BUDAPEST: Only a decade ago, with its "goulash socialism" Hungary seemed the most prosperous communist economy. After communism collapsed, Hungarian leaders, and the Hungarian people, thought that their less restricitve system offered big advantages over other communist countries in the race to reform. Where others had to rush, Hungarians thought they could change more slowly. Today, that illusion is tattered.

Hungary's economy differs from other post-communist economies in two ways: the huge debts with which Hungary began the transition, and the open economy that these debts inspired. Although the debt burden decreased since 1993, it still retards growth. As a proportion of GDP Hungary remains one of the most indebted countries of Eastern Europe.

Unlike Poland, however, Hungary never rescheduled its debts. So to maintain creditworthiness, the country has been forced to adopt pragmatic economic policies that today deliver an unusual economic openness -- this, and not the ephemeral benefits of "goulash socialism" is the longterm hope for the Hungarian economy. For with this opening, Hungary absorbed the largest foreign direct investment (FDI) in the region.

Raw politics caused Hungary to open its economy. Hungary's safety valve since 1990 has been to generate open structures. After a slow start, since 1995 privatization has pushed this process forward. Geared to closing gaping holes in the state budget, privatization sales became the favorite mechanism rather than mass distribution schemes in the manner of the Czechs. Sales led to more FDI, as the only people with deep enough pockets to pay big money for state assets came from abroad. In a virtuous circle, FDI reinforced trade openness: according to the Ministry of Industry, Trade and Tourism, 80% of Hungary's exports are generated by companies fully or partially owned by foreigners.

This trade dynamism was derailed only when the country's macroeconomic policy, particularly exchange rate policy, lost credibility in 1993-94. The lesson policymakers drew is that Hungary's deep integration into the international economy makes it impossible to pursue soft macroeconomic policies; the impact of such laxity on Hungary's external balances is immediate because international capital markets lose confidence quickly in the country.

A third pillar of Hungary's open economy, unusual in the region, is the internationalization of banking and energy. Openness in Hungary's banking sector, measured by the share foreign strategic investors' control of the sector's total assets, is unprecedented, not only by transition economy standards but also by European ones. After the recent privatization of the Hungarian Credit Bank to the Dutch bank ABN AMRO, this share is more than 60%, and likely to grow.

The path to such openness was thorny: foreign competition in the early 1990s deepened the structural problems of big Hungarian banks, a malady which faster privatization could have eased. State banking bail-outs cost about $3 billion. Despite early errors, Hungary's banking industry is now the most sophisticated among the transition economies and the internationalized part is modernizing its corporate services, contributing to the health of companies in the wider economy. Such openness encourages additional foreign companies to invest in Hungary, because they can rely on the support of banks familiar to them. Hungary's insurance industry is even more international: 95% of the insurance market is controlled by foreign strategic investors.

Energy sector privatization strengthens the economy's openness, too. Global energy companies in Hungary are interested in promoting strong growth in the number of customers using their services; they act, alongside banking and insurance industries, as a vital lobby on the government for greater foreign investment and openness.

These mutually re-enforcing actions explain why, despite numerous predictions that the Hungarian market would be "saturated" with foreign investment, nothing of the sort has come to pass. Accelerating internationalization means that the country is capable, in a sustained way, of absorbing investments equal in type and size to those received in the last 5 years. This will be helped even more if economic policy, particularly tax policy, becomes more investment friendly.

So Hungary's debt crisis posed an opportunity to modernize and transform the country -- particularly Budapest -- into a regional center for trade and finance. According to the Institute for World Economics in Budapest, 39 out of the 50 largest multinational companies now have production facilities in Hungary. Hungary's international integration makes it more suited to playing a regional role than neighboring countries. Within 4-5 years Hungary may possess a more developed banking industry than neighboring and more affluent Austria, where state ownership and informal government interference remain characteristic in banking.

Two big policy challenges face Hungary. One is chronic overtaxation. Although the share of tax income to GNP has decreased over the last three years, it is due more to a lax tax regime than to a systematic reduction of marginal tax rates. Many influential groups, however, effectively avoid high taxation. This situation is detrimental to long term investment and needs to be changed to lower and broader the tax base. Tax modifications planned for 1997 are modest steps in the right direction: personal income taxes as well as the employees' contribution to the social security system are being shaved and simultaneous measures have been taken to strengthen tax administration. Braver steps are needed.

Pensions are a second area for serious reform. Privatizing pensions, or some substantial part of them, will impact domestic savings and thus the demand side of the capital markets. This is important since Hungary's growth should not rely only on foreign savings and investments. So today's pay-as-you-go system must be accompanied by a capitalized system that will be voluntary for a large part of today's employees and mandatory for new entrants. If opponents to these reforms block real change, they risk a quick closing of Hungary's openness to growth.