ANALYST VIEW - Hungary PM misses IMF boat before potential downgrade - Merrill Lynch

“Renewed cooperation with the Fund would have added credibility to the fiscal consolidation plans, facilitating budget funding in the coming year. Alas, heightened global risks and still elevated uncertainty surrounding the government’s policy mix in our view imply a high risk that Hungary will soon lose investment grade status by one rating agency and potentially other will follow in the coming year," Tenconi said in a research note earlier this week.Does Hungary deserve investment grade status?

Tenconi sees a “high risk" that S&P will downgrade Hungary by one notch in coming weeks.

Moody’s has also been reported to be reviewing Hungary’s rating this month, but she expects the agency to affirm the rating and the outlook for now.

In Tenconi’s view, Fitch is likely to review in the coming six months, seeing a risk of a downgrade to the outlook and she would not rule out the possibility of a downgrade to BB+ in the coming year if funding difficulties materialise.

Although the three agencies have slightly different approaches, the rating assessment pivots around four issues:

1. The deficit outlook, where risks are biased on the upside;
2. Debt dynamics, where you find short-term improvements but risks in the long term;
3. The new debt repayment scheme, which is not a primary concern, but the overall banking sector health and the business environment are; and
4. Hungary’s funding, which is feasible under favourable global conditions.

1) Deficit outlook: risks biased on the upside.

According to the latest statements all three rating agencies expect a budget shortfall at around 3% of GDP in 2012, above the 2.5% of GDP goal. (The central bank said in its latest forecast that the budget gap is likely to come in at 3.1% in 2012.)

Tenconi reiterated that the draft budget uses fairly conservative growth assumptions, but the deteriorating global backdrop in her view implies that “a deviation of 1% of GDP is likely and risks are biased on the upside."

“Over and beyond the challenges due to weak growth, recent comments from government officials raise questions about the true commitment to reforms now that Fidesz’s approval rating is falling."

Among the risks Tenconi listed the reintroduction of interest subsidies for mortgages (estimated cost HUF 6.3 bn a year); an 18% increase in the minimum wage next year and a further 8.6% in 2013/2014; the government paying for the wage cost increase beyond the first 4-5%; support to the local council also apparently underestimated in the budget (according to TÖOSZ association; support of an additional HUF 50 bn will be needed in 2012) and that the ongoing restructuring of the local councils’ CHF debt may eventually result in unplanned fiscal cost to the central government.

2) Debt dynamics: short term improvements, but long term risks

Thanks to the returning pension assets and the early repayment of part of the IMF loan this year the debt to GDP ratio is likely to fall by around 8 percentage points of GDP this year. “However, we have strong reservations about further improvements thereafter if the government does not show stronger ability to control spending and more credible resolution in sustainably prudent fiscal management."

3) New debt repayment plan

The FX debt relief programme that allows households to repay at a preferential exchange rate has raised criticisms, but Tenconi does not believe any of the three agencies will see it per se as an important negative factor.

“All of them however have highlighted the importance of a predictable business environment and strong support from the foreign parent banks to their local subsidiaries. We see deterioration in both and the key risk is an acceleration of the deleveraging of foreign banks in coming years."

In Tenconi’s view, deleveraging implies two problems, namely that it is negative for growth, as long as private sector savings are low, and it reduces the ability of banks to absorb local bonds.

She noted that Prime Minister Viktor Orbán and Fidesz parliamentary group chief János Lázár both indicated that if the take up of the FX debt relief programme is not significant enough, new measures will be implemented next year.

4) Funding

Tenconi estimates Hungary’s total financing needs at EUR 13.2 bn in 2012, up from EUR 12.3 bn in 2011. Net foreign issuance will be zero, but the Government Debt Management Agency (ÁKK) will have to issue around EUR 4.5 bn to pay back the EU-IMF loans and the maturing Eurobonds.

The chart below shows foreign investors hold a significant share of the local and FX bond markets.

“Going forward their exposure will need to increase as the ability of local players to absorb new paper is limited. However, this could prove challenging given the potentially lower rating and an unfavorable global backdrop."

What positive surprise could materialize?

The government has intensified negotiations with China and the ÁKK recently underscored they aim to diversify the investor base and Bank of China may become primary dealer in future, Tenconi said.“We would view this as an important positive step forward. However, it remains to be seen whether these changes can happen quickly enough. Had the government moved forward with a precautionary SBA with the IMF, the risks from global contagion would be noticeably lower and the benefits from the already implemented reforms on funding cost greater."

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• deficit,
• economy,
• debt,
• merrill lynch,
• orbán