Fitch cuts Hungary's outlook to negative

Highlights of Fitch's rating review

• outlook cut to Negative from Stable, rating confirmed at 'BBB'
• high probability of delayed disbursement of EU funds
• economic growth to slow to 0.4% in 2023 from 4.7% in 2022
• inflation to average 17.6% in 2023 vs. peer median of 5.7%
• HICP to peak in Q1 around 25%
• energy supply risks could re-emerge ahead of the 2023-2024 heating season
• budget gap to narrow to 4.3% of GDP in 2023 from an expected 6.1% in 2022
• public debt to decrease further toward 65% of GDP from an expected 73.5% in 2022
• central bank to gradually lower one-day deposit rate and slowly ease monetary conditions from mid-2023
• current account deficit to narrow to 3.3% of GDP in 2024

Tough environment highlights policy weaknesses

In Fitch's view, a tougher international environment, including higher global interest rates, volatile energy prices and weakening demand from key trading partners is exposing vulnerabilities stemming from a policy mix that is influenced by political considerations.

Inflation is among the highest of all Fitch-rated sovereigns as price caps have proved ineffective and added to fiscal costs, while monetary policy transmission is being hampered by targeted mortgage interest rate caps,

Fitch said in the country's first rating review late on Friday (20 Jan).

The rating agency noted that a sharp pre-election fiscal expansion was followed by post-election fiscal tightening and then broadening of sectoral windfall taxes in the 2023 budget.

"Concerns over the policy mix and access to EU funding put pressure on the currency in October 2022, triggering out-of-cycle tightening by the central bank that has added to growth headwinds," it added.

Continued uncertainty about EU funds

Fitch sees a high probability of delays in the disbursement of EU funds. Despite the approval of Hungary's National Recovery and Resilience Plan, which prevented the premature loss of 70% of EUR5.8 billion (3.2% of GDP) in grants, the first disbursement is conditional on Hungary fulfilling 27 "super-milestones", many of which are on rule of law.

Implementation of super-milestones will be monitored during the Recovery and Resilience Facility (RRF) programme and Fitch sees a high possibility that differing interpretations and political considerations will delay RRF disbursements.

Although the direct impact of a delay in disbursements on medium-term growth and external finances would be modest, in Fitch's opinion

it would raise further questions over policy credibility, highlight governance challenges and potentially hurt investor sentiment.

Economic growth to weaken

Fitch expects growth to slow to 0.4% in 2023, from 4.7% in 2022. Following strong growth of 7.1% in 1H22, the economy contracted by 0.4% qoq in 3Q22, and weak growth is also expected for 4Q22 as double-digit inflation continued to weigh on household disposable incomes, and increased uncertainty hit investment activity.

"In 2023, elevated inflation, decreasing real wages, and low consumer sentiment will shrink household consumption. Investment growth will slow, as a planned cut in public investment spending, high funding and raw material prices more than offset the positive impact of expected flow of remaining funds under the 2014-2020 Multiannual Financial Framework," it said.

Inflationary pressures to rise

Fitch forecasts Hungary's inflation to remain high relative to peers, projecting an average of 17.6% in 2023, well above the projected peer median of 5.7%, as pressures arising from international food and fuel prices and exchange rate depreciation have broadened.

Fitch expects HICP inflation to peak at around 25% yoy likely in 1Q23, and to remain above 20% throughout 1H23.

"Price growth should then begin to slow sharply down due to the base effects, with the headline HICP decreasing toward 6% yoy by year-end, although commodity prices, domestic price caps and regulated utility prices add significant uncertainty. Nominal wage growth will remain below but close to inflation, increasing the risk of a wage-price spiral," it said.

Energy supply risks remain

Fitch reminded that at present Hungary does not have alternative gas sources secured in case of a full halt of gas supply from Russia (which covers 80% of Hungary's needs).

Although the country is well positioned to navigate the 2022/23 winter, energy supply risks could re-emerge ahead of the 2023-2024 heating season,

it warned.

Fiscal deficit to narrow

Fitch forecasts the budget deficit to narrow to 4.3% of GDP in 2023, from an expected 6.1% of GDP in 2022. It notes that its forecast is slightly higher than the government target of 3.9% of GDP, due to Fitch's more pessimistic growth outlook, although the rating agency notes the government's record of sticking to or over-performing annual targets.

"Slower spending growth after last year's elections and the absence of a one-off payment on emergency gas purchase (1.2% of GDP) will lower the deficit," Fitch said.

"The revised budget now allocates 3.4% of 2023 GDP for the subsidies related to utility prices, which will be partly offset by a broadening and deepening of windfall taxes and further spending cuts. Given recent sharp falls in gas prices, the final cost of subsidies related to utility prices could be lower than projected and poses upside risk to budget performance in 2023," it added.

Public debt to decrease further

Fitch expects Hungary's gross general government debt to continue decreasing and to move toward 65% of GDP in 2026, from an expected 73.5% of GDP in 2022. It projects the decrease to be predominantly driven by strong nominal GDP growth and a reduction in the budget deficit.

Nonetheless, debt will remain high compared with the current peer median of 55.5%.

"While Hungary demonstrated access to a variety of financing sources in 4Q22, the relatively low average maturity of debt compared to peers and higher cost of domestic borrowing mean interest payments are forecast to increase to 8.8% of revenues in 2023, from 5.5% in 2021 (current 'BBB' median of 7.8%)," Fitch said.

Monetary policy to remain tight

The National Bank of Hungary (MNB) raised its key rate by a cumulative 10.6pp to 13.0% in 2022. After pressure on the currency in October, the MNB introduced a one-day deposit facility with 18% interest, which became the effective interest rate and has been kept flat since its introduction. Policy transmission is hampered by a loan interest rate cap scheme on household mortgages.

Fitch expects the MNB to gradually lower the one-day deposit rate to the level of the key rate and to slowly start easing monetary conditions from the end of 2Q23, with the key rate still in double-digit territory by the end of the year. In 2024, further rate cuts are expected with the target rate stabilising at 5-6%.

Current account to gradually improve

Fitch estimates the current account deficit (CAD) reached 6.8% of GDP in 2022, and expect it to narrow to 3.3% of GDP in 2024, in line with decreasing global commodity prices and slowing domestic demand.

"Hungary is a net energy importer and its net energy trade deficit almost tripled in 1Q-3Q22 and reached 8.0% of GDP as of 3Q22 (on a 12-month rolling basis)," the rating agency pointed out.

Continued solid net inflow of FDI and capital transfers from the EU under the 2014-2020 MFF will support deficit financing, but the net external debt is forecast to turn into a debtor position in 2022. Fitch sees net external debt rising from -8.1% of GDP in 2021 toward 10% of GDP in 2024 ('BBB' median: 3.3% of GDP in 2023).

Banking sector remains stable

Fitch expects the sector's profitability to improve in 2023 as 2022 results were affected by a high regulatory burden and impairment charges.

However, potential further state interventions pose a downside risk to sector's profitability in 2023.

The rating agency projects asset quality metrics to deteriorate moderately in 2023 and the sector non-performing loans ratio to increase to around 5% by end-2023 from 3.4% in 3Q22.

Rating sensitivities

The negative outlook itself means that chances of a downgrade have increased.

Factors that could lead to negative rating action/downgrade:

• Failure to address concerns about macroeconomic policy credibility and governance that could expose Hungary to renewed periods of market stress or worsen macroeconomic imbalances.
• Erosion in competitiveness, potentially stemming from inflation entrenched at high levels and/or persistently higher energy prices, leading to materially lower medium-term growth and a sustained deterioration in external finances.

Factors that could lead to positive rating action/upgrade:

• An improvement in governance and economic policy likely reflecting a combination of rule of law enhancements and a policy mix that will contribute to tackling existing imbalances and enhancing the credibility of macroeconomic policy.

In a statement issued after the decision, the Ministry of Finance stressed that Fitch downgraded Hungary's outlook due to deteriorating external conditions, but on the positive side, the country remains in the investment grade.

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