S&P Joins Moody's In Downgrading Hungary To Junk, Outlook Negative - Full Note

On November 25, Moody's cut Hungary to junk. Now it is S&P's turn: "The downgrade reflects our opinion that the predictability and credibility of Hungary's policy framework continues to weaken. We believe this weakening is due, in part, to official actions that, in our opinion, raise questions about the independence of oversight institutions and complicate the operating environment for investors. In our view, this is likely to have a negative impact on investment and fiscal planning, which we believe will continue to weigh on Hungary's medium-term growth prospects. Moreover, in our opinion, the downside risks to Hungary's creditworthiness have also increased as the global and domestic economic environments have weakened."

Full note:

Overview

  • In our view, the predictability of Hungary's policy framework continues to weaken, harming Hungary's medium-term growth prospects.
  • We are therefore lowering our long- and short-term sovereign credit ratings on Hungary to 'BB+/B' from 'BBB-/A-3' and our long-term counterparty credit rating on the National Bank of Hungary (the central bank) to 'BB+' from 'BBB-'.
  • We are also removing all ratings from CreditWatch negative, where they were placed on Nov. 11, 2011.
  • We are assigning a recovery rating of '3' to Hungary, which reflects our assessment of "meaningful recovery" of 50%-70% in the event of a sovereign default.
  • The negative outlook reflects our view that there is at least a one-in-three possibility of a downgrade over the next year if we see that Hungary's fiscal or external performance deteriorates.

Rating Action

On Dec. 21, 2011, Standard & Poor's Ratings Services lowered its long- and short-term foreign- and local-currency sovereign credit ratings on the Republic of Hungary to 'BB+/B' from 'BBB-/A-3'. The outlook is negative. We also removed the ratings from CreditWatch negative, where they were placed on Nov. 11, 2011. We have assigned a recovery rating of '3'. At the same time, we have revised the transfer and convertibility assessment to 'BBB' from 'A-'.

We have also lowered the long-term counterparty credit rating on the National Bank of Hungary (the central bank) to 'BB+' from 'BBB-' and removed the ratings from CreditWatch negative.

Rationale

The downgrade reflects our opinion that the predictability and credibility of Hungary's policy framework continues to weaken. We believe this weakening is due, in part, to official actions that, in our opinion, raise questions about the independence of oversight institutions and complicate the operating environment for investors. In our view, this is likely to have a negative impact on investment and fiscal planning, which we believe will continue to weigh on Hungary's medium-term growth prospects. Moreover, in our opinion, the downside risks to Hungary's creditworthiness have also increased as the global and domestic economic environments have weakened.

In our opinion, changes to the constitution and the functioning of some independent institutions, including the central bank and the constitutional court, have undermined Hungary's institutional effectiveness. Following changes to the process of appointing members of the central bank's monetary policy committee in 2010, the authorities most recently have proposed legislation that we believe could further compromise the central bank's independence. If enacted, such legislation would transfer to the government the power of the bank's governor to appoint the bank's deputy governors. The proposed legislation would also require the bank's board to notify the
government, in advance, of its agendas for meetings, as well as raise the number of members of the rate-setting Monetary Policy Council to nine from seven.

Moreover, we believe that measures taken over the past year, which affect several services sectors, could hinder economic growth by reducing banks' willingness to lend and companies' appetite to invest. In particular, the imposition of temporary tax hikes on various services--including telecoms, energy, and the financial and retail sectors--is likely to depress investment and job creation in the short term, in our view. This could constrain growth prospects at a time when we see risks to the open Hungarian economy are rising due to the uncertain outlook for the global economy. However, we note that following the unilateral move to facilitate households' prepayments of foreign-currency-denominated mortgages at concessional rates, the authorities have subsequently collaborated with the banking sector to share the burden of a redesigned policy aimed at easing the debt-servicing burden on mortgage holders.

In our view, both policymaking and creditworthiness could be bolstered from participation in a multilateral program. In November 2011, the Hungarian government formally approached the IMF and the EU regarding a new financing arrangement; the previous joint program had expired in October 2010 without another program being agreed. Preliminary discussions on a new program were cut short in December 2011, but the authorities have indicated that negotiations are likely to resume in January 2012.

Hungary's current account has shifted into surplus, but we see that external debt net of liquid assets--at an estimated 65% of current account receipts in 2011--remains high. Although we view the stronger external performance positively, we see that Hungary still faces substantial refinancing needs, particularly in the short term as the government begins to amortize its debt to the IMF and EU.

At an anticipated 70% of GDP at end-2011, we consider net general government debt to be high compared with peers, despite the relief, on an accounting basis, provided by the government's decision in late 2010 to direct private pension assets (equivalent to 9.8% of 2010 GDP) into the budget, effectively reversing the pension reform introduced in 1997. The pension transfer, in our opinion, has not improved the overall state of Hungary's public finances, as it has exchanged an explicit liability for an implicit one. Roughly 40% of commercial general government local-currency debt is held by nonresidents. The financial crisis in late 2008 revealed the rapidity with which local currency bonds held by nonresidents can be sold if investor confidence falters, resulting in increased pressure on the balance of payments. In our view, this makes Hungary unusually vulnerable to sudden shifts of capital flows.

Furthermore, an estimated 50% of total general government debt is denominated in foreign currency, which we think makes the debt burden highly sensitive to exchange rate fluctuations. Another potential area of risk is the large share of foreign-currency-denominated loans to the resident private sector, largely to unhedged Hungarian households. The high level of foreign-currency-linked liabilities constrains Hungary's monetary flexibility, in our view.

The ratings are supported by what we view as Hungary's comparatively advanced economy, highly skilled labor force, and relatively well-diversified economic and export structures.

The recovery rating on Hungary's foreign currency debt is '3', indicating our view that post-default recovery would likely be approx. 50%-70%. The recovery analysis assumes a default stemming from a sharp adjustment in the country's exchange rate. Under this hypothetical scenario, the recovery rating is supported by the country's flexible and open economy.

Outlook

The negative outlook reflects our view that there is at least a one-in-three possibility of a further downgrade over the next year if we see that Hungary's fiscal or external performance falters, resulting in increased debt burdens. We believe the Hungarian economy remains vulnerable to external shocks that could, for example, trigger a substantial decline in non-resident holdings of government securities, leading to negative balance sheet effects that would weigh on economic performance--with negative implications for public debt dynamics.

Conversely, if the government were to use its strong majority in parliament to establish policies that encourage investment, while implementing its structural reform program, the Széll Kálmán plan, we expect that the downward pressure on the ratings could dissipate or even reverse.