S&P affirms sovereign ratings, negative outlook on Hungary

Overview

“In our view, Hungary's creditworthiness continues to be constrained by the economy's weak growth prospects, limited monetary flexibility, and high stocks of public and private external debt.

“The rating is supported by the economy's well-diversified economic and export structures, which ensure a relatively stable tax base.

“We are affirming our 'BB/B' long- and short-term sovereign credit ratings on Hungary, as well as the 'BB' long-term issuer credit rating on the National Bank of Hungary.

“The outlook remains negative, reflecting at least a one-in-three chance of a downgrade if the policy framework lessens confidence and medium-term economic growth prospects, or significantly raises financing costs and leaves the country exposed to sharply diminished capital inflows."

Rationale

S&P said the ratings are constrained by its view of “Hungary's weak growth prospects, constrained monetary flexibility, and high stocks of external debt." The rating agency also believes that institutional checks and balances have weakened in recent years.

“Because household, corporate, and government balance sheets remain highly euroized, policies that increase the probability of exchange rate depreciation could, in our opinion, weigh on economic performance, and push up debt burdens. The rating is supported by the economy's well-diversified economic and export structures, which ensure a relatively stable tax base," S&P said.

“Over the last two years, fiscal policies have lowered net government borrowing needs substantially. However, we believe they have done so partly at the expense of growth prospects. In our view, since 2011 Hungary has made fiscal progress, mostly either by capital withdrawals from the private pension system or by selectively raising taxes on foreign investors, including parent banks. General government expenditures have been contained, but not materially decreased, at just under 50% of GDP for 2013. This is high compared to most of the middle-income sovereigns we rate."

S&P does not anticipate that the government will reduce spending significantly in 2014, either. “As a consequence, we do not view net general government debt to GDP as trending permanently downward; our forecast stabilizes at about 74% of GDP through to 2015. Any such forecast also depends heavily on expectations of future exchange rate movements given that approximately 40% of government debt is foreign-currency denominated."

S&P considers Hungarian growth prospects to be weak compared to peers, forecasting real GDP growth of just under 1% on average between 2013 and 2015.

“This reflects likely continued financial-sector impairment, as well as our expectations for moderate net foreign direct investment inflows and weak private sector employment growth. While there is some evidence of increased employment activity, this is mostly owing to government jobs programs rather than increased labor demand in the private sector," S&P said.

The rating agency also sees mixed signs of competitiveness. “On the one hand, wage inflation has remained at levels well above reported inflation; while export market shares for Hungary have not improved to the extent they have for some peers, partly due to downsizing in Hungary's previously large electronics sector. On the other hand, the inflation-adjusted exchange rate has depreciated substantially since 2007."

Noting that like many regional peers, much of Hungary's recent economic weakness reflects private sector deleveraging, S&P also assessed, however, that “the duration and scale of capital outflows from the Hungarian economy--amid diminished net foreign direct investment--as higher than in many other Eastern European economies."

The rating agency estimates that each year since 2009, foreign parent banks have rolled over on average 85% of the gross external funding of their Hungarian subsidiaries. “We anticipate that the rollover rate will remain well below 100% during 2013, leading us to project that depository corporation claims on the non-government sector will decline for the third consecutive year. In our view, these especially low rollover rates at least partly reflect Hungary's less-predictable business environment and tax framework."

“Further, several years of negative credit growth have driven the investment-to-GDP ratio to decline to an estimated 17% of GDP this year, compared with 22% in 2006, leaving gross investment levels below the estimated amortization of Hungary's capital stock. Non-construction investment growth remains low. In 2013, we expect private investment will continue to decline, year-on-year, though should gradually recover from 2014," S&P said.

It also noted that nonperforming loans and restructured loans in Hungary's banking system remain high and that financial-sector balance sheet repair has been slow, “reflecting low profitability and a stagnant property market."

“During 2012 and 2013, parent banks provided an estimated 3% of GDP in net capital to their subsidiaries. Our baseline expectation is that, due to reputational considerations, European parents will keep supporting their loss-making Hungarian subsidiaries. However, government policies that continue to generate additional losses for the financial sector could test foreign banks' commitment."

S&P anticipates that the Hungarian government will meet its objective of keeping fiscal deficits below 3% of GDP over 2013-2015, using the accruals-based European (ESA 95) accounting standard. It also projects that the current account will remain in a surplus of 1%-2% of GDP this year and next, before narrowing in 2015 as domestic demand recovers. S&P sees net general government debt to GDP remaining close to 2012 levels of 74% of GDP through to 2015.

“Our calculation of net general government debt is narrower than the government's as we deduct from the general government debt only the most liquid assets, such as deposits held at the National Bank of Hungary and commercial banks," the rating agency noted.

High Nonresident debt holdings could be a problem

Of general government local-currency debt, S&P estimates 38% (which is equivalent to an estimated 16.8% of GDP) is held by nonresidents. While the rating agency views this as positive in terms of diversified funding, it underlined that the financial crisis in late 2008 illustrated the rapidity with which local currency bonds held by nonresidents can be sold if investor confidence falters. “This increases pressure on the balance of payments, the exchange rate, and, ultimately, debt-servicing capacity."

“At approximately 40% of the total, the foreign currency component of general government debt remains high. This renders the debt burden highly sensitive to exchange rate fluctuations."

Hungary's external liabilities are moderately high, and rapidly declining. S&P estimates external debt, net of official reserves and financial sector external assets, at about 47% of current account receipts in 2013, down from a peak of just over 80% in 2009.

The rating agency noted that most of the improvement in the current account position in 2008-2012 was on the back of reduced imports, rather than stronger exports (the exception being stronger services exports). In August 2013, Hungary repaid its stand-by loan (2.2% of GDP) to the IMF, ahead of schedule.

For 2013 as a whole, the government will need to refinance 19% of GDP of debt, followed by 20% of GDP in refinancing in 2014, EUR 2 billion (2% of GDP) of which is owed to the EU.

“We view Hungary's monetary flexibility as relatively limited. This reflects the high euroization of its financial sector and the sensitivity of inflation to the exchange rate channel. While we see some risks from the central bank expanding its balance sheet for its "Funding for Growth" scheme, this will not likely undermine the bank's broad commitment to price stability, in our view.

“If the Hungarian forint were to depreciate significantly, however--say if nonresidents decided to close local currency positions--then the government's debt burden, and that of the private sector, would rise. This could undermine what we expect to be a fragile economic recovery this year."

Outlook

“The negative outlook reflects our view that there is at least a one-in-three possibility that we could lower the ratings over the next year if Hungary's economic recovery weakens significantly, if banks accelerate their withdrawal of credit, or if we see external or government finances materially weaken.

“In our view, the Hungarian economy remains vulnerable to diminishing confidence that could, for example, trigger a substantial decline in nonresident holdings of government securities, leading to higher financing costs and weaker economic growth.

“Conversely, we could revise the outlook to stable if we saw the government using its strong majority in parliament to establish policies that encourage investment, while implementing its structural reform program (the Szell Kalman Plan). Similarly, the ratings could stabilize, or even improve, if we saw a sustained reduction in the country's net external liability position, even as economic growth strengthens."

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