EU Disciplinary Action against Hungary Carries Huge Risk for Economy

The European Union’s decision to launch a new rule of law mechanism against the Hungarian government threatens to strip Hungary of billions of forints in much-needed funding. The move comes at a time when the government needs to rein in a swelling budget deficit and faces a slowdown in the economy.

Hot on the heels of Prime Minister Viktor Orbán’s landslide victory in Hungarian parliamentary elections, the European Commission announced that it would trigger a new mechanism against Hungary designed to withhold EU budgetary funds from member states accused of undermining the rule of law. Hungary becomes the first member state to potentially face funding cuts for breaching EU laws and standards.

Conditionality mechanism
The mechanism is a recently introduced procedure designed to protect the EU's financial interests against breaches of rule of law taking place inside a member state. Policy makers in Brussels devised the mechanism to prevent governments within the EU that do not comply with the bloc’s rules from profiting from EU taxpayers' money. The regulation came into force in early 2021 after some member nations failed to veto the text. Poland and Hungary criticized the instrument and unsuccessfully brought a case before the European Court of Justice to discredit its legitimacy. Warsaw and Budapest have been accused of backtracking on democratic norms and both countries are currently under the EU’s Article 7 procedure.
The regulation defines rule of law as a set of fundamental values, including legal certainty, effective judicial protection, independent and impartial courts, separation of power and non-discrimination. The mechanism targets breaches of EU law that affect or pose a serious threat to the EU's financial management, namely the common budget. Violations that can trigger the mechanism include the ones that have a negative impact on the execution, control and audit of EU funds, the prevention of fraud and corruption, and the cooperation with relevant EU agencies.
In the event of such a violation, the Commission can submit a proposal to the European Council. A qualified majority — 55% of EU countries (15 out of 27) representing at least 65% of the bloc's population — is then needed for it to pass.

Move on to the next step
Earlier this week, European Commission President Ursula Von der Leyen announced that Brussels was launching the mechanism against Hungary and said that the Commission had informed the Hungarian government of the move after reviewing the government’s responses to a letter the EU executive sent last November about its rule-of-law concerns. “We’ve carefully assessed the result of these questions,” von der Leyen said, speaking to the European Parliament. “Our conclusion is we have to move on [to] the next step.”
The decision to move ahead could signal a turning point in Brussels’ willingness to go after member states accused of corruption and democratic backsliding. This is not the first instance that Brussels implements disciplinary action against Hungary over democratic values. Last summer, the EU suspended payments from its pandemic recovery funds to the tune of EUR7.2 billion to both Hungary and Poland over democratic backsliding and corruption.
The Commission has long-standing concerns regarding Hungary's judicial independence, conflicts of interests and systemic corruption. OLAF, the EU's anti-fraud agency, has put the country at the top of its list of irregularities involving EU funds, with public projects considered to be over-budgeted and overpriced.
"The main requirement for reform is the anti-corruption question, and we are at the moment being not able to find a common ground and to conclude," von der Leyen told MEPs.
Orbán contradicted von der Leyen when he said the following day that he did "not know of any outstanding issues" and that "it's just not true, we have agreed on all these issues."
As a next step, the Commission will have to build a legal case providing evidence that the EU law breach harmed the EU budget. Hungary is entitled to make comments about the Commission's legal findings, offer additional information and propose solutions to address the alleged breaches. If the executive remains convinced that the common budget is still under threat, it can issue a recommendation to freeze EU funds. The recommendation is sent to member states, who have one month to discuss it and take a vote.

Economic malaise
The EU’s move comes at a time when Hungary faces dire economic times due to high energy prices, rampant inflation, increasing interest rates, and the slowing of growth.
Hungary’s budget deficit in 2021 was 6.8% of GDP and analysts predict that in order to meet the new budget deficit target of 4.9% of GDP, investments and capital transfers need to be frozen or deferred. Higher energy prices have cost Hungary at least HUF one trillion forints a year and the deteriorating economy could also have a HUF 350-billion impact on the budget, according to an analysis by OTP Bank. All of these together represent a more than 3% budgetary adjustment of Hungary’s GDP.
Péter Virovácz, senior economist of ING Bank in Budapest, told economic portal G7.hu that the war had an even worse impact on the economy than the coronavirus pandemic. Rising energy prices will force the Hungarian government to increase domestic utility prices, which in turn will increase inflationary pressures in the economy. With inflation running at an almost 15-year high of 8.3% in February, Orbán will have a tough task in unwinding some of his measures that had helped tame price growth in the run-up to the elections.
Unlocking pandemic recovery funds withheld by Brussels could play a key role in fixing the budget, so Orbán is expected to fight for that, but it could be a lengthy process.
At the same time, the launch of the rule of law mechanism against Hungary could lead to a partial or full suspension, interruption or reduction of EU funds allocated to the country. The procedure can also prohibit the country from entering new financial agreements with the bloc and force it to repay pending loans earlier than initially expected. The measures can be lifted at any time if the accused member state takes action to correct the situation and the Commission concludes the EU law breach, even if it persists, no longer poses a threat to the EU budget.