsgáló (auditor– Wirtschaftsprüfer)]


169

tain local government layers, target profes-sional associations and with regard to the over-all provincial local administration primarily forthe purpose of comparing the budget stabilityof the local governments. The audits are ge-nerally financed from the public funds of theprovince, and are supplemented with fees andcontributions collected from the auditedorganisations. Regardless of who performs theindependent external audit, the party is notauthorised to impose sanctions. The reportsare also sent to the competent public (provin-cial) authorities.

The audit reports of the audit of office usually

summarise the findings of one year

(Jahresbericht), but there are also some reports,

which are prepared every two years23. These are

detailed reports on 200–300 pages. All audits are

based on randomly selected samples (stich-

probenweise Prüfung). The German law inter-

pretation (similarly to Austria) is based on the

assumption that local governments operate with-

out violating the laws and regulations and fulfill-

ing all their tasks specified by law. The expression

of audit is not used in Germany.

LEGISLATION AND PROFESSIONAL REGULATIONS IN ENGLAND

Institutional framework of audit

In Britain the external financial audit of localgovernments and local authorities is the respon-sibility of a government commission (AuditCommission for Local Authorities in England andWales – AC), which has been active since 1983.In 1990 the competence of the AC was extend-ed to the National Health Service. In 2000, it wasextended with the so-called 'best value inspec-tions', applicable to certain services and func-tions of local governments. In 2003 the inspec-tion of housing associations was also added tothe tasks and competencies of AC. The ACappoints the auditor of the local governments(and any other regional agency) following con-sultation with the organisation to be audited.(The health authorities are exceptions from thisrule.) The auditors could be employees of theOperations Directorate, i.e., extended arm of theAC or employees of a private audit company.The audited organisations do not have theoption to select their own auditors individually.

Chart 3

MODIFIED AUDIT MODEL (THE HESSEN MODEL)

Local government(mayor)

Association of localgovernments

Provincial parliament

Provincial government

audit

delegation in the competence of the presidentreportannual summary report

AUDIT OFFICE(Rechnungshof)

Auditor(Wirtschaftsprüfer)


170

AC receives a relatively low amount from the

central government in the form of transfers. The

majority of its revenues are audit fees and con-

sideration for inspection work conducted at local

governments and health services. The fees are

established by the committee. The operations

directorate and the employed private audit com-

panies charge identical fees, because they fulfil the

same role in the audit (audit of the reports). The

members of the 15-member board are appointed

by the deputy minister. The members are selected

from a large group. (See Chart 4). Their tasks

include the audit of the financial reports of local

governments, health and other services (hotel

service, fire brigade, civil defence, etc.), i.e.,

11,000 public institutions (audited and inspected

bodies). With its staff of 2,300 employees, the AC

audits the financial reports of more than 250 local

governments24 and also conducts performance

audits primarily with regard to health services.

(The report of each local government is available

on the Internet.) As an external independent

agency (independent watchdog) it audits on

behalf of the government and not the Parliament.

Comprehensive PerformanceAssessment – CPA

The effective British laws set a requirement totake measures for providing the best servicesnot only for the local governments, but also forall local authorities (for example supervision ofnational parks, fire and disaster preventionagencies). At the same time, the audit commis-sion was generally authorised to inspect such.In the initial period (2000–2001) there was astrong distinction between the audit of thefinancial reports and the other supervisory typeaudits, but later the two audit types were com-bined (combined audit and inspection work).The purpose of this measure was to provide thewidest possible overview for the population onhow its own local government performs itstasks compared to the other local governments inEngland (and Wales). The reports integrateaudit- and supervisory-type findings. They arecompleted with the assessment of the capabili-ties of the local management in terms of com-munity management.

Chart 4

TASK STRUCTURE AND ORGANISATION OF THE AUDIT COMMISION

Source: Public Sector Audit Institutions in Europe (EURORAI, 2004) p. 112 Regional

Local Govt HousingCriminal justice

Health Communications Finance Human ResourcesDirector General –

Wales

Audit Commision15 members from local government. National

Health Service, accountancy and academia

Chief ExecutiveOperationsDirectorate


171

In December 2002 the AC published the compar-

ative reports of 150 local governments, and in

2003 and 2004 they published a comparative

report of 238 district governments. In 2005 it

developed and introduced a complex audit of 46

fire fighting and disaster prevention authorities,

falling also under its competence. The group of

local government bodies is significantly larger

than that of local governments. The AC glossary

classifies all the organisations here to which audi-

tors are delegated on the basis of the effective leg-

islation. Apart from the village and town coun-

cils, various authorities also belong to this group

(police headquarters, fire fighting headquarters,

national park supervisions, etc.).

The CPA also includes three types of cus-tomised audit procedures, developed for threeaudit areas:

•First the methods applicable to the singletier and county councils (single tier andcounty councils) (since 2002) and then

•To the district councils (district councils)and finally

•The fire fighting and life saving authorities.The main purpose is to assist local authori-

ties improve the quality of residential services.The professional contents of the audit systemare the measurement and assessment of the per-formance of local governments, extending tothe organisation and full range of their activ-ities. The system framework is defined by afour directional approach and evaluation:

Corporate assessment (Corporate assess-ment);Assessment of the use of resources (Useof resources);Service assessment (Service assessment);Direction of travel (Direction of travel).

The CPA covers the review and evaluation ofthe entire of system of operation. It is a multi-dimensional audit, "'system control' model,which evaluates the real financial and manage-ment processes simultaneously and collectively.

Its purpose is to assist improve the quality ofoperation of the local governments and maketheir activities comparable. The four directionalapproach applied to the various organisationsrequires various procedures. In this frameworkthe AC (as indicated in Chart 5), in each localgovernment every three years,

•Assesses the quality of services: the child andyouth policy, care for old people, real estate(home) management (including energy andwater supply, care for homeless people,etc.), environment and nature protection(waste and rubbish removal, etc.), culturalservices (libraries, museums, sports oppor-tunities, tourists services), fire protectionand disaster prevention;

•Evaluates the use of the resources availablefor such activities (the financial positionand finances, the financial report, the oper-ation of the internal management systemand the correlation between the expendi-tures and quality of services);

•Judges the activities of the managementboard (attempts, plans, ranking and deci-sion-making capacities, willingness tolearn, achievement of the set targets,etc.);

•'Classifies' the directions and intensity ofdevelopment of the local government.

The objectivity of CPA is based on the use ofspecific performance indicators, and quantifica-tion of performance between excellent andunacceptable. It uses sufficiently detailed crite-ria for providing the various grades. The resultsand outputs are summarised in tables by localgovernment and are published also in aggregatetables. The 'marked' performance of any localgovernment within a particular category (inline with the four-directional approach indicat-ed above and also as an aggregate result) is com-parable to the mark of any other local govern-ment. The detailed evaluations of the auditedlocal governments are also accessible on theInternet.


172

The reports also vary. Apart from the audited

local governments, they are used and read by the

most interested external parties (public agencies,

interest representation organisations, creditors,

media, etc.). The reports are available on the AC

website, which naturally does not only publish

the reports, but presents also other important

technical information (guidelines, indicators,

legislative background, etc.).

The AC developed procedural guidelines forthe independent financial audit of local govern-ments, which are periodically revised and pub-lished.25 These guidelines define the mission,nature, level and scope of the local audit work,covering all the activities of the organisation.As AC defined its own mission, it intends to bethe driving force of development of local pub-lic services. In its interpretation external finan-cial control is an important part in the processof accounting for public funds, but it is not theaccounting function itself. This latter one is thecompetence and task of the government andnot the financial audit agency. The AC practicesignificantly contributes to the good manage-ment of community funds and effective gover-nance of public services (corporate governance).

The external auditors in the public sector prima-rily provide an independent opinion of thefinancial report of the audited agency, but theirwork is more than that: it also covers thereview of the various measures of the local gov-ernments and the integration of the findingsinto a report. The three criteria, based on whichAC distinguishes the independent financialaudit of the public sector from that of the pri-vate sector are as follows:

•In the public sector the external auditors(external auditors of the public sectors) areappointed independently from the auditedagency;

•The activities of the external auditors of thepublic sector do not only include the auditof the financial report, but also involve theeconomy, efficiency and profitability aspectsof the management of the organisation andthe managerial actions;

•The external auditors of the public sectormay make their report summarising theresults of their work available for the pub-lic.26

It should also be mentioned that, in co-oper-ation with other competent supervisory agen-cies (other local services inspectorates), AC has

Chart 5

CPA PROCEDURE FOR THE ASSESSMENT OF THE DISTRICT LOCAL GOVERNMENTS

ExcellentGoodFair

WeakPoor

Use ofresources

assessment

Direction of travel statement

Service performance information

Council requests re-categori-sation and is able to demon-strate significant evidence of

improvermentor

Audit Commission identitiesevidence of significant

deterioration

Corporateassessment

Stage 1 Stage 2


173

also developed another evaluation systemdescribed as the Comprehensive AreaAssessment (CAA). As the CPA system, italso has four main components:

Joint risk assessment, performed with theagency supervising the local governments;

Quantified evaluation of the direction oftravel (development) for each local authority;

Assessment of the use of resources in eachpublic institution;

Publication of the results and repeatedevaluation of the national performance indica-tors.

Contrary to CPA, the CAA to be intro-duced in 2009 focuses on the operation, condi-tions and performance (outcomes) of a largerarea instead of the individual local govern-ments. The CAA is an innovative approach try-ing to find ways for joint information collectionand co-operation of the official agencies. It triesto present the quality of the services providedby the various local government agencies andlocal authorities to the population. It gives aclear and objective evaluation of the success ofoperation of the local agencies in a particularzone for the purpose of improving the qualityof life. As the generally presented informationof this assessment is directly accessible for any-one, it may help citizens to call their represen-tatives to account and join the decision-makingprocesses.

The valid local government model inEngland and Wales has three ultimate goals:

Financial assessment of the measures ofthe audited organisation in relation to

•the legality of transactions (legality),•the financial position•internal financial control systems (internal

financial control)•and the standards of financial conduct, pre-

vention of corruption;Audit of the financial report of the agency;Assessment of the measures of the organisa-

tion in relation to

•the economic, effective and profitable useof resources

•elaboration and publication of the specialperformance information (especially in thecase of local government bodies)

•and compliance with statutory require-ments.

This model implements the so-called integrat-ed audit concept of the Audit Commission,according to which any work focusing on theassessment of a problem provides informationfor another assessment. In this context theactivities of the auditors focus on a risk-basedapproach to audit planning (risk-based approachto audit planning). This reflects an overall assess-ment (overall assessment) of the relevant riskthat is applied to the audited agency. Accordingto this approach the auditors focus not only onsavings, but also how local governments can usethe savings for their own benefits. They giveadvice for the improvement of the quality ofmanagement in order to provide more effectiveservices, but they do not participate in politicaldecisions. One of the main objectives of AC isto learn the best practice of the local agenciesand recommend it to other local governments.

Each healthy organisation would like tounderstand its own performance, therefore itmeasures it regularly to know whether or not itworks well (and if it does, how well), and to getto know the opportunities to improve the situ-ation. The AC relied on this concept when itrenewed the National Indicator Set (NationalIndicator Set) of local governments. The com-petent ministry published a set of 199 indicatorsin May 2008. These indicators (see Table 3) tryto supply professional information for the cen-tral government for managing the matters oflocal governments. In this context the vfmaudit activities of AC mean comparisonsbetween local governments and publishing theresults thereof. The performance indicatorscollected from local governments indicatingtheir performance (performance indicators) are


174

available also for the general public (Internet).The Government defines the 'best value' gener-al indicators (Best Value General Indicators)and the list of service specific indicators. Thelocal governments use them both for planningand the preparation of their reports (reviews)to assess their own performance. The AC com-plements the government indicators with itsown performance indicators (Audit Commis-sion Performance Indicators).

The independent financial audit reports onlocal governments are primarily addressed tothe audited organisations. In England andWales the reporting obligation and responsibil-ity of the Audit Commission and the auditorsare clearly distinguished. The AC must prepareannual reports. These reports are sent to theSecretary of State (Secretary of State) fromwhere they are sent to both houses ofParliament. The law sets a requirement for ACto prepare studies (the Commission must under-take studies), in which it makes proposals toimprove the efficiency of operation of local

governments (recommendations for improvingvalue for money in local government). Each localgovernment receives these studies, which arealso available for the general public, and thenthey are also sent to the competent members ofParliament. If the reports contain proposals ofany nature that fall within the scope of interestof the Central Government then the studies arealso sent to the chief auditor of NAO.

Pursuant to the law, auditors have variousreporting obligations:

•a certificate (certificate) stating that thefinancial report has been audited in compli-ance with the legislative requirements;

•opinion (opinion) on the financial report;•statutory report (statutory report) for spe-

cific local governments on the audit of per-formance of their plans (audit of the bestvalue performance plan);

•a letter addressed to the members of allelected bodies of the local government onthe annual audit (annual audit letter), sum-marising the major audit findings.

Table 3

SOME NATIONAL INDICATORS APPLICABLE TO LOCAL GOVERNMENTS

Number Indicator5 general satisfaction with a local zone

8 sports and recreation of adults

9 use of public libraries

10 visits to museums and galleries

13 English language skills of immigrants

15 severely violent crimes

24 satisfaction with the actions of the police and local authorities against anti-social behaviour

28 crimes committed with arms

39 hospitalisation of alcohol addicts

47 number of people who died or were severely injured in road accidents

52 school meals (lunch)

54 services to handicapped children

57 participation of children in quality and spectator sport

117 people aged 16-18, who do not work or participate in education or further training

123 ban on smoking

129 final care for people who wish to die at home

151 ratio of employees among the people of active working age, etc.


175

CONCLUSIONS

Without aiming for completeness, we can drawsome conclusions that are especially relevantfor the financial audit of Hungarian local gov-ernments.

In the analysed European countries theexternal financial audit of local governments isperformed by significantly different types ofinstitutions.

The organisational and institutional solu-tions are not consistent even within the indi-vidual states (Germany, United Kingdom).

The external financial audit of local gov-ernments is typically a task of the governmentand not the audit office. (The exceptions includesome German provinces and the Austrian auditoffice in terms of its audits performed in townswith more than 20,000 residents.)

The audit objectives (procedures) aredeclared in high level regulations. The audittasks, competencies and responsibilities areclearly separated.

The annual financial report of each localgovernment is audited in one form or anotherevery year (audit).

In this field the independent internal con-trol institutions have a very important role.

The professional contents of the auditsinclude the compliance (Ordnungsmässigkeit,financial audit) and performance audit aspects.

While the external audit of the annualreports is mandatory, performance audits arerather optional.

The audit methods are continuously devel-oped, as a result of which the integrated audit hasbeen established in the United Kingdom (CPA).

The frequency of audits is one year forannual reports and 3–5 years for other audits.

Private auditors also perform audits in thepublic sector, based on assignments issued bythe state control agencies and not by local gov-ernments.

The audit procedures are identical in thepublic and private sectors, the financial auditorsof the two sectors (private auditors, publicauditors) co-operate with each other.

Local governments generally pay a fee forthe audits.

The auditors have a high degree of inde-pendence, and assume responsibility in propor-tion to their independence.

1 This conclusion is clearly proved by a study writtenwith a scientific approach and published a few yearsago, the author of which deliberately did not dis-tinguish between the concepts of the audit office,the court of accounts and the accountancy office.(Kinga Pétervári: Közpénzek – magánpénzek avagya számvevõszéki ellenõrzés alkotmányjogi prob-lémái (Public funds – private funds or the problemsof a State Audit Office audit under the constitu-tional law. Gondolat. Budapest, 2004, pp. 61–86.)The consultants and opponents of this PhD thesis,referred to as a 'masterpiece' of PhD theses, werewell-known university teachers and constitutionaljudges.

2 See the provisions of the original Article 2 (5) of theAct on the State Audit Office. Parliament passed theAct on 30 October 1989. Date of promulgation: 10

November 1989. The quoted provisions remainedeffective for years following the approval of the Acton local governments in 1990.

3 AO published a press release on its website about aco-operation agreement signed by its president andthe chairman of the Hungarian Chamber of Auditorswhen the manuscript of this study was closed.

4 Bundes-Verfassungsgesetz, Chapter V (Rechnungs-und Gebarungskontrolle) Stand 10. April 1995

5 The Austrian Constitution contains unique provi-sions regulating the audit of local governments(Bundesrechnungsabschluß), which is similar tothe solution whereby the final accounts of the stateare prepared and submitted to Parliament byÖRH. Another unique rule is that each document

NOTES


176

on a national debt or public commitment must becountersigned by the president of ÖRH or hisdeputy. (However, such a countersignature appliesonly to the legitimacy of the debt ensuring that thedebt is regularly entered into the public generalledger.)

6 Rechnungshofgesetz, Bundesgesetz vom 16. Juni1948 über den Rechnungshof

7 Regionale externe Finanzkontrolle (2. überarbeiteteund erweiterte Auflage) EURORAI, 2001

8 Prüfbericht über die finanzielle Kontrolle derGemeinden durch die Abteilung Gebarungskont-rolle (IIIc). Bregenz, im Juni 2006

9 Verfassung der Bundeshauptstadt Wien (WienerStadtverfassung – WStV)

10 Landes-Verfassungsgesetz über die Verfassung desBurgenlandes. Artikel 74. Aufgaben des Landes-Rechnungshofes, Paragraph (2), Point 6

11 The chairman of the 80-member Österreich-Konvent (active between June 2003 and end ofJanuary 2005), dedicated to the preparation of thestate and constitution reform, was Dr. FranzFiedler, former President of the Austrian AuditOffice.

12 This is one of the dilemmas described by TanjaKoller for the authors of the Constitution: DieNeuerungen für den Rechnungshof – insbesonderedie Überprüfung der Gebarung von Gemeindenund Gemeindeverbänden durch Landeskont-rolleinrichtungen, Journal für Rechtspolitik 15, 322– 330 (2007)

13 Neuhofer, H.: Gemeinderecht. Zweite, völlig neuar-beitete Aufgabe, pp. 505–507, Springer, Vienna –New York

14 For more details see: Zavelberg, H. G.: DieKontrolle der Staatsfinanzen, Duncker & Humblot,Berlin, 1989

15 See, e.g., Gemeindeordnung für Baden-Württem-berg in der Fassung vom 24. Juli 2000

16 For details see Regionale externe Finanzkontrolle(Eine vergleichende Studie) 2. überarbeitete underweiterte Auflage, EURORAI, 2001

17 Binus, K.H.: Überörtliche Kommunalprüfung.Dissertation Martin-Luther-Universität, Halle-Wittenberg, 2005

18 See for example Zusammenfassender Bericht zurüberörtlichen Prüfung (Energiemanagement in denLandkreisen und kreisfreien Städten des LandesBrandenburg) Ministerium des Innern, Kommu-nales Prüfungsamt. Potsdam, 14. 11. 2006

19 See the German Constitution (Grundgesetz, Art. 28)

20 See the 2007 annual report of the provincial institutehttp://www.gpabw.de/gbericht/taetigkeiten_der_gpa.htm#Statistik

21 Gemeindeordnung für den Freistaat Bayern in derFassung der Bekanntmachung vom 22. August 1998

22 Vetzberger, K.: Die überörtliche Rechnungs-prü-fung in Thüringen. Landes-und Kommunalverwal-tung (Zeitschrift) 2001, pp. 546–548

23 See for eaxmple: Thüringer Rechnungshof Bemer-kungen 1995 zur Haushalts- und Wirtschafts-führung mit Bemerkungen zu den Haushaltsrech-nungen 1992 und 1993

24 The structure of settlements in England is funda-mentally different from the residential structure ofCentral or Southern Europe; there are significantlyfewer settlements than for example in Hungary.However, it has twice as many local governments assettlements, which is explained with the segmenta-tion of towns into districts.

25 Code of Audit Practice for local government bod-ies. First published in March 2005 by the AuditCommission for local authorities and the NationalHealth Service in England

26 These characteristic features of the audit of publicfunds are in line with the position of the PublicAudit Forum, which includes all the national auditagencies of the United Kingdom.

WORKSHOP

177

T

Klára Busa – Tamás Kóti – Tibor Tatay

Proposal on the developmentof the voluntary health insurance fund system

There seems to be a decision reached in one of themajor social debates of the past years, underwhich the uniform, single social health insurancesystem in Hungary is to be retained. Regrettablyovershadowed by the above debate, the place androle of complementary health insurance systemsand their potential courses of development havefailed to be determined.

Compared to countries in Western Europe, itis unique to the Hungarian health insurance sys-tem that, since the political change, complemen-tary health insurances have failed to gain suffi-cient ground and are thus unable to fill their rolein the health care financing system. Despite theabove, individual health care contribution bypatients, beyond their payment of social insur-ance contribution fees, can be considered signif-icant even today (its annual sum being HUF500bn approximately), which is mostly out ofpocket payment, however, rather than prelimi-nary savings made by regular fee payment.

It is a general problem of health care systems(including those of developed countries) howthe sustainability of the systems can beensured. The main reasons for the problem arewell known and generally accepted.

A change in the age composition of thepopulation. At the global society level, societyas a risk pool involves enhanced risks since therate of elderly, inactive population compared to

salary earners has grown and this age grouplacks accumulated sources to spend on medicaltreatment.

The widening of service opportunities atincreased costs. The rocketing development ofmedical science and technology, which requireshigher capital concentration at the same timedue to the appearance of capital intensiveequipment in health care and diagnostics.

The market of health services, the supply, isin transition. It is no longer reimbursement butactual financing that is the question since pri-vate health services which expect the return ofall their expenses (including amortisation) havegained an increasing role.

Rising customer awareness. Through thedevelopment of science, there has been grow-ing focus on prevention. Screening examina-tions have become increasingly efficient, therehas been a global fight against a growing num-ber of illnesses and there has been growing evi-dence on the importance of lifestyle in ourlives. The pursuit of a healthy lifestyle and pre-vention are likely to form the basic pillar ofmodern medicine.

It is important tasks of those involved in theorganisation of health care systems to meetseveral expectations simultaneously, createequity in access to services, increase efficiencyand ensure financeability.

WORKSHOP

178

We must also do away with the illusion that,although Hungarian health care is of the stan-dard that we experience, it is at least remarkablyfair, i.e. it provides adequate social security. Thisis not the case unfortunately. The financing ofthe Hungarian health care system does not pro-vide sufficient security to the populationbecause, although the rate of public financing(but not its value) can be regarded acceptable inan international comparison, private financingconstitutes direct payment by the populationalmost exclusively, which involves being depend-ent on their current financial situation. What ismore, a significant part of private financing – anda decisive one within the service financing – isgratuities, with no opportunities for accountabil-ity or consumer protection. It has also beenmade evident in the past years that, in the trans-formation of private financing, voluntary com-plementary insurances in the service financinghave not come up to hopes, while social securitycan be considered adequate only if there is a thirdpayer behind private financing (the reimburse-ment paid by patients), too, i.e. if reimbursementis independent of the current state and financialsituation of the patients. In this respect, the situ-ation in Hungary is extremely poor.

It would be important to promote thespreading of complementary insurances andintroduce a health-targeted savings accountssystem not only because of their effect ofspurring demand but also considering thatthese systems are suitable for channelling pri-vate financing towards the direction of themore secure “preliminary payment”. This couldbe the basis for transforming gratuities intolegal and accountable service purchase and forall this to foster a move towards the security ofcitizens and the fairness of the system. It isthese individual problems and demands arisingin a widening circle that health funds are able toaddress systematically.

Voluntary health funds are able to find solu-tion for the financing of several types of servi-

ces not covered by public health insurance.These may include complementary services pro-viding coverage for services not included in thecore insurance package (dentistry, certainmedication, long term care, rehabilitation,alternative medicine, extra hotel services, etc.as supplementary services) as well as the pay-ment of contribution as demanded by the pub-lic insurance package in the case of its use (co-payment as a complementary service).

Private health insurance and voluntary healthfunds within the former have an influential rolein meeting the targets of the health insurancesystem and, through this, in the system ofhealth care as a whole. The coexistence andinterdependence of various types of healthinsurance systems can be observed everywhere.The beneficial effects of complementary healthinsurance should be enhanced and supported.

We believe that the voluntary health fundsystem is a unique system that is able to collecta considerable amount of health-targetedhousehold savings and, complementing thepublic health insurance system, finance healthservices. Voluntary health funds are able tocomplement the insurance institution activitygaining ground in private financing, filling arole in prevention and covering non-classicbusiness insurance fields. In the past years, theregulatory environment of health funds hasundergone several changes. On the basis of theexperience gained so far, the system requiresrepositioning. For the stabilisation of thehealth fund system and the attainment of long-term development, the operation of healthfunds should be considered both as a servicefinancing and as a savings collecting system.

THE HEALTH FUND SYSTEM IN HUNGARY

Since 1993 (Act XCVI of 1993 on VoluntaryMutual Insurance Funds- hereinafter: VFA),the health fund system in Hungary has under-

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gone significant transformation. The systemhas grown to a size that makes it unavoidable,but there are significant further opportunitiesfor development.

By the end of 2007, the number of healthfund members was over 733 thousand people(see. Chart 1). It is characteristic of healthfunds that they finance services not only fortheir members but also for close relatives theyhave identified. Therefore, the financing ofservices by health funds influences the healthof over two million people in reality.

The value of services financed by healthfunds was over HUF 34 billion in 2007. Thecomparison of fee payments and expenditureon services reveals that health fund membersuse the majority of the fees paid on health tar-geted services within a year. The latter provesthat, at the moment, health funds basicallyserve the financing of services related to dailyhealth preservation and restoration.

Voluntary health funds are characterised bythe following:

They are (association-like) non-profit civilorganisations based on the association of per-sons, closely related to and complementingsocial insurance, which are owned by theirmembers and which, as their basic activity, per-form services for their members. Health fundssimultaneously implement solidarity and,through the individual accounts, meet individ-ual demands. Solidarity is mostly implementedwithin the family and for relatives, while, inoptimal cases, it refers to all health fund mem-bers.

Health funds do not implement risk selec-tion: anybody who accepts the basic rules andpays the membership fees can be a member.

Under the amendment of VFA, voluntaryhealth funds have been authorised to keep thehealth accounts introduced on January 1, 2004.Through this amending proposal, the state

Chart 1

CHANGES IN FUND MEMBERSHIP

Source: HFSA

Membership

thou

sand

ppl

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declared that it regarded health funds to be theprimary organisations able to complementsocial insurance.

Since the establishment of health funds –similar to the case of pension funds – the statehas supported health fund membership and feepayment by tax credits. This also indicates that,in the long run, voluntary health funds are tohave as prominent a role in the development ofhealth insurance as pension funds have in thepension system.

The greatest challenges related to healthfunds can be put down to serious communica-tion problems. The services of pension fundsseem to be more simple since these constitutelump sum or allowance services that depend onten years of contribution payment or retire-ment. The service port folios of health fundsare most diverse, however, and their assessmentrequires interdisciplinary technical informed-ness. Yet, the communication on pension fundshas been much more extensive than that onhealth funds.

FIELDS OF DEVELOPMENT FOR HEALTHFUNDS

So as to determine the functions and serviceareas of health funds, the definition of healthshould be kept in mind: “a person can be consid-ered healthy if he is able to work according to hisqualifications, is not harmed by activity fitting hisage and – in the case of children primarily – iscapable of undisturbed development.”

Fields of cooperation with socialinsurance

The basic principle of cooperation betweensocial insurance and voluntary health funds isthe harmonisation of sources, which means aregulated unification of financing in specified

fields. In the year 2007, voluntary health fundsfinanced health-targeted services worth overHUF 34 billion, a significant part of which wasdirectly related to health services financed bysocial insurance. This sum equals approximate-ly half of the annual budget for basic services ofthe Health Insurance Fund.

In the adjustment to the real world of multi-ple values, health as a value must be given theposition it deserves in our social value system.In order to foster this, active health behaviour,real risk sensitivity and efficient needs commu-nication are required at the societal level.Classic, therapeutical health care (health dam-age management) must be developed into aninstitution based on health needs that provideshealth risk management services and turns theprinciples of cost efficiency-social justice intopractice.

Health culture does not exist in itself, so thescope of development includes, among others,lifestyle culture and erudition, and develop-ment must thus be supported in this broaderscope. Health culture embraces the totality oflife, from the conception to humane death. (seeChart 2)

Health preservation and illness preventionreflect the impact and result of composite fac-tors characteristic for the value system and cul-tural standard of society. Under living condi-tions, it is the general economic background,the labour market background, educationalconditions, living standards and the environ-mental background that are of importance.Significant lifestyle elements are: physicalactivity, diet, smoking, alcohol- and drugs con-sumption.

Voluntary mutual health funds contribute tothe harmonic development of health culture byproviding health preservation and illness pre-vention services primarily, including servicessignificantly influencing health but not qualify-ing as health services, like sports or convales-cence and wellness holidays.

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Prevention, health screeningsIt is a priority task identified in the governmentpolicy to establish a uniform system of healthtests, screenings, health preservation, illnessprevention, medical treatment, care and reha-bilitation. A prerequisite for the speedy imple-mentation of this task is to coordinate theactivities of the organisations playing a role inthe realisation of national health policies,including health funds.

It is the basis for the establishment of a uni-form system to harmonise activities related tothe survey of health status and the monitoringof changes therein. Only this basic step willpave the way for the establishment of healthneeds, health planning and the use of servicesthat mean the efficient meeting of health needs.

A significant part of health fund services canbe directly related to services of preventivenature financed by social insurance, to screen-ings identified under Health Ministry Order51/1997 (Dec. 18) that are accessible within theframework of compulsory health insurance andto the objectives and policies determined bythe government. It is thus screening examina-tions for the whole population, oncologicalscreening, mammography, gynaecological cer-

vical screening, colon and rectum screening;the reduction of coronary-artery diseases andmovement organ diseases as well as the fortifi-cation of psychological health that can be iden-tified as priority goals through advocating ahealthy lifestyle and encouraging healthy dietand physical exercise.

The implementation of national health goalsrequires efficient and intensive organisationalwork as well as health- and human centred, tai-lor-made health preservation and monitoringactivities. Health funds can be efficientlyinvolved in this organisational work. The statussurveys and health screenings continuouslycarried out by the funds should be harmonisedwith similar activities financed by social insur-ance. This could guarantee a more efficientsocietal coverage and prevent the – occasional-ly occurring – double financing as well.

It is characteristic for the two systems that,while funds are able to achieve over 80 per centattendance at screenings among their members,the rate of attendance is significantly lower,approximately 30 per cent, in the case of socialinsurance financed screenings. It is obviousconsidering the latter that voluntary healthfunds are able to more efficiently organise

Chart 2

HEALTH CULTURE

Living conditions

HEALTH STATUS

Lifestyle

Health services Demography

Health preservation,illness prevention

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screenings for their members (and the relativesthereof), including sending back screeningfindings to patients. The National Health Fund(NHF) could sign a contract with voluntaryhealth funds as sub-contractors commissioningthem to organise attendance at screenings forNHF members and their families. Funds couldcomplement screening protocols, using find-ings to design a health conscious lifestyle.After the screening organised and financed byvoluntary health funds, NHF would transferthe amount of financing available to the volun-tary health fund, following the report of databy the latter.

For the attainment of the objective it isessential that the system of prevention activi-ties carried out in various areas (basic and spe-cialised health care) be considered in a uniformway. This work involves, among others, revis-ing family doctors' records and working outand introducing a uniform health insuranceindicator system. In the establishment of theindicator system, it is important to implementan insurance attitude alongside professionalaspects.

As a result of the above work, a personalhealth plan would be worked out for everyinsured person which, by revealing the healthstatus and lifestyle risk factors, could help indesigning a health conscious lifestyle. Thesestandardised health plans could replace the“doctor's recommendations”, much limited inprofessional content, currently used in thehealth fund system.

Health planning based on health status indi-cators would serve as a basis for optimal man-agement. Considering all the above, it is ourbasic interest to focus all the strength of thehealth profession in Hungary on the expectedprogramme, to attain measurable results. Thisgoal is to be achieved by an active support forthe development of health culture only.

The basic services of voluntary mutual healthfunds should include as enacted by law making

a detailed survey of the health needs of itsmembers through cooperation with familydoctors of the necessary extent. This require-ment would be an obligatory precondition forhealth fund members for using the services ofthe fund and should be granted special taxcredits accordingly.

The detailed health survey of health fundsshould cover annual obligatory dentistrycheck-ups, internal medical as well as cardio-logical examinations, which would create anopportunity for the early detection of endemicillnesses (cardiovascular illnesses, hypertonia,brain stroke, metabolic disorders, diabetes, res-piratory illnesses, asthma or allergic illnesses,chronic hepatitis, oncologic alterations) as wellas for health preservation.

In the health surveys financed by healthfunds there are two special fields – dentistryand psychic illnesses – which serve typically asfields of complementary fund activities sinceneither dentistry illnesses nor psychic disor-ders are completely covered by public healthservices. The lack of services specialised in theprevention and the early detection and therapyof these illnesses poses a special problem inboth cases. The typical work environmentaround fund members poses especially highrisk for psychic health disorders, while themaintenance of healthy teeth is of outstandingimportance in the world of work.

Connection opportunities betweenhealth funds and business insurancecompanies

The tax credits granted to and the non-profitnature of health funds as well as the fact thatthey finance in-kind health-targeted servicesprimarily, create the necessary basis for them toundertake to finance also health insuranceproducts provided by business insurance com-panies. The health insurance products of busi-

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ness insurance companies provide cash services(daily fees in the case of illnesses and hospitalcare, cash insurances against dreaded illnesses,etc.). Under our proposal, fund members couldbalance the fees of health insurance productsused by themselves or their relatives from theirhealth fund accounts. In the case of an insur-ance event, the money paid by the insurancecompany would be credited to the fund mem-ber's account also (similar to the tax refund bythe Revenue Office). Through the above itcould be guaranteed that the money be usedonly on health targeted services determinedunder the prevailing health fund regulations orbe set aside for such a purpose. The health-tar-geted use of tax credits could thereby be fur-ther guaranteed.

Through the solution outlined above, thecash services of health insurance policies (cashinsurances) provided by business insurancecompanies would significantly extend thefinancing background of the in-kind services ofhealth funds. Connecting the two systemswould produce a synergic effect in the opera-tion of both systems. Health funds as majorcustomers could attain significant discounts atthe respective insurance companies for theircustomers and the relatives thereof. This wouldgenerate a revival at the complementary healthinsurance market, easing the burden and pres-sure on the social health insurance system. Thehealth fund account settlement of services thusfinanced would furthermore promote thewhitening of extra services related to servicesfinanced by the social insurance.

The changes proposed would require nobudget funding but would contribute to thewhitening of private health services.

Health fund services

In the above outline on the potential connectionsof health fund functions, certain service opportu-

nities have been mentioned already, which arehereby to be presented in a system. The servicescan be related to health status as well as the lifeperiods of individuals. Health funds are able toboth finance and organise these services.

Prevention services (aimed at health preser-vation):

• support of sports activities (tickets, seasontickets, support of sports club membership),

• support of recreation (active rest, well-ness),

• organisation of screenings,• contribution to the prices of vitamins and

other dietary supplements, lip cares and,among others, sunscreens available atpharmacies.

Services aimed at health restoration:• support of rehabilitation,• support of dental treatment,• support of services not financed or partly

financed by social insurance,• replacement of social insurance funding,• financing of natural medicine services.Services related to the status of permanent

illness:• support of home care,• contribution to the prices of medicine and

medical aids.It is to be noted that several of these service

elements have appeared at health funds in thepast years, but their establishment and devel-opment into a stable system have been madeimpossible due to constant changes in regula-tions. In addition to determining and establish-ing the circle of services and functions, pre-dictability and stability in regulations are alsoessential conditions for development.

THE VOLUNTARY HEALTH FUND SYSTEMAS A SYSTEM FOSTERING SAVINGS

Fostering household savings is an economicpolitical goal. Household savings are sources

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available for financing the economy. Contractsavings are relatively more reliable than otherforms of savings, which is an important eco-nomic political aspect. Contract savings areusually more permanent and are for longerperiods. Due to their nature, they can be usedfor limited purposes only, so their range of useis predictable. What is more, the purposes ofuse by health funds outlined above serve pos-itive societal goals. The investment of savingscollected at health funds can be well regulatedso, through the regulations, these savingscould be used towards the financing of theHungarian economy. The unique organisa-tional structure – under which it is all-timemembers that are the exclusive owners of thehealth fund assets – would make it possiblefor the yields on investments to be kept with-in the country: to be re-invested or spent inHungary.

Payments to health funds are presented inChart 3.

As can be seen from the chart, membershipfee payments gradually increased, reachingHUF 32 714 million by 2007. In 2007, 84.5per cent of health fund membership fee rev-enues came from employer's contributions.Unfortunately, the rise in the rate of employ-er's contributions stopped in the year 2007,however, due to unfavourable changes in taxa-tion. When examining the average payment perfund member, the unfavourable changes areeven more apparent. (see Chart 4).

Despite the above, the assets of health funds,primarily the sum accumulated on a coveragebasis serving as a background of services with-in the former, increased (see Chart 5).

Thus, the health fund system was able togrow and absorb growing savings despite theunfavourable change in regulation conditions.By the end of 2007, total health fund assetsamounted to over HUF 44 billion.

Payments into health funds, both individualpayments and employer's contributions, have

Chart 3

CHANGES IN THE PAYMENTS TO HEALTH FUNDS

Source: HFSA

Employer's contributions to membership feesMembership fees paid by members

HUF

mill

ion

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been granted tax credits. At its current lifephase, the health fund sector would have ashaky existence without tax and contributioncredits. The system, however, produces the off-set of these credits through its operation.

The tax regulations changing year by yearhave differentiated between tax credits to pen-sion funds and health funds on several occa-sions. The unfavourable changes concerninghealth funds affected tax credits supportingboth the membership fee contribution paid byemployers and the direct payments by fundmembers. Prior to the year 2000, pension fundswere granted 50 per cent, while health funds 25per cent tax credits, after which the uniform taxcredit rate of 30 per cent was introduced forboth types of fund, involving considerabledevelopment in the health fund sector.

The population of Hungary is generallyknown to have a poor health status and is alsoknown to bear considerable direct financialburden (of approximately HUF 500 bn annual-

ly) beyond the contributions, when usinghealth services. The objectives laid down also inthe government policy would justify preferen-tial treatment for health fund tax credits.Through favourable tax regulations, the healthfund system could attain further significantdevelopment, which would also significantlyimprove the health status of society. It is to benoted here that the health fund system financestypically health care services that are not or areonly partly financed by the NHF, and this isthe only form of complementary health insur-ance that does not apply risk selection andwhich finances in kind health services.

It is unfortunate that, in the past years, thesystem of credits has changed annually, whichhas seriously endangered accountability and,through this, the operational stability of thefund system. It is also important that the realvalue of credits be kept.

The proposed changes would involve a min-imum reduction in revenues, while they would

Chart 4

CHANGES IN AVERAGE MEMBERSHIP FEE PAYMENT PER MEMBER

Source: HFSA

Average employer's contribution to membership feesAverage membership payment (members)

HUF

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produce considerable gain in health, ease theburden on state health financing, incorporateprivate services into a system and promote theimplementation of the government policy.

The gain on health would involve a reductionin state health expenditure on the one hand, sincethis is the clear consequence of a general improve-ment of health status, while the early detection ofillnesses furthermore would make their treatmentpossible at lower costs. On the other hand, animprovement in working ability would result in arise in tax and contribution payments.

Since health fund payments are based on con-trolled settlements, they could also help in thewhitening of incomes in the black or greyeconomies like the above mentioned gratuitiesand often even incomes from dental and naturalmedicine services. There are certainly only roughestimations available on the latter, but from theexperience related to health fund services in thepast years, serious conclusions can be made ontheir order of magnitude. Strengthening the taxpayment morale through this way would be

cheaper and longer lasting than any audit activityby a tax authority. The resulting increase inincome tax and VAT revenues would probablyexceed the fall in state revenues due to the taxcredits in the short run already.

The permanently accountable operation ofthe health fund system would foster an increasein household savings, which is also among thedesired goals. Moreover, the collected savingscould be used only on a target-oriented rangeof expenditure, easing the burden on the stateand improving life quality. Retaining thehuman capital of the country would serve thecountry's long-term development.

The operational experience of the health fundsystem so far has shown that the potential fall instate revenues due to the tax and contributioncredits have been exceeded by the extra rev-enues gained from the rise in legalised income.Moreover, the 'fall in revenues' is a relative termconsidering that employers might not give theiremployees such high contributions or salaries ifcredits were not granted. The taxation system

Chart 5

CHANGES IN THE ASSETS OF HEALTH FUNDS

Source: HFSA

Total assetsProvision of cover

HUF

mill

ion

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does not only have the role of collecting rev-enues but is also to represent social politicalaspects and preferences. Considering this latterfunction as well, the “balance” of health funds ispositive despite the granted credits.

SUMMARY OF THE EXPECTED SOCIETAL-,HEALTH- AND ECONOMIC POLITICALEFFECTS OF THE DEVELOPMENT OF THEVOLUNTARY HEALTH FUND SYSTEM

Strengthening self-careThe establishment and support of institutionsof self-care is also meant to achieve that theprocess of recovery should not be interpretedas the completion of medical treatment but asthe complete social reintegration of the indi-vidual, i.e. as his return to work. This alsoinvolves the restart of the individual's collec-tion of sources of self-care and his contributionpayment.

Managing the growing household burden,guaranteeing co-paymentIt is a world trend that, in welfare sates, therange of services covered by social insurancesystems has been diminishing in accordancewith economic financeability. The financing ofhealth services not covered or only partly cov-ered by social insurance can be solved with lesstension and in a systematic way through theinvolvement of the complementary healthinsurance system.

Defining the basic care packageDetermining the services financeable by com-plementary health insurances is a step towardsdefining the basic care package to be financedby social insurance. Thereby the problem isapproached from the question examining whatservices are outside the scope of social insur-ance financing, which are thus to be dealt withby complementary health insurances.

Meeting differentiated demands, extra rev-enues and outside investmentsThere is considerable pressure on institutionsand services financed by social insurance tomeet also demands that are in fact not part ofthe basic care package. Through the involve-ment of health funds, the tension caused byhigher expectations can be eased.

Curbing the gratuity systemIt may eliminate the distorting effects of thegratuity system if differentiated level servicesare available legally, through complementaryinsurance. In the health fund system, a contractwith the service provider and account-basedsettlement, which are the most efficient ways tofilter gratuity, are obligations by law in any case.

Whitening the private health economy In the current practice, individual customersusually pay for the services without receivingan account. At the market of health services,health funds have a considerable bargain posi-tion when purchasing services for their mem-bers and the relatives thereof. In many cases,depending on the services, they are able toattain 5–30 per cent discount. From the pointof view of individuals, this more than compen-sates for the sums deducted for the operationalcosts of the funds. The whitened private healtheconomy does not only mean more tax rev-enues but also makes the operation of thissphere macroeconomically monitorable.

Strengthening quality assurance, consumerprotectionHealth funds are in the position to set severalquality criteria at the service providers they havecontractual relations with that individual cus-tomers would not be able to achieve due to theirdefenceless situation. Funds usually have a teamof health care experts who are able to be partnersof the service provider also from the profession-al point of view. For individuals, the health fund

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serves as a background, providing case manage-ment for their members or relatives thereof inthe case of complaints or situations seeminglyimpossible to solve. In the case of complaints,the fund is able to take action against the serviceprovider, even including the opportunity of ter-minating contract, thus preventing further badquality services for their clients.

Since patient satisfaction is a single factor, itsimprovement affects the whole health care sys-tem of a country.

Fostering a healthier lifestyleConnected to the current illness-orientedhealth care, health funds with a suitable profes-sional programme would be able to add a health

conscious attitude to the lifestyles of individu-als. This could foster a transformation in theuse of social insurance-financed services frommore expensive and serious health servicestowards shorter treatments at lower costs (outpatient treatment, day care hospitals, plannedinterventions).

It is a further important aspect that, throughthe products and services financed by healthfunds, their members and relatives thereof, hav-ing a healthier lifestyle, would rely on the servic-es of the health system financed by social insur-ance less frequently and to a lesser extent. Peopleleading a healthier lifestyle would be more activein the societal division of labour and need to bepaid sickness allowances less frequently.

ANNAS, G. J. (1994): When should preventive treat-ment be paid for by health insurance, New EnglandJournal of Medicine, 331, pp. 1027–1030

BALÁZS, P. (1997): “Hidden private financing andlegal cost reimbursement in health care”,Népegészségügy, Issue 1

HURLEY, J. – GROOTENDORST, P. (2003): Healthcare services, health insurance market and govern-ment role, Flagship courses, Health Care ManagerTraining Centre of Semmelweiss University

KINCSES, GY.: The new coexistence of the publicand the private in health care, 1999–2001

KINCSES, GY. (2002): Considerations on renewingthe health care system

KINCSES, GY., ED. (2005): The basic questions inmaking the third package, Working material of theworking group of ESKI (National Institute forStrategic Health Research) and MABISZ(Association of Hungarian Insurance Companies),(manuscript)

KORNAI, J. (1998): Considerations on the healthcare reform, Közgazdasági és Jogi Könyvkiadó,Publishing House

KÓTI, T. (1999): Quality assurance alternatives atvoluntary mutual health insurance funds, MOTESZMagazin, 7, pp. 40–43

MOSSIALOS, E. – THOMPSON, S.: EuropeanObservatory in Health Systems and Policies: VoluntaryHealth Insurance in the European Union

Health Care Systems in Transition, Hungary,(1999), European Observatory on Health CareSystems, WHO Regional Office for Europe

Health Insurance Association of America (2000):Source book of health insurance data, Washington D.C.

Mutual Societies in Europe (Contribution of AIMto the preparation of a European Commission policydocument) – January in 2003

The OECD Health project. Private Heath Insurancein OECD countries

Possible objectives and resulting entitlements ofessential health care packages, Health Policy 45 (1998)pp. 195–208

www.pszaf.hu (Hungarian Financial SupervisoryAuthority homepage)

LITERATURE

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O

Miklós Nagy

What does the ferryman pay?Quantification of a public foundation's losses

Our study examined the financial effects ofBudapest Enterprise Development PublicFoundation's (Budapesti VállalkozásfejlesztésiKözalapítvány, hereinafter referred to as BVK)participation in Baseline consulting programme2.2.1. under the Economic CompetitivenessOperational Programme (ECOP). Adjustingour calculations on a gradual basis, we reached aconclusion that, in total, the public foundationhad accumulated a minimum of HUF 16.8–19.2million in negative cash flow effect by the time ofthe financial closure of the programme at thebeginning of 2008. It is an important fact thatBVK, in spite of all these, was able to implement100 per cent of its programme – at the cost of greatefforts.

Approximately HUF 6.2–6.4 million can beattributed to paying for items that were not fund-ed within the programme, as even BVK wasforced to accept subsequently, in order to be ableto proceed with the programme (rejections accept-ed). Another deficit of HUF 7.2–9.9 millionresulted from the fact that the central coordinatorexceeded the originally 60-day payment deadlineon a regular basis, which made programme fund-ing facilities uncertain, and required involve-ment of unplanned supplementary resources onBVK's part. (The fact that this value falls short ofthe first rough estimate specified in chapter 1.1., ismostly due to the existence of advance payments.)

The fact that the transfer of nearly HUF 123 mil-lion earmarked to improve the liquidity situationwas also delayed added another HUF 0.36–0.50million to the deficit. At this point, it must benoted that not even the mere fact of providing anadvance payment was free from arguments, andthe amount was specified by the ManaementAuthority of the ECOP as the minimum of grantamounts, which is contradictory when consider-ing the program objective and contents.

It is to be seen that participation in the pro-gramme also yielded a number of hardly quan-tifiable expenses that could not be planned for inadvance, as well as unfavourable effects, in addi-tion to relatively easily quantifiable expenseitems. Due to liquidity problems, a six-monthsuspension of the programme and continuousarguments about settlements, the relationshipdeteriorated with the consultants who were forcedto wait for their remuneration for up to a year,also with the coordination body and with theministry. Consequently, programme efficiency fellshort of the expectations, primarily due to areduced motivation of the network of consultants.As a result, the effect of synergy expected amongproduct systems within the integrated system ofservices was not sufficiently felt. In addition, theprogramme withdrew capital and resources fromother non-profit programmes run by BVK,whereby they also fell short of their planned oper-

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ating efficiency. On top of all that, BVK wasforced to develop rules of procedure and softwarethat ensured operation of the programme on anational scale, from client relationships to treas-ury payments.

On the whole, we may state that the over-whelming majority of the deficit stemmed fromweak central programme coordination and theconsequential problems of liquidity managementthat deviated from the plans. A lesson that mustbe learnt from this case is that, for similar pro-grammes in the future, particular attention mustbe paid to risks arising from options of settlementfrequencies, unrealistic funds transfer deadlinesand costs allowed to be settled. So, risks wouldneed to be “priced”. This would facilitate specifi-cation of an amount of capital that needs to bepermanently tied up for successful implementa-tion still prior to launching the programme, aswell as the replacement cost, in addition to a liq-uidity plan that also uses specific regulatoryanomalies determined in an empirical system. Atthe same time, subsequently inexplicable freevariations to the sets of rules accepted as constantson planning and contracting face experts incharge of implementing services with hardlyresolvable difficulties.

INTRODUCTION

As a member of the Hungarian EnterpriseDevelopment Network Consortium, BudapestEnterprise Development Public Foundationconcluded an agreement with the Ministry forEconomy and Transport on 18 December 2002,or, more specifically, with HungarianEnterprise Development public benefit organi-sation (Magyar Vállalkozásfejlesztési Kht., theintermediary body) representing the former, toparticipate in an enterprise development net-work. The programme objective is to build upa system of institutions indispensable for inter-mediating development and support pro-

grammes to small and medium-sized enterpris-es, and the EU Structural Funds in particular.In the framework of cooperation, BVK agreedto implement the related programmes, to makeproper use of the resources made available to it,and to cooperate with the intermediary bodyon a continuous basis.

A baseline consulting programme (ECOP 2.2.1.)

was launched in April 2004 as a central pro-

gramme under the Economic Competitiveness

Operational Programme (ECOP) of the

National Development Plan. The objective here

was to assist stability, growth and strengthening of

newly founded and already running small and

medium-sized enterprises. HUF 2035.3 million

was available to implement the entire central pro-

gramme.

The programme on a national scale was imple-

mented by a national network of county-based

and Budapest-based enterprise development

foundations (local centre for enterpreneurs).

As a member of this network, Budapest Enterprise

Development Public Foundation signed a con-

tract in February 2005 with ECOP Management

Hungarian Authority and with Hungarian

Enterprise Development public benefit organisa-

tion on implementing services in the capital.

Later, the Hungarian Enterprise Develop-ment Network Consortium, Takarékbank Zrt.,Hungarian Development Bank Plc. and theMinistry for Economy and Transport signed acooperation agreement on 21 April 2005 onestablishing a new service system for micro,small and medium-sized enterprises in order toimplement the contents of the programme.

The new service system (integrated enter-prise development services model) was basedon horizontal partner relationships where –non-profit and for-profit – organisations pur-suing enterprise development cooperate in aclosed system in order to dispatch availablegovernment, EU and market funds to enter-

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prises as efficiently and effectively as possible,in order to support their development ideas. Inthis way, such cooperation means practical rep-resentation of the European Union's principles(partnership and subsidiarity). (See the systemflowchart)

BVK's primary duty under the IntegratedEnterprise Development Programme was toprovide training, consulting, decision-prepara-tory and corporate communications activitiesin the capital in order to be able to use supportfunds available from various sources. Theseconstituted a framework for launching ECOP2.2.1. Baseline consulting central programme,which focussed on (partially) reimbursing ade-quately qualified and registered consultants forconsultancy provided to micro, small andmedium-sized enterprises, in market circum-stances, i.e. contributing a kind of free knowl-edge transfer adapted to the companies' needsto the enterprises to be supported. A signifi-cant result of the ECOP 2.2.1. programme wasfor the BVK to develop an algorithm needed tooperate the programme, whereby a facilityopened up to manage programme coordinationon an electronic system on a national scale,starting from the relationship between consult-ants and clients (over 80 thousand contacts)through EMIR to treasury payments.

The programme was financially settled on 31January 2008. Professional closure took placeon 7 April 2008, whereby the intermediarybody confirmed utilisation of 100 percent of allavailable resources.

BVK incurred two types of expenses relatedto running the programme. For keeping con-tinuous contact with companies and consult-ants, a steady administrative base had to beestablished and operated for settlements withthe intermediary body. Both infrastructural andpersonnel payments were associated with it. Atthe same time, it was BVK's duty to monitorconsultancy, check actual use of services, andpay consultants' invoices. With this activity,

consultants' salaries represented the over-whelming majority of personnel expenses.

Programme implementation was far frombeing seamless, stemming from serious contra-dictions within the central programme coordi-nation instead of service implementation.Similarly to other local enterprise developmentcentres, BVK was also confronted with gravefinancial problems directly following thelaunch, which only kept intensifying as – in linewith the initiators' intention – the basic systemof consultancy was gradually completed. It wasrooted in a strategy that lacked careful deliber-ation on wording the programme specification,as well as the financing party' behaviour thatgenerated a gravely disadvantaged situation forthe implementing organisations, includingBVK.

The bodies that managed direct relationshipswith the consultants and the companies werefaced with having to advance a total of HUF2.2 billion as the expenses of the funding pro-gramme on a national scale, often for a periodover six months, which the organisations were,and could not have been properly prepared fordue to their limited financial resources. Allthese concluded to a situation where participa-tion in the programme caused serious liquidityproblems for the BVK, and funds earmarkedfor other purposes had to be released and per-manently tied up in order to avoid scandalabout the program.

What this study quantifies is the total lossesincurred by BVK through participating in theECOP 2.2.1. programme. On assessing losses,we primarily concentrated on items that can bemeasured in pecuniary terms and steadily sup-ported in professional terms; at the same time,a section is dedicated to the sources of seriousmoral losses that are difficult to measure inpecuniary terms. A non-exhaustive presenta-tion based on a financial analysis is given toilluminate how professional shortcomings ofcentral programme coordination and regula-

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tion represented difficulties to BVK's activityto provide services, how they generated finan-cial losses and resulted in reduced efficiency inthe integrated system of services.

The primary goal of quantification is not tosubstantiate some pecuniary claim but rather topoint out: undeliberated funding, lax observa-tion of rules and unpredictable willingness ofthe central management to cooperate maycause serious losses to the organisational sys-tem set up with a view to intermediating serv-ices, ultimately disintegrating and terminatingit in the long run. We intend to call the deci-sion-makers' attention to the issue that if ahard-working ferryman is forced to pay hispassengers' fares, too – instead of receivingwages for his work –, a ferry service will hardlybe available on the river in the long run.

1. LOSSES MEASURABLE IN FINANCIAL TERMS

In line with the contract concluded for theECOP 2.2.1. programme, the public founda-tion initially (between 2004 and October 2006)performed financial settlements with the inter-mediary body on a quarterly basis. In practice,what it meant was that although variousexpenses were incurred on a continuous basis,BVK had to make an advance payment on theseuntil the next settlement date. According tothe agreement, consultants' invoices could onlybe transferred for settlement once they hadbeen paid.

1.1 The first approach

Considering that the amount due to BVK andallotted for availability (maintaining adminis-tration) throughout the entire period wasalmost HUF 73 million, and the limit for con-sultancy amounted to slightly over HUF 419

million, prefinancing alone represented a seri-ous test to the public foundation, as the inter-mediary body was obliged to pay acceptedinvoices in 60 days following submission, inline with the relevant provision of law. A suffi-cient amount of programme financing advancepayment received in due time ought to havebeen a solution to this problem, however, onlyminimum amounts were received and the tim-ing was wrong, so it was unable to ensure suf-ficient liquidity in funding the programme.

The volume of this burden can be seenthrough a simple approximation: since BVKwas forced to finance all expenses for a mini-mum of 60 days – perfectly in line with the pro-visions of the contract! –, the total interest lossincurred during the 3.5 years of the programmeon providing advances on a limit of HUF 492million was:

HUF 492 million x 60 days360 days x 7,5%= HUF 6,15 million,

where the interest rate of 7.5 per cent was anapproximation of the central bank base rateapplicable to the relevant period1. However, itmust also be considered that, with this amountof expenses, the public foundation is unable toreceive resources, and the burden amounts toHUF 8.2 million even when using a prettyfavourable interest rate of 10 per cent. Alsoconsidering that this expense was incurred dis-tributed within a period of 3.5 years, an annualloss of HUF 1.8–2.3 million may be estimated,i.e., roughly that is the minimum amount BVKpaid per annum for participating in the pro-gramme.

1.2 Deadlines unobserved

While the loss approximated in section 1.1could be foreseen as early as on signing thecontract, one could hardly have expected that

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payment of funds ab ovo available from EUresources did not take place by a deadline of 60days. However, the data reveal cases when theintermediary body had BVK waiting for over200 days, what is more, the number of dayselapsed between submission of invoices for thefirst quarter of 2005 and funds transfer was 318days, that is almost a year, which is five timesthe period promised.

Such extreme payment deadlines typicallyhave an underlying cause where the intermedi-ary body questioned justification of some ofthe invoices submitted to them, or requestedadditional or missing documents. Such requestfor missing documents was occasionallyrepeated two or three times within a settlementprocess. Considering the eighteen periodic set-tlements, the payment deadline of 60 days wasobserved on a single occasion only – in March2007. At the same time, the intermediary bodyexceeded the final payment deadline followingthe last submission of missing documents onfour occasions.

The primary problem here stems from thefact that the intermediary body only tookactions towards payment after passing anexplicit decision on each invoice on acceptanceor rejection. However, it led to situationswhere items deemed immediately payable onsubmission were idling on the treasury'saccount, generating extra interest to them,while BVK was forced to tie up extra resourcesin the programme to finance the same forindefinite periods. Other institutions that had adifficult time obtaining capital were forced tosuspend payments in such periods, i.e. the pro-gramme was halted until the approved itemsnot yet transferred were received.

A complex calculation table was produced toquantify such losses. Our logic for measure-ments was as follows. First, the dates of varioussettlements and submission of missing docu-ments were established, and then we deter-mined the original respective due dates of the

various amounts, according to the contract.This date was 60 days subsequent to the sub-mission in case of items that the intermediarybody did not question, while for other items, itwas the date of submitting the last (conse-quently, accepted) missing documents. Itemsultimately rejected were not considered,although, in a number of cases, even six monthselapsed before it turned out for BVK that theexpense was not allowed to be settled.

The next step was to calculate the interestlosses at the interest rates applicable to the datewhen the invoice was submitted for the periodbetween the due date (submission date + 60days) and the payment date, as well as thefinancing costs. The third step quantified theincrements of these interest amounts lost untilthe financial closure of the programme, i.e.until 31 January 2008, considering that the baserates kept changing.

For calculating the interest burdens for theperiod between the payment date and the duedate, linear interest calculation was used in thefollowing formula.

Amount x average interest x days in delay365=interest, loss within the year

where the average interest calculated for period t:

,

wherek is an interest rate valid for a given montht is the month of the due datex is the month of the payment date

As the period elapsed between payments andthe financial closure was typically over a year,compound interest calculation was used forsuch periods.

Interest loss within the year x average interest (days to closure/365)= full financial loss

1)1(

12

−⎥⎦

⎤⎢⎣

⎡+=

−

=∏

txx

tjjt kinterestaverage

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Average interest calculated for period i:

,

wherek is an interest rate valid in the given monthi is the month of the payment daten is the month of the financial closure

Again, the calculations were made consider-ing two different interest rates. First, we usedthe currently effective central bank base rate, asit yields a strict estimate of the minimum loss-es, as BVK would in no way not have been ableto finance its activities at a lower cost. On thesecond calculation, we added a 2.5-percentagepoint extra charge to the interest rate, whichrepresents a considerably more realistic but stillminimum estimate of the public foundation'scost of funds. The reason we still stick to thisapproach is that it reflects in part that BVKused its other fixed reserves invested in gov-ernment securities for funding, and the result-ing loss was actually more moderate than thecurrent interest rate of BVK. At the same time,it is important to recognise that this solutionterminated the possibility of running orlaunching other projects through withdrawal ofcapital and cross-financing.

To illustrate detailed calculations, a table of

central bank base rates related to availability(administrative) costs is presented in AppendixNo. 3. For a summary of our results, see Table 1.

Although the calculated interest loss to clo-sure is less than 1.25–1.74 of the total amountof funds, it is to be seen that BVK incurred aloss of HUF 4.6–6.5 million in addition to theexpenses imposed by the contractual financingdeadline of 60 days. Therefore, if we intend toestablish the total loss resulting from participa-tion in the programme from BVK's point ofview, we also need to consider the financingcosts of the 60 days permitted by the contract.

1.3 The second approach

If the expenses resulting from the financingobligation specified in the contract are added tothe loss resulting from delayed paymentsdescribed in section 1.2, the amount of whichcan be approximated through a rough estimateseen in section 1.1, the result adds up to totallosses of HUF 10.76 million and HUF 14.62million respectively, which, considering theprogramme period of 3.5 years means an annu-al average deficit of HUF 3.0–4.2 million.

In order to receive a more accurate estimate,we have calculated the total loss by using theactual figures for each item, instead of a fixed

1)1(

12

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−

=∏

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ijji kinterestaverage

Table 1

LOSSES RESULTING FROM DELAYED TRANSFER OF FUNDS(HUF)

Central bank base rate Amount Interest loss to payment Interest loss to closureAvailability 72,948,400 1,145,351.61 1,263,347.80

Consulting 419,151,223 3,030,936.19 3,348,757.80

Total 492,151,224 4,176,287.79 4,612,105.59

+ an extra cost of 2.5 Amount Interest loss to payment Interest loss to closurepercentage points Availability 72,948,400 1,558,236.91 1,775,023.86

Consulting 419,151,223 4,075,023.06 4,641,852.29

Total 492,151,224 5,633,259.97 6,416,876.15

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average interest rate of 7.5 per cent. The totalsreceived in the latter case are presented in Table 2.

These more accurate calculations reveal thatthe total profit/loss of the public foundationdecreased by approximately HUF 7.2–9.9 mil-lion, as a result of its participation in the pro-gramme. (A difference from the rough esti-mate results from the fact that the current cen-tral bank base rate should have been weightedwith the existing demand for financing, and anincrease in the latter coincided with a decreasein the base rate.)

Although this approach yields a much moreaccurate result compared to the first one, fur-ther adjustments are needed for two reasons.The first reason is that it was ignored that thevarious operating costs were typically incurredevenly distributed throughout the operatingperiod, and not on preparing the accounts. Onthe other hand, it was also ignored that thecoordinating organisation has recognised andaccepted the existence of extra burdens, andreceived a HUF 123 million advance paymenton 31 August 2005, subsequent to an amend-ment to the law, under an obligation of settle-ment when 80 per cent of the programme wascompleted, at the latest. In order to be able toconsider all these, a statement of BVK's cashflow in the ECOP 2.2.1. programme has beenproduced.

1.4 Cash flow based measurement

In the cash flow model, different operatingexpenses were always recorded at the end ofthe month when they were incurred. Giventhat consultants' invoices were accepted byBVK only directly prior to settlement dateswith the intermediary body – irrespective ofthe completion date – in order to reduce itsown financing burdens (shifting the same tothe consultants), the majority of expensesresulting from consulting were always incurredaround the settlement dates.

Figures 1 and 2 show the level of cash underthe programme, i.e. cumulative cash flow calcu-lated at the central bank base rate, as well as atthe central bank base rate plus a 2.5-percentagepoint extra charge of financing. On making ourcalculations, we settled interest burdenspayable on the need for financing on a month-ly basis, i.e. in case of a need for financing, thefigure will indicate a decreasing cash level alsoin the absence of a different type of expense. Inthe figures, the cash level calculated withoutthe accepted rejections is represented by a dif-ferent line.

The two figures are an excellent illustrationof problems concerning the financial manage-ment of BVK, which implemented the pro-gramme: until the advance was received in

Table 2

TOTAL LOSSES AND FINANCING COSTS RESULTING FROM DELAYED TRANSFER OF FUNDS(HUF)

Central bank base rate Amount Interest loss to payment Interest loss to closureAvailability 72,948,400 1,974,397.22 2,161,496.97

Consulting 419,151,223 4,554,505.54 5,016,945.07

Total 492,151,224 6,528,902.76 7,178,442.03

+ an extra cost of 2.5 Amount Interest loss to payment Interest loss to closurepercentage pointsAvailability 72,948,400 2,672,735.60 3,014,446.78

Consulting 419,151,223 6,098,884.09 6,928,827.65

Total 492,151,224 8,771,619.69 9,943,274.43

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August 2005, the project had an increasingneed for financing, continuously consumingthe liquid assets available to BVK, like a greedymonster in a Hungarian folk-tale. With theexpenses approaching HUF 30 million, otherresources had had to be invested in the projectby the time the advance was received, whichwas able to keep the system “above water” foronly seven months, and then BVK was againforced to use its own funds. It was no usereceiving major funds transfers later to offsetinvoices settled earlier, such funds were insuffi-cient to turn the cash balance into positive.

Losses caused by the project are clearly rep-resented by the volume of the cash balanceremaining after the – theoretically complete –financial settlement. (See Table 3) Althoughrejections also accepted by BVK represent aconsiderable difference, it is to be seen that themajority of these expenses were incurredbecause the expenses permitted in the originalcontract to be settled were not specified accu-rately enough, and the intermediary body con-tinuously set new rules, in addition to reinter-preting its earlier guidelines. On the one hand,it can be stated in no way that the items reject-ed with BVK's approval are clearly expensesincurred through a fault of the implementingparty, with burdens to be borne by BVK alone.On the other hand, it is an important lesson tobe learnt that rejected items did not consider-ably change the course of cash flow for theproject, i.e. the loss incurred by the imple-menting party by the time of the closure can betraced back to wrong planning instead of prob-lems with settlement.

According to our adjusted calculation thatconsiders all well-documented items, by the clo-sure date on 31 January 2008, BVK incurred aloss of at least a HUF 10.6–12.8 million, butHUF 16.8–19.2 million seems more realistic,through participation in the entire ECOP 2.2.1.project, even at a conservative estimate.Considering that this expense was associatedwith a total utilised amount of HUF 492 million,the system causes a loss of 2.2–3.9 per cent of thegrant amount to the implementing organisations.

On the whole, the outcome may be that theimplementing organisations will be interestedin decelerating, or even discontinuing the pro-grammes, or, that the people working more areimposed higher penalties in the system.Provided that organisations still participate insimilar programmes in the wake of decisionsmade on other than economic grounds, itwould result in their other earlier programmesor resources becoming scarce, giving rise to akind of cross-financing system. In this way, theintermediary body actually drains funds of oth-ers provided for other purposes, while contin-uously disintegrating the underlying distribu-tion network, which must not be a goal.

1.5 Losses related to advances

The approach seen in section 1.4. does inte-grate all factors; at the same time, there is anopportunity to quantify another factor, lossesrelated to the transfer date of advance pay-ments. According to BVK's interpretation, theHUF 123 million advance payment transferred

Table 3

CLOSING CASH FLOW POSITION OF THE ECOP 2.2.1. PROGRAMME FOR BVK(HUF)

Total expenses Excluding accepted rejection itemsAt central bank base rate –16,842,417 –10,644,218

+ an extra charge of 2.5 percentage points –19,185,165 –12,781,660

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Figure 1

MONTHLY CLOSING CASH IN BKV’S ECOP 2.2.1. PROGRAMME(central bank rate)

Figure 2

MONTHLY CLOSING CASH IN BKV’S ECOP 2.2.1. PROGRAMME(central bank rate + 2.5% points)

mill

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HUF

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Including all expenses Excluding accepted rejections


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on 31 August 2005 was actually due on 8 April2005 (from that date on, a legal opportunitywas available to perform the funds transfer, andBVK even requested so), i.e. the authority wait-ed 145 days to carry out the funds transferinstead of the agreed 60 days. This loss of HUF3.2–4.3 million, however, would only be legallyenforceable in part, as it previously raised theproject cash flow position to the positive range(although temporarily only), so a portion ofthe loss presented in Table 4 actually representslost profit from investing a positive balance.

Accuracy of this calculation could be consid-erably improved if, instead of interest lost, weexamined how an advance payment transferredin due time, i.e. within the period 8 April 2005+ 60 days (up to 7 June) would have improvedthe cash flow position of the whole project onclosure. (See Figure 3 and 4) For our calcula-tions, we considered full utilisation of the 60

days, i.e. the theoretically possible worst situa-tion for BVK, thus approaching the lossincurred from the lower limit. (See Table 5)

Our results indicate that the closing fundscould have been HUF 357–505 thousand higherthrough an earlier transfer, assuming that noreturn is yielded to BVK on a positive balance.Therefore, this is the loss actually incurred bythe implementing organisation, and approxi-mately HUF 2.9–3.8 million of the losses seen inTable 4 represents lost returns on investments.

2. INDIRECT LOSSES THAT ARE HARD TOQUANTIFY

On implementing the ECOP 2.2.1. pro-gramme, BVK incurred a number of costs,expenses and losses that were extremely diffi-cult and unpredictable to measure in pecuniary

Table 5

CLOSING CASH FLOW POSITION OF BVK UNDER ECOP 2.2.1. PROGRAMME, WITH ANADVANCE TRANSFERRED IN JUNE

(HUF)

Closing position Total costs Excluding accepted rejection itemsAt central bank base rate –16,485,332 –10,287,133

with an extra charge of +2.5 percentage points –18,680,556 –12,277,051

Changes caused by delayed transfers *At central bank base rate –357,085.00 –357,084.65

with an extra charge of +2.5 percentage points –504,609.00 –504,609.00

*Difference between balances calculated with a funds transfer in June and one in August (Table 3)

Table 4

TOTAL LOSSES AND LOST REVENUE DUE TO DELAYED TRANSFER OF FUNDS(HUF)

Central bank base rate Amount Interest loss to payment Interest loss to closureAdvance 123,037,806 2,751,656.47 3,247,067.06

+ an extra charge of 2.5 Amount Interest loss to payment Interest loss to closurepercentage pointsAdvance 123,037,806 3,467,972.47 4,327,323.12

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Figure 3

MONTHLY CLOSING CASH IN BKV’S ECOP 2.2.1. PROGRAMME(central bank rate, advance payment in June 2005)

Figure 4

MONTHLY CLOSING CASH IN BKV’S ECOP 2.2.1. PROGRAMME(central bank rate + 2.5% points, advance payment in June 2005)

mill

ion

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terms, still, they could not be ignored onreviewing, due to their significance. In the con-tinuation, we are going to review the most sig-nificant ones of these.

BVK used its reserves tied up for otherpurposes to finance the programme.Accordingly, the amounts tied up in the ECOP2.2.1. programme did not serve their originalpurpose, however, we have always ignoredfinancial and social yields lost in other areas sofar. Please note that the central bank base ratecharged on the tied up capital hardly representsthe total loss incurred due to a lack of oppor-tunity to use the funds elsewhere, as we havereason to believe that the social yields of proj-ects implemented with the participation ofBVK, which also reflect external effects, arehigher than the base rate.

On settlements, a number of items arose,which BVK deemed as justified, and paid forthem; however, the consideration value of suchinvoices was never received. Such disagree-ments result from an inaccurate definition ofexpenses eligible to be represented, and seriousproblems resulted from the fact that oftenmore than six months elapsed until a certaintype of expense turned out to be ineligible forsettlement in the programme. For this reason,however, BVK carried on operating formonths, until a final decision was made, con-sidering such invoices to be eligible for repre-sentation, and did not seek to eliminate orreplace them.

There are multiple controversial itemsthat were, in BVK's opinion, undoubtedly jus-tified and necessary for the project, but stillwere not accepted by the intermediary body.During the period of 3.5 years, a total invoiceamount of HUF 9.67 million was rejected bythe intermediary body, HUF 4.26 million ofwhich BVK accepted. (These losses are attrib-utable to insufficiently clarified conditions ofeligibility for settlement on contracting.)There is an additional unrefunded amount of

HUF 5.4 million that cannot be explained byany interpretation of settlement, according toBVK's position. Given, however, that rejectionhad been made clear already during the pro-gramme, BVK wrote off rejected invoices as itsown loss, and replaced them by additional oneson programme settlement, in order to utilisethe full grant limit (i.e. to implement the proj-ect objectives). Consequently, in order toutilise the full limit, BVK actually had to reacha cost ratio of 102 per cent.

Due to delays in the programme, extrawages and overhead costs were incurred byBVK for approximately 6–8 months, whichwere allowed to be represented in the originallimit (invariable in amount), but if the projecthad been successfully completed in due time,this amount could have been contributed tomeeting the objective, i.e. programme efficien-cy was significantly impaired. According toBVK's estimate, costs arisen in favour of theprogramme but not settled because the limitran short amounted to a minimum of HUF2,709,352.

As the programme schedule for payingadvances was rather unfortunate, the enormousdelays caused constant cash flow problems toBVK. It resulted in delayed payments, wherebyBVK incurred considerable loss of trustthrough no fault of its own, while those wait-ing to be paid incurred other accessory costs.

Helpfulness of the management authoritywas not unanimous throughout the pro-gramme, which may result in a considerablesetback for the participating organisations'future willingness to cooperate. For example,the ratio of advance payments was defined as25 per cent, while section (4) of article 91 ofgovernment decree 217/1998. (XII. 30.) pro-vides a facility for the management authority incase of central programmes (and ECOP 2.2.1.was a central programme) to ignore the 25 percent rule, and to provide a portion in line withthe financing ratio that suits the given measure.

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So, it is the management authority's compe-tence to decide on the ratio of advance pay-ments. BVK requested a higher ratio of advancepayments on multiple occasions in order toeliminate liquidity problems, but these wererejected by the ECOP management authorityon every occasion.

The provision of law also provides a facilityfor easier terms for non-profit organisations onsettling advance payments. The settlementdeadline may be delayed until the date the pro-gramme is 95-per cent completed, instead ofthe normal 80 per cent, for non-profit organi-sations, if permitted by the managementauthority. However, such requests made byBVK were also rejected by the authority. Allthese reveal that although provisions of lawprovide facilities to reduce liquidity problems(that is, legislation or amendments are notinevitable), such intent of the managementbodies seemed to be absent for this pro-gramme.

In order to reduce its financing burdens,BVK – similarly to other regional implement-ing organisations – developed a practice ofaccepting external consultant's invoices onlywhen the settlement period approached, inorder to make payments directly before therequired deadlines, and thus minimising theneed for financing. What it meant was that con-sultants often waited months to be paid afterperforming their duties. In many cases, it led toconsultants leaving the programme, and notintending to cooperate with BVK in otherways, either. Another nuisance was that con-

sultants waiting for their money were notinterested in popularising the services of theECOP 2.2.1. programme and other grant pro-grammes, as they had to finance the coststhemselves, which made them feel the draw-backs of the grant system through their ownadversity. This is why the full subsidy amountreached the targeted entrepreneurs consider-ably more slowly, which caused a competitivedisadvantage to the economy.

It is a strange contradiction that it was pre-cisely the consultants, whose duty was to prop-agate grants, motivate and help entrepreneursto enter the grant system, that were forced intoan increasingly grave financial situation, and itresulted in considerably decreased motivationof consultants. Another contradiction awaitingresolution in the future is that state organisa-tions supervising the available funds may beinterested in stretching the programme asmuch as possible, as it may yield extra interestrevenues to them.

As a result of uncertain payments, theauditor recommended representing loss invalue in the balance sheet for the year 2005 – asno material payments were made until thespring of 2006 –, which caused lower profits,and resulting moral damage.

The strenuous professional work neededto operate the programme despite the financialand professional problems considerablydecreased the capacity otherwise intended tobe used to maintain contact with the consult-ants, or to train and educate them. This neces-sarily impaired program efficiency.

NOTE

1 For the central bank base rates of the National Bank of Hungary for the various periods, see Appendix No. 2

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Appendix No. 1

APPENDIX NO. 1 THE INTEGRATED ENTERPRISE DEVELOPMENT SERVICES MODEL

FINA

NCIN

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Self-

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porti

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H O L D I N G F U N D

D I R E C T F I N A N C I N G

R E F I N A N C I N GDevelopment implementation

Liquidity financing

Cont

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ro fi

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ing

loan

s

Gran

ts a

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dies

Loca

l cen

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pre-

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s, re

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terp

rise

deve

lopm

ent

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: com

mer

cial

bank

s

Loan

pur

pose

s:

deve

lopm

ent,

curre

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ty

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80

% lo

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: loa

n ac

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ts m

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dat

a su

pply

45%

55%

Fact

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g co

mpa

ny

Mic

ro fa

ctor

ing

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me

WORKSHOP

203

Appendix. No. 2

CHANGES IN THE CENTRAL BANK (MNB) BASE RATE

As of 28 November 2003 12.50%

As of 23 March 2004 12.25%

As of 6 April 2004 12.00%

As of 4 May 2004 11.50%

As of 17 August 2004 11.00%

As of 19 October 2004 10.50%

As of 23 November 2004 10.00%

As of 21 December 2004 9.50%

As of 25 January 2005 9.00%

As of 22 február 2005 8.25%

As of 30 March 2005 7.75%

As of 26 April 2005 7.50%

As of 24 May 2005 7.25%

As of 21 June 2005 7.00%

As of 19 July 2005 6.75%

As of 23 August 2005 6.25%

As of 20 September 2005 6.00%

As of 20 June 2006 6.25%

As of 25 July 2006 6.75%

As of 29 August 2006 7.25%


As of 25 October 2006 8.00%

As of 26 June 2007 7.75%


As of 1 April 2008 8.00%

WORKSHOP

204

Appe

ndix

3

QUAN

TIFI

CATI

ON O

F LO

SSES

INCU

RRED

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rate

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ar

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(HUG

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7.80

BIBLIOGRAPHY REVIEW – Books

205

TThe first part of (Alexandre Lamfalussy's) bookon the international financial crises was pub-lished in English in the wake of the Russiandefault, in 2000. The Hungarian version, pub-lished in 2008, was supplemented with a 2006paper by the editors. According to the publish-er's summary, Sándor Lámfalussy studied thecorrelation between financial globalisation andthe vulnerability of the international financialsystem through the analysis of four major cri-sis experiences in emerging markets, as well asthe dotcom bubble. The book consists of thepapers read during the Henry L. Stimson lec-ture series at Yale University, as well as thepaper read by Xenophon Zolotas in Athensupon the request of the National Bank ofGreece.

Although according to the title the book dis-cusses the history of crises that evolved in theemerging markets, it has a lot to say to thedeveloped countries, what's more, to present

day people. It is so topical that we can hardlybelieve that these sentences were committed topaper years ago.

I note here that I myself thoroughly dis-cussed financial crises in the Hungarian litera-ture. My paper titled Világméretû pénzügyiegyensúlyhiány (Global financial imbalance –KJK) analysed the debt crisis back in 1987. I repeatedly addressed this issue in the booktitled Nemzetközi Pénzügyek (InternationalFinances – 2006, Jatepressz), the co-author ofwhich was Péter Halmosi, and in my course-book with a similar title, which was publishedwithin the framework of the Human ResourceDevelopment Operational Programme (HRDOP)in 2007, and which is accessible via the inter-net. However, the subjects of SándorLámfalussy's analysis come not from litera-ture, but from life itself.

The author's professional competence standsabove all doubt. He possesses both theoretical

Sándor Lámfalussy

Financial crises inemerging marketsVanishing tenets

AKADÉMIAI KIADÓ, BUDAPEST, 2008


206

and empirical experience in bank management.He approaches issues from the practical side,but he also worked as a professor at theCatholic University of Leuven for many years.He was the president of the EuropeanMonetary Institute, the forerunner of theEuropean Central Bank. He played a crucialrole in the establishment of the EuropeanCentral Bank, and is also called the “father” ofthe euro. He also received eternal acknowl-edgement in the field of international bankingregulation, especially in the development andadoption of the so called Basel norms. Intoday's finances he is one of the most compe-tent professionals, wherefore we can hardlyquestion the substantiation of his criticalremarks.

Lámfalussy could sense well in advance theproblems of the international financial system.Naturally, there were other people – albeit notmany – who also saw where the processes wereleading (As J. Stiglitz wrote in one of his recent-ly published essay: “It didn't take Nostradamusto foresee the string of events…”) Yet, onlyfew were brave enough to ask the proper ques-tions. Sándor Lámfalussy did ask them.

According to mainstream finance, it was notproper to question certain tenets. Let us list afew of these disputed doctrines!

The money and credit markets of the devel-oped countries are sufficiently deep and devel-oped to enable them to properly protect them-selves against risks. Similar institutional sys-tems must be established in the emerging coun-tries, and then potential crises can be fore-stalled.

The financial infrastructure of the Westerneconomies is so developed that there is no needfor state regulation, self-regulation is sufficient,since stability is in the very interest of this sec-tor.

Among the developed countries, those withmore extensive securities based mediation aremore efficient. These institutions – like the

hedge funds – need no separate supervision,not even if they work with a high leverage ratio,since the banks, from which they borrow, aresupervised. Higher profits can be yieldedthrough capital market institutions, since costsare lower in this case.

Banks, on the other hand, must be bailed outunder all circumstances if they get in trouble,since they can launch a domino effect and dragthe economy down.

The spread of financial innovations is desir-able, since they provide a large pool of tools forrisk hedging and atomisation, and the expan-sion of profitable businesses.

Debts must always be repaid to the lastcent. Pacta sunt servanda. If this principle isnot followed, borrowed money may get lost,and the trust in the financial institutional sys-tem will vanish in thin air.

In the globalised world full liberalisation ofcapital movements is desirable. Incidentally,this is included in the IMF charter, too.

To tell you the truth, I myself have conduct-ed research according to these principles, andrelied on them in practice, too, as an under-secretary of state, as a minister, and as thepresident of the Hungarian State BankingSupervisory Agency. Yet, I had some faintdoubts (which I did air in the past one and ahalf decades) about the shrinking role of thestate; I doubted the encouragement of self-regulation in the banking sector, and the exces-sive use of financial innovations – whichserved more the purpose of profit-makingthan of risk mitigation. Yet, I basically accept-ed the tenets listed above. Since who in theformer communist bloc could have been suffi-ciently prepared to criticise the theoreticalfoundations of the operation of the interna-tional financial system on the basis of practicalexperience? We made each decision followingthorough discussions with the professionalorganisations. Basically, no one else had a dif-ferent concept. The practical experience of the


207

Hungarian banking sector was still ratherinsufficient. “Deposit, credit, foreign curren-cy” – suggested the neon light advertisingboard of that time. The two-tier banking sys-tem came into being a mere three years before1990, and the above cited work of mine(Világméretû pénzügyi egyensúlyhiány) alsocame out then, which, as far as I know, was thefirst publication to describe the essence offinancial innovations on the basis of BIS infor-mation. We were hardly aware of the new typesof financial transactions. At best we knewabout the primitive innovations – asLámfalussy put it – that were represented byvariable-interest roll-over credits. This in partled to a drastic rise in Hungary's foreign cur-rency debts. As far as the repayment of thesedebts is concerned, in 1990 I could draw thepractical conclusion that the internationalmoney markets responded to the politicalchanges with great mistrust. The AntallGovernment – which was just about to beformed – had to face the fact that state bank-ruptcy was imminent in a couple of days unlessit was ready to declare its willingness to repaydebts. However, naturally we new that loansare always signed by two parties: the lenderand the borrower. (This is strongly emphasisedby Sándor Lámfalussy in this work of his.) Intheory, banks subscribing the securities couldalso be aware of the indicators of theHungarian economy. However, the ultimateinvestors – who could even be ordinary people– had all the right to believe that the securitiesof the National Bank of Hungary were safe.Lámfalussy also confirms that it was generallyheld at that time that sovereign debtors couldnot go bankrupt.

Yet, we managed to get on the verge of col-lapse. With the given foreign exchange reserves,or rather, due to the lack of such reserves, andconsidering the balance of payments, the crisiscould be overcome only by obtaining the good-will and the standby credit of the IMF. On the

other side, IMF extended the loan on the con-dition that Hungary agreed to repay the earlierloans.

A lot of – mostly political – criticisms wereexpressed in this issue in connection with thestandpoint of the first government. However,domestic experts were in general of the opin-ion that we had to undertake the repayment ofdebts, since any other script would have trig-gered an even more tragic effect for the coun-try. At least, this is what we thought wouldhappen in the short and medium run. We hadinformation according to which Latin andCentral American countries that are muchbigger than Hungary forced their creditors toreschedule their debts and attained certain dis-counts. (We can read about it in this book ofLámfalussy's.) However, this seemed to workonly in countries the size of which is bigenough to shake the financial and economicsituation of the lending countries, or ratherthat of the lending institutions. The smallercountries could be cornered more easily. Theydo not meet the “too big to fail” requirement.Maybe confidential talks could have beenorganised for Hungary, too – certain talkswere indeed conducted – but in the givenpolitical circumstances no real possibilityexisted for debt reduction. Since the economywas so dependent on imports, we could notrisk the suspension of funding resources, noteven temporarily. (See the comment on page36 in Issue 1/2008 of Közép-EurópaiKözlemények)

Lámfalussy describes changes on the inter-national money market since the crisis of1982. He presents that as a result of priceexplosion the oil dollars inflated the creditsupply in the developed countries. (This issuewas immediately and most deeply studied inthe Hungarian literature by István Gyöngyössyin his doctoral dissertation titled A mainemzetközi pénzrendszer mûködése /Theoperation of the current international curren-


208

cy system/, which was published by KJK in1982. In addition, in my 1987 work/Világméretû pénzügyi egyensúlyhiány –Global financial imbalance/ cited above Ianalysed the debt crisis that evolved in thedeveloping and the socialist countries by theearly 1980s relying on information from BIS.In search of the underlying causes I pointedout that in the developed countries the socialprogrammes, in the developing countries thelavish investment projects, while in Hungaryboth factors contributed to excessive publicspending. However, while the developedcountries of Europe had enough savings, thedeveloping – and the socialist – countries hadto rely mostly on external resources. Thisbecame one of the major factors of the vul-nerability of these countries.)

Sándor Lámfalussy thoroughly collected thedifferent and identical features of crises. Inaddition to excessive public spending he alsopointed out that the private sector also heavilyrelied on foreign currency influx several times.Due to liberalisation, incoming capitals pushedthe exchange rates up, which often made thecurrencies overvalued – and thus contributedto the growth in the current account deficit ofthe balance of payments. The responsibility ofthe private sector is further increased by thefact that as a result of suspicious signs, exces-sive capital flights were carried out.Lámfalussy describes the characteristic fea-tures of the Russian crisis in a rather wittymanner. It reminds me of the joke in which acreditor is not willing to lend to the formersocialist large company, because it does notknow it, while the other refuses to lendbecause it does know it... Being aware of thepast, the Russians did not nourish any confi-dence in those in power, and took the moneyout of the country at a rapid pace. On theother hand, in the beginning foreigners were ineuphoric fever – using Lámfalussy's words –and enthusiastically provided loans to the

country. Then, when problems began to show,they fled the scene themselves.

An important finding of the author is thatthe reason behind the failure was not alwaysthe defective internal macroeconomic policy.And it happened several times that fromamong the available remedies the IMF appliedthe recipe of mandatory budgetary constraintsin a stereotyped manner. Another importantfinding is that foreign currency indebtednesswas always one of the main reasons. Includingstock market financing. Since portfolioinvestors and fund managers often decideabout the movement of capitals on the basis oflarge-scale indices. In the case of direct invest-ments this would be less dangerous, howeverdirect investments have always accounted fora minor share in securities investments. It istrue that loss-bearing, which securities hold-ers are compelled to accept, “comes in handy”for the system in preventing the spread of thecrises, however, in less well-off countries theloss of wealth leads to massive impoverish-ment.

Lámfalussy analyses the role of the exchangerate systems, since it can be seen that peggedexchange rates played a role in each crisis, as aresult of which foreign exchange reserves soonmelted away in crisis situations. We could alsosee that the size of the crises – and conse-quently the size of the remedy actions -hasgradually grown. The author draws attention tothe problem of “moral hazard”, for lenders andinvestors increasingly relied on the fact thatthey would be bailed out by their governmentsor international organisations.

For today's readers the most exciting detailsof the book are those referring to the currentcrisis.

Lámfalussy describes how strong the creditboom was in the U.S. economy, what bubbleswere caused by the lax budgetary policy, and atthe end of his work – as he gets closer to ourdays – he highlights the role of China, too. By


209

maintaining its undervalued exchange rate,China accumulated huge exchange reserves,which contributed to the global oversupply ofliquidity. This was one of the reasons of laxmonetary policy in the U.S., which has lead tothe growth in mortgages and thus to the cur-rent crisis.

The author, as we have shown, does not con-fine himself to the emerging markets. He alsoraises the question whether the self-confidencewith which the developed countries describedthe level of development and strength of theirfinancial markets was justified or not. Did theyhave the right to claim that the emerging coun-tries should do nothing but adopt their tech-niques and institutions, and then – applyingproper macroeconomic policies – they canavoid crises? Was it a sound idea to leave theregulation of risk-taking practically to thebanks on their own developed markets?

The life of banks is regulated by three basicprinciples: liquidity, solvency and profitability.Liquidity means the ability of prompt pay-ments, while solvency means that the value ofthe bank's assets is always higher than that ofliabilities, wherefore the bank is creditworthyat all times. It can obtain resources from otherfinancial institutions, including, ultimately,the central bank, since it has assets to back bor-rowings… Thus, liquidity, too is likely to beensured at all times. However, profit motiva-tion may blur vision. Especially at a time,when abundant resources are available. Due tothe level of regulation, money mediationthrough the banks is relatively expensive.Profits can be yielded on the capital market,which is much less regulated than the bankingsector. The large financial funds and hedgefunds operated practically without being reg-ulated despite that fact that their investmentswere often based on large amounts of bor-rowed assets. It can be said that this is theresponsibility of the lending banks. However,this does not change the fact that through the

irresponsible banks they can drag down mass-es of innocent depositors.

Lámfalussy firmly criticizes bailout actionsthat fully get creditors out of the mess underthe excuse of public interest. He emphasisesthat a loan contract always involves two parties:a lender and a borrower. What professionalcontempt was formerly shown for people whocited the responsibility of lenders, too, in rela-tion to the debt crisis, and who called for asort of debt acquittance! Maybe this does notseem completely absurd from a man of sucheminence. The author pointed out: the hungerfor profit led to excessive risk-taking.Therefore, it would be a mistake if thoseresponsible passed on the negative conse-quences exclusively on debtors. Then theywould still be interested in maintaining thistype of “moral hazard”.

It is not necessarily a good thing either thatpreference was given to capital market media-tion, primarily in the Anglo-Saxon countries.Investors excessively relied on the judgementof securities rating institutions, which were farfrom being on the ball. They rated the repack-aged versions of the current mortgages in amanner which made the investors' models suit-able for buying. Financial innovations havemade the market less and less transparent.Excessive confidence in the mathematical mod-els produced a strong bandwagon effect amonginvestors and made the current day crisisunavoidable. But if this is really the case, whydo developed countries inflict their own sys-tems on the emerging countries? It is clear thatfinance techniques cannot yield a solution bythemselves. This is especially so in countrieswith large external debts.

Lámfalussy bravely approaches other, for-merly taboo subjects, too, such as the liberali-sation of speculative capital flows. This is oneof the issues in which we ranked among the'top-grade students'. The author clearly states –in fact, stated several years ago! – that the pre-


210

mature liberalisation of such capital flows isnot advisable. What is more, he says that weshould simply forget that this is included in theIMF charter.

I agree with all sentences of his. I wish I hadread them earlier! Lámfalussy would have rein-forced me in what I thought and said. But itwould have been advisable for other people,too, to consider the viewpoints of this out-standing expert. Fundamentalist market advo-cates should ponder about what has led to the

current crisis. One thing is sure: the course ofchanges that took place in the past two decadesunder the Washington Consensus has broken.Privatisation, liberalisation, deregulation: theseterms need to be reviewed. A new era is immi-nent. But shall we not swing to the otherextreme? Do people who take regulation intheir own hands have sufficient moral backing?This is something that we also need to thinkabout.

Katalin Botos

Dear Author,

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211

MMargit Rácz, a senior member of the Institutefor World Economics of the HungarianAcademy of Sciences offers her readers adynamic, enjoyable and often markedlyprovocative piece of writing. The volume canbe regarded as a certain kind of summary (ifyou like, you can define it as a manual or text-book); however, it can equally be considered tobe an essay to be debated. It is a summary, asthe author gives a comprehensive and criticalanalysis of the main events that have occurredsince the Treaty of Maastricht, and organizesthem into a unique logical order. At the sametime, it is an essay to be debated, because sherefuses to think within the framework of pre-fabricated schemes and solutions. Throughoutthe book, the reader can sense the author's con-viction that the process of European integra-tion is not a story finished but a moving targetthat is being shaped in a complex and compli-cated economic and political space. On the one

hand, it is evident that economic reason dic-tates that, in order to produce the highest pos-sible gain, states should maintain their achieve-ments attained so far and enhance cooperation.On the other hand, political reason seems tooverwhelm economic reason: more and morefrequently, there are (in certain cases serious)clashes between the interests of a member stateand the interest of the community – at least inthe short run. The volume clearly suggests that,in the long run, a commitment to the rein-forcement of mutual confidence that enhancesthe deepening of the EU is rewarding at com-munity and state levels alike. Yet the book isrealistic, too; it points out that “policy makers”– as it is evident in those situations that resem-ble the prisoners' dilemma – tend to defendtheir own interest, even if doing so they exer-cise adverse effect on the long-term interest ofthe community.

The title of the book may be misleading

Margit Rácz

Challenges and choiceof alternatives for theEU in the 2000s The single internal market and the common currency

AKADÉMIAI KIADÓ, BUDAPEST, 2007


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insofar as the author does not focus exclusive-ly on the first few years of the new millenni-um; in fact, it can be stated that the elabora-tion of the events of the 1990s is of greaterimportance. Indeed, it is impossible to discussthe European processes of the 2000s withouttaking into consideration the most significantphase after the Treaty of Rome – the 1990s,that is, the period of the launch of the singlemarket (1993) and the common currency(1999). Those who want to understand theEU of our time cannot skip a thorough analy-sis of the last 15-20 years. Moreover, withoutthe knowledge of the past, it is impossible tooutline future tendencies of development, asthese tendencies are interrelated with paths.However, the subtitle of the volume – TheSingle Internal Market and the CommonCurrency – is very appropriate. Margit Ráczoffers a thorough and critical analysis of thesetwo closely interlinked fields; yet, while doingso, she puts these two eminent results of eco-nomic enhancement in a far broader contextand gives a general assessment of theEuropean integration process. It is not theauthor's fault that the final conclusion is notexplicitly positive.

The approach of the work is best illustratedwith the notion of “faith without illusions”. Itis widely known that Margit Rácz is one of themost committed advocates of European inte-gration – an integration that she understandsto be not only a market-based integration in anarrow sense of the word; she calls (wouldcall) for closer cooperation at the institutionallevel. Meanwhile, she exposes in a mercilessstyle all those economic and political limits(even narrow-mindedness) which, as she putsit, “practically mark the end of economic deep-ening” (p. 9).

Furthermore, this notion – which is far frombeing optimistic – is highlighted in the prefaceof the book, where the reader immediatelyfaces all those major challenges which Europe

has failed to respond to properly so far. Thebudgetary reform cannot be postponed anylonger – this statement, among others, is veri-fied by globalisation (and especially a failure ofachievement in a productivity competition thatis of global dimensions) and ageing society (pp.10–11). Furthermore, the accession, albeit verybeneficial for Hungary, appears different fromthe perspective of the EU: “enlargement bringsabout changes of such a scale which almostconceal the problems related to the standstill ofthe deepening process.” (p. 11). Thus there arenumerous challenges while the institutionsqualified for solving them seem less and lessable to come up with permanent solutions onthe national and supranational levels alike.

The first major section of four chapters isintended to offer information on the majorchallenges of the period between 1995 and2005, that is, of a period mainly characterisedby the introduction and use of the commoncurrency. Another interesting point is that theauthor discusses the performance of the 15-strong EU and its member states not in isola-tion but in comparison with the USA. The firstchapter sheds light on those background dealsthat had determined the evolution of the euro;the German-French relationship is given spe-cial emphasis. As the author points out, theintroduction of the idea of the common cur-rency gave an opportunity for the “influentialgodfathers” to reshape the integration projectas a whole, creating the three-pillar EuropeanUnion (p. 15). The chapter also gives anaccount of the dilemma that the Maastrichtconvergence criteria pertain to nominal indica-tors exclusively and thus fail to deal with thedangers that result from the differences of lev-els of development. That is, the foundingfathers did not look for an answer for the fol-lowing questions: “how great is the dangerposed by heterogenity of development in termsof the functionality of the monetary union?”(p.16) and “which level of economic integra-


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tion guarantees that the states are suitable forbeing members of a currency union?” (p. 17)

Chapter 2 offers a thorough and compre-hensive statistical analysis; yet, obviously, theauthor does not fail to make her critical obser-vations here as well. Possibly, the most impor-tant message of the chapter is that Europe – ifeverything remained unchanged – could fallbehind in terms of modernisation to a disas-trous degree. As for productivity, the USA hasfar better indicators that Europe (p. 31); lag-ging behind in the global economic competi-tion, Europe cannot be in a position favourablefor deepening. Instead, as a rule, solutions (or,rather, attempt for solutions) of member statesdominate (p. 32), which, in turn, clearlyenhance heterogenity (p. 32 and p. 35). Amember state looking for a way out couldstrongly rely on productivity that is of high-quality in terms of innovation and R+D, espe-cially in those industries that use cutting edgetechnologies. Yet, as Rácz points out, Europehas failed to achieve great success in this fieldeither. The author cites the case of Ireland as apositive example several times throughout thevolume. Unfortunately, since then the Irishmiracle has come to be under considerablepressure: it is not known when Irish economywill overcome the present recession.

A major notion of Chapter 2 is related to arestructuring defined by the author in terms ofthe changes of the GDP per capita (calculatedon the basis of purchasing power parity). In theperiod from 1996 to 2006, the three “big”countries (Germany, Italy, and, to a lesserdegree, France) lost their relative power con-siderably; and, as Rácz says, such a restructur-ing exerts a negative influence on the integra-tion process as a whole (p. 43). At this point,the author offers another significant message,related to enlargement; she formulates her ideaclearly when, referring to her own statisticalsurvey, she states that the slow-down of EUdeepening is not due to the enlargement of

2004, “as the process of the deepening of inte-gration has not accelerated among the 15 mem-ber states in the pre-enlargement period,either” (p. 45).

The volume attributes considerableemphasis to the assessment of Germany. Forinstance, Chapter 3 is dedicated to the discus-sion of the challenges of this country of a pop-ulation of 80 million. It is possible to complainand ask if in such an essay it is worth to high-light a single state even if the state in questionis certainly the most important one in severalrespects; however, there is no point in raisingsuch questions. There is no point in doing so,because, on the one hand, it is true indeed thatif Germany has problems, then the EU hasproblems (here it is possible to say “Hungary”instead of “the EU”), and, on the other hand, itis Germany that the author knows the best,therefore, this chapter may reveal correlationsunknown for the majority of readers. Thedescription of the systemic crisis of theGerman model of social market economy pro-vides an example for this. This model “provedto be more and more overwhelmingly expen-sive in the first years of the 1990s, while thetraditional and rigid system of reconciliation ofthe interests of the state, the employers and theemployees failed to function properly anylonger” (p. 50). Yet this type of model erosionkeeps Europe as a whole in a state of uncer-tainty as “the German model (...) no longerserves as a structure to follow” (p. 51). Quiteinterestingly, Margit Rácz's opinion of eco-nomic reforms is most tangible in this chapter:she does not wish back a model that created theGerman miracle, neither does she call for somenew social contract but expressly advocates animplementation of a budget reform thatenhances private sector investments. At thesame time, the author emphasises that the per-fect solution would be to couple programmesintended to solve budgetary problems andefforts made to accelerate modernisation (p.


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66). Unfortunately, these two do not necessar-ily reinforce each other – this is especially truein the short run.

The next chapter (Chapter 4), is a briefone, but it may be regarded as one of the bestsections. Budgetary reform, which has beendealt with in great detail in the previous chap-ters of the book, now emerges in a completelydifferent context. The author investigates if are-formulation of the fiscal policy (a responsi-bility of national authorities within the frame-work of the GMU) makes further deepeningpossible. In this chapter, Margit Rácz clearlyexpounds that European politicians would findheating the EU engine profitable only if it pro-jected the prospect of reducing the costs ofnation-level reforms. Yet the chances areslight. What is more, certain member states,frightened of the even greater social costs ofopening, does not shrink back from limitingthe liberalisation of the service market whilequoting national interests (pp. 77–78). (As tothe nature of the correlation do the two phe-nomena, the author points them out mostexpressly in the final remarks. She says thatcommon currency and common market inthemselves do not provide sufficient extragrowth for the member states. In the absenceof such a hoped-for extra growth, we cannotexpect measures (e.g. the liberalisation of theservice market) that would make the benefitsof the common currency and the single markettangible (p. 181).

The second part of the volume narrowsdown the scope of the hitherto broad investi-gation, and deals with the question if theEuropean cooperation, based on the commonmarket and currency, has the prospect of fur-ther deepening (after all) or the reform com-pulsion, perceivable on the level of memberstates makes national economies immune tocommunity-level challenges. The answerunfolds in three well-structured chapters ofclear argumentation; unfortunately, the conclu-

sion seems to be negative. The first chapter ofthis part outlines the two decades of the devel-opment and achievements of the single marketin textbook-like way. A major conclusion ofthe analysis – based on several Commissiondocuments and especially the reports of AndréSapir (2003) and Wim Kok (2004) – is as fol-lows: “in the 15 EU member states, the notionsof and rules pertaining to market economies[described in different ways] mean safety andfamiliarity for the citizens. Adjustment to thechallenges posed by globalisation endangers,among others, this type of familiarity.” (p. 104)That is, in spite of the pressures that are pres-ent on various levels and in various forms, themajority of the society is for status quo, whichmakes it difficult even for highly determinedpoliticians to commit themselves to reforms.

Having discussed the single market, theauthor starts dealing with the common cur-rency and its institutional system, the GMU.The author states at the very beginning theevolution of the euro is better accounted forby geopolitical events than by the principlesof economic science (p. 116). In spite of (ormaybe because of?) this fact, she dedicates arelatively long section for the discussion ofthe convergence criteria and for the presenta-tion of the macroeconomic performance ofthe member states. The analyses seem to boildown to the conclusion that no matter howindicators are measured or modified, the pointis (was) that the GMU be launched with theparticipation of as many members as possible,and especially of the big states. An interestingissue raised by the author is whether the cul-ture of stability could have been firmly estab-lished in Italy (as well) if it had not been forSilvio Berlusconi and his (too early) populistturn. It might be added that – as Margit Ráczmentions several times – Germany, which hadbeen regarded as an apostle of the stabilityculture, did not prove to contribute to thistype of commitment; in fact, as it becomes


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evident in the final (3rd) chapter of the sec-ond part, Germany did much to dilute thehopeful Stability and Growth Pact. This chap-ter offers several enigmas for the reader toponder on. For example, the fact that theexternal value of the euro is no longer deter-mined by a weighted average of the perform-ance of some of the GMU members but theeconomic performance of the eurozone (whatis more, the EU as a whole) (p. 141). We needto understand this to be able to have a mean-ingful vision of the evolution of a big and liq-uid euro market that can compete with thedollar. Furthermore, as Rácz points out, thelimits and bounds of the international role ofthe common currency are defined by the EU'sability for further deepening (p. 158).However, this question has not been answeredas yet; neither do we know an ideal balance ofnational and supranational levels which canmake the euro and the European integrationas a whole successful.

All in all, the greatest merit of the booklies probably in the fact that it raises provoca-tive questions and formulates points veryexplicitly, and thus urges the reader to think allthe time and to adopt a standpoint. MargitRácz formulates her ideas in such a manner thatalmost all indicative sentences encourage thereader to imagine that there is a question markat the end; that is, the style in this case is atleast as important as the content. This, howev-er, involves the danger that readers, hours afterreading a specific chapter, find themselvesarguing with Margit Rácz or trying to answerher questions. From this perspective, it wouldbe very useful if the book was read not only byenthusiastic students, habitual doubters andthe staunch advocates of European integrationbut also by those fellow-men of ours who def-initely shape Hungarian policies (includingeconomic policy) with the decisions theymake.

István Benczes


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EEdited by András Vigvári, the collection ofstudies with a noteworthy title was publishedin 2007. The collection bears the title of a fa-mily relic that is passed down from generationto generation, one that is our last precious andcherished asset, i.e. the family silver.

We associate this with the heritage of theHungarian system of municipalities, i.e. thevalue of the assets coming from the benefitsreceived after the change in the political sys-tem. The changing tendencies of managingthese asset elements provide the basis for theexamination of the research findings describedin the volume. The author's purpose was to givea comprehensive picture of the processes of theasset management of the municipalities in thepast fifteen years, the possibilities of revampingit, as well as the practical issues related to thetopic, by relying on the selected studies.

The volume contains seven studies, each ofwhich was written about the asset management

of the municipalities, and you can also readnine case studies. The evaluation was per-formed by such experts who regularly monitorthe events related to the Hungarian system ofmunicipalities, and are strongly committed tothe research into the processes of asset ma-nagement. The studies are the summaries andfact-finding works of the analyses performed inthe framework of the research aimed at foun-ding the training programs, which is part of program No. 3.1.1 of the RegionalDevelopment Operative Program aimed atstrengthening the local state administrationresources. These studies include proposals forshifting the processes related to asset manage-ment into a favorable direction.

The asset management of the municipalities,which is part of budgetary financial manage-ment, is researched by few, in spite of the factthat it is a current and very significant issue,which statement is supported by the conclu-

András Vigvári (editor)

The family silver Studies on the asset management of municipalities

GOVERNMENT HUMAN RESOURCE SERVICES AND STATE

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sions of the studies in the volume. After theshift in the political system, a significantamount of assets came to be managed by themunicipalities, which “heritage” has been large-ly reduced in the period since then, partly as aresult of undertaking excessive public tasks,and partly because of the low amount of statesubsidies.

In the first part of the volume, theauthors of the studies lay down the theoreticalbases for municipality asset management. Youcan learn, among others, about the evolutionof the size and composition of these assets inthe past fifteen years, the level of regulation ofasset management, the role of the economicassociations controlled by the municipalities inthe finances of the municipalities, and you canalso receive answers to such practical questionsas the regulatory and organizational condi-tions of operation, the process of municipali-ties receiving assets, the experience of settle-ment operation in Hungary and abroad, or thepossibilities of renewing the regulation of assetmanagement.

The first study of the volume focuses on thehistory of the Hungarian practice of municipa-lity asset management, the importance andtimeliness of the research into the topic, itsinterpretation, as well as its key economicissues, and those problems which are relevantfor the municipality reforms are also discussed.Special attention should be paid to the size andprimary task of the asset elements that came tobe managed by the municipality sector, as wellas to ensuring the sustainability of the publicservices, since, as has also been pointed out bythe editor of the study András Vigvári, theseassets have increasingly become the sources offuture financial risks, and the financial difficul-ties may result in using up the “heritage”. Thevery appropriate title of the article, which is“Dead-End?”, also refers to the questionabilityof the effectiveness and efficiency of today'sfinancial management, and that the planning

and financing systems should be reconsidered,while the performance of tasks should berestructured. The conclusions of the study aresupported by several years of research experi-ence, international comparative studies, as wellas the outcomes of case studies and question-naire-based surveys.

In Dezsõ Gyõrffi's work entitled “The Levelof Regulation of Municipality AssetManagement in view of the Audits”, the deve-lopment and responsible asset managementpractices of some five thousand local andminority governments are assessed. The authorexamines the steps of providing the local go-vernments with assets, the financial bases ofthe consequent task performance obligations,and he evaluates how the size and compositionof the heritage and the pecuniary positions ofthe municipalities changed between 2001 and2005, by relying on indicators and aggregatedbalance sheet data. Furthermore, the financialindicators provide a picture of the deterioratingnational tendencies in the debts and liquidity ofthe municipalities. In the second part of thestudy, the conditions and requirements of assetmanagement, the operation of the related laws,the level of regulation of the framework pro-vided by the laws, decrees and resolutions arediscussed by the author.

The purpose of the third study of the volumeentitled “The Role of the EconomicAssociations Controlled by the Municipalitiesin the Asset Management of the LocalGovernments” is to help readers understandthe nature of risks inherent in the system oflocal governments. The co-authors JózsefHegedüs and Andrea Tönkõ examine the signi-ficance of contingent liabilities in theHungarian system of municipalities, in com-parison with the conclusions of the interna-tional technical literature. According to thestatement of the study, the uncertainty in boththe income and the expense sides of the systemof municipalities is related to the irregular


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nature of subsidies and incomes provided tothe municipalities, as well as to the contingentliabilities, which may be undertaken as a resultof the events discussed in the article. Theauthors give an overview of the regulatory andorganizational conditions of the operation ofmunicipalities, they describe the Hungarianpractice by presenting case studies, while in thesummary chapter, the reader can get familiarwith the elements of the municipality riskmatrix.

In her study, Zsuzsa Kassó also places greatfocus on the importance of learning aboutinternational practices. Although the out-standing role of individual municipalities isrecognized in a number of areas, in general wecan state that in practice, the efficientHungarian method of developing public ser-vices is not yet full-fledged. The study entitled“Settlement Operation and Municipality AssetManagement” calls attention to the precondi-tions of developing more effective and moreconscious cost management and settlementoperation, in relation to the organization ofpublic services. In order to improve social pro-fitability, the requirements and expectationslisted in the article should be measured andquantified as a precondition. By applying per-formance indicators and indicators related tothe changed proportions, the positive or nega-tive impacts exerted by the individual actionscan be concretely measured but their use willbring about genuine results if the reasons thatgenerate the problems in the situation in ques-tion are also identified. The conclusions of theauthor suggest that there is no general rule forthe selection of the right indicator but she pro-poses numerous systems of grouping anddeveloping performance indicators. In the se-cond part of the study, the purpose, methodol-ogy and key work phases of the developmentof municipality strategies are described, alongwith the potential solution alternatives andorganizational frameworks of settlement ope-

ration tasks, and the expense assessment possi-bilities.

The authors of the fifth study, Tamás Boór,Róbert Kovács and Adrienn Németh primarilydiscuss the question of the extent to which themunicipality's assets contribute to ensuring theperformance of the tasks of local public servi-ces and what the tendencies of this contribu-tion are, in space and time. Besides the presen-tation of the proposals regarding theHungarian practice of organizing the local pub-lic services and the more efficient operation ofthe municipalities, the international project-approach asset management experience is alsodescribed here. The new concept of providingpublic services, i.e. the reform school calledNew Public Management, which has evolved inthe Anglo-Saxon countries, as well as its signif-icance, are also discussed by the authors, alongwith the English, French, German and Austrianpractices in the areas of service and administra-tive organization, and health care systems. Inthe last chapter of the article called “AssetManagement and Strategy in the Organization,Operation and Development of Local PublicServices”, you can get acquainted with a casestudy on some Budapest service supply zones,in which the unique problems of the zone sys-tem and the questions of developing a complexindicator system related to these problems areexamined. It is an important conclusion of thestudy that asset management is closely relatedto the performance of tasks, it is a specificdimension thereof but the size of the assetsnecessary for performing the tasks can only beplanned accurately when the consensus-basedpublic service strategy has already been created.

In István Varga's study called “The Creationof Business Administration Type of AssetManagement”, the author examines how themarket and business administration approach isenforced in the municipality budgetary andasset management area, which has by nowbecome critical in the entire public service area.


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The lack of this approach, which means thatthe realistic cost relations of the public servicesare not the subject of the study, can be sensedin several aspects, it emerges uniquely in thecase of big cities as well, which problems aredealt with as special issues in the individualpoints of the chapters. The enforcement of theeffectiveness and cost-saving principles, as wellas the need for the analysis of actual costs andbenefits should be paid special attention in thefuture, which means that a general change inattitudes is needed, and the conditions andrequirements of responsible asset managementshould be clarified. In the practice of munici-pality asset management to date, the establish-ment of the legal regulatory frameworks andthe owners' interests were not given appropri-ate priority, which fact hindered responsibleasset management. It is defined by a funda-mental requirement in the study that the equa-lity of municipality asset management withbudgetary management should be created, andthe author outlines the specific future actionsneeded to achieve this aim.

András Vigvári, the author of the closingstudy of the volume, in his article entitled“Towards a New Asset Management Paradigm”,summarizes those proposals, on the basis ofthe research experience, which refer to themodernization and transformation of munici-pality asset management. In the framework ofthis, a comprehensive, uniform system of rulesshould be built for asset management, and thelegal issues should be settled. The author givesan overview of the general defects of the statu-tory regulation of public assets, the peculiari-ties of the “Hungarian model”, the justificationof the relevance of transformation, and hemakes proposals for the key aspects of the newregulatory frameworks. In the area of regula-ting asset management, you can get a compre-hensive view of the problems related to thelocal decrees, simultaneously to which you canalso be informed of the possible solutions. In

the future, it would make sense to strive forproactive asset management, according towhich an asset management concept should bedeveloped. In the last part of the study, in dis-cussing the regulatory issues, the need for theprinciples of complexity, prudence and disclo-sure appears, along with the significant oppor-tunities to improve the circumstances in theinformation background of asset management.

In the second part of the volume of stu-dies, the reader may get familiar with today'sasset management practices of the settlement,small regional and county level municipalities,in the form of case studies. Zoltán Agg presentsto the reader the economic program of theVeszpém County Municipality, and the peculi-arities of its financial management, whileDezsõ Gyõrffi describes the activities, the evo-lution of the asset structure and the level ofregulation of the asset management of theTiszaújváros Municipality between 2002 and2005. In several case studies, the asset manage-ment issues and principles of settlements areexamined; Károly Jókay and Tamás Boór showthe achievements of the City of Veszprém,Zsuzsa Kassó describes those of the City ofNyíregyháza, István Varga deals with the PécsMunicipality, and Róbert Kovács presentsthose of Budaörs. Co-authors György TiborSzmetana and Zsuzsanna Tóth present the casestudy of a Budapest district that comprises foursettlement parts, namely that of theMunicipality of Ferencváros. One can learnabout the issues related to the asset manage-ment of the Mezõkövesd Multi-purpose SmallRegional Association from the conclusions ofan article written by Róbert Kovács, or fromZsuzsa Kassó's third article published in thisvolume of studies, which is a presentation ofthe practical methods of the regional zonesthrough the examples of the maintenance ofpublic lighting and the local public roads. Theuniform content structure of the case studiesensures the comparability of the asset manage-


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ment issues and peculiarities of the individualmunicipalities, and the nature of practicalapplicability.

The extraordinarily high-standard volumeof studies, which is also the merit of the pub-lisher, contains very useful attachments. The listof abbreviations and the names of the institu-tions, as well as the glossary and the explana-tions of the concepts used in the volume makethe book easy to use. The abstracts at the begin-ning of the studies and the brief English lan-guage descriptions in the last part of the volume,which summarize the major conclusions of thearticles, are also of great help to the readers.

The book of studies gives a comprehensivepicture of the theoretical bases and the practi-cal questions of municipality asset managementand the performance of tasks, their Hungarianand international features, as well as the dilem-mas and development of the asset managementbuilt on the new principles of the businessadministration approach in an easily under-standable way, which can be recommended toboth the theoretical and practical expertsinvolved in this field of study and to studentsand readers interested in the financial manage-ment of municipalities.

Ildikó Gyõrffy

Documents

1-2 Tartalom A