ACRA affirms and withdraws LT BBB and ST S2 of Hungary, outlook Negative

ACRA has affirmed and withdrawn the following credit ratings of the Government of Hungary (hereinafter, Hungary, or the country) under the international scale:

  • Long-term foreign currency credit rating at BBB and local currency credit rating at BBB;
  • Short-term foreign currency credit rating at S2 and local currency credit rating at S2.

The outlook on the long-term foreign currency credit rating is Negative and local currency credit rating is Negative.

The credit ratings are unsolicited and ACRA has withdrawn them for a business reason.

Credit rating rationale

Hungary’s BBB sovereign credit rating is based on strong historical GDP growth, which is likely to fall sharply in the short term, a significant reduction of foreign currency exposure (although it remains relatively high compared to the country’s CEE peers), and balanced banking sector fundamentals. The rating is constrained by the country’s weak fiscal position with elevated financing needs, an elevated level of general government debt, and constrained economic potential. Relatively weak institutional factors is also constraining factor.

Following 4.9% GDP growth in 2019, the Hungarian economy, whose GDP PPP per capita stands at 70% of the EU average, is going to slide into a deep recession in 2020. ACRA expects the country’s GDP to decline in the range of 6.5–10.0%. In our view, the openness of the country’s economy and its dependence on Eurozone countries, which are its key trade partners (especially Germany), will hit the economy hard this year. With an average ratio of exports and imports to GDP at 90.8% in 2019, Hungary is one of the most open economies in the CEE region. According to the IMF’s latest forecast, in 2020 the Eurozone is likely to see its GDP fall by 7.5%, while Germany’s GDP will contract by 7%. The temporary halt in operations of the country’s carmakers, which had only recently resumed production, has had a big negative impact on the economy, which is dominated by manufacturing, especially the automotive industry. Manufacturing accounted for 21.6% of the country’s gross value added (GVA) in 2019.

A minor mitigating factor for the country’s economic downturn is the slightly lower share of SMEs in the country’s GDP structure compared to CEE peers. This sector employed 68.9% of all employees (CEE average is 72.5%), and made up 53.9% of GVA at factor costs (CEE average is 61.8%) in 2019. This sector was hit hardest by the quarantine measures imposed due to the coronavirus pandemic. An important mitigating factor is the wide range of anti-crisis measures adopted by the Magyar Nemzeti Bank (MNB, Hungary’s central bank) and the government amounting to 20% of GDP.

Medium to longer-term challenges to Hungary’s economic recovery could be poor demographics, the expected phasing out of EU funds, and a lower share of research and development expenditure in GDP than the EU average. As for the automotive industry, in the long term, beyond the crisis, it will face the challenges of electric vehicles, growth of the sharing economy, and the emergence of self-driving cars.

The MNB was the most dovish central bank in the CEE region; it has kept the key rate at 0.9% since 2016 until now. It has responded to the crisis with a set of conventional and unconventional measures. The MNB is attempting to simultaneously provide liquidity and prevent the local currency from depreciating. The MNB’s measures to boost liquidity include extending the list of the collateral, government and mortgage bond buying program (supporting medium and long yields at low levels) and relaunching its previous lending program, the Funding for Growth Scheme. To limit local currency liquidity, the MNB has introduced one-week deposit auctions, increased collateral loan rates from 0.9% to 1.85% and is conducting FX-swap operations by providing foreign currency for local currency. The MNB does not rule out hiking the key rate. The MNB has also announced a waiver of capital buffers for systemically important banks.

There are risks to the resilience of Hungary’s public finances to the pandemic shock. At the end of 2019, the public debt-to-GDP ratio stood at 66.8% — one of the highest in the CEE region — and indicated lesser fiscal space compared to peers. ACRA expects the general government’s debt-to-GDP ratio will deteriorate by the end of 2020.

According to the government’s expectations, compared to the initially planned 1.0% of GDP, the general government deficit will increase to 2.7% of GDP in 2020. In ACRA’s view, the 2020 budget deficit could be deeper due to the larger contraction of GDP compared to the government’s expectations (3% of GDP) and the hefty package tilted toward measures that directly influence the budget deficit of the current year.

The fiscal package includes measures that will have a direct impact on the budget balance. These measures range from 70% wage compensation for employees of companies affected by coronavirus and the reintroduction of 13th month pensions to subsidized credits worth 4.3% of GDP (HUF 2,000 bln), support for the tourism sector worth 1.3% of GDP (HUF 600 bln), and investment support worth 1.0% of GDP (HUF 450 bln). A similar effect on the budget, at least partially, can be expected from tax allowances. State guarantees, which are likely to have a limited impact on this year’s budget deficit, only accounted for 1.1% of GDP. Compensating measures that could reduce the government’s needs for debt financing are introduction of a one-off tax to be paid by banks and taxes to be paid by non-resident retail companies.

Hungary’s increased financing needs are aggravated by low average public debt maturity. Gross financing needs amounted to 15% of GDP in 2020 prior to the crisis. In previous years, the government relied heavily on demand from households, who funded the government at higher than market costs. Since the crisis began, household demand has cooled down and institutional investors have become the main government debt buyers. Their ability to increase demand will also depend on the MNB’s presence in the secondary market. In ACRA’s view, refinancing risks will increase as the government focuses on issuing short- and medium-term debt to finance the deficit.

Moreover, the increased share of floating-rate bonds (around 16% of domestic debt) in Hungary’s public debt structure exposes the government to interest risks, especially in the current volatile market environment. Materialization of interest risk could push up the already high debt service ratio, which stood at 5.2% to budget revenue in 2019.

The crisis will test the resilience of the country’s banking sector. Prior to the crisis, the fundamentals of the sector looked solid. Hungarian banks are well capitalized, have low levels of non-performing loans, and meet liquidity requirements. Banks’ foreign exposure decreased, assets in foreign currency have exceed liabilities, and as a result, the banking sector was a net creditor. However, the abrupt halt of economic activity due the pandemic could dent household income and push up the unemployment rate. Both will negatively impact citizens’ ability to repay loans, resulting in higher NPLs.

Hungary’s external position poses some concern. At 95.3% of GDP, Hungary’s total external debt was one of the highest among the CEE peers at the end of 2019. The country’s short-term external vulnerability is mitigated by 155% coverage of FX debt due in 2020, however in the longer term, external debt coverage remains challenging. By the end of 2019, international reserves covered only 20.1% of the country’s external debt and 28.3% of external debt in foreign currency (as of Q3 2019). This level of coverage is one of the lowest in the region. The country’s net international investment position stood at -50% at the end of 2019, and was lower compared to the country’s CEE peers.

Since the beginning of the crisis, the local currency’s depreciation has been manageable and comparable to that of the Polish złoty and the Czech koruna — around 5% vs the euro. The MNB’s reserves have decreased by USD 3.5 bln (11.9%) since the beginning of the year. The decline can be associated with swap operations, when the MNB provides foreign currency to market participants in exchange for local currency on a temporary basis. The reserves will be restored when the swap contracts expire, but risks related to the adequacy of reserve coverage will remain in the event of prolonged pressure on the local currency due to relatively high external exposure.

Hungary’s institutional factors are relatively weak according to the World Bank’s governance indicators. Almost all indicators show that the quality of Hungary’s institutions is worsening. Decreasing institutional quality may also negatively affect public investments as the European Commission takes into account the quality of institutions in the allocation of EU funds. The European Court of Justice’s recent ruling on the country’s refusal to take in migrants and the extra authority which was recently granted to the Hungarian prime minister to combat the crisis may result in a deterioration of these indicators.

Sovereign model application results

Hungary has been assigned an A- Indicative credit rating in accordance with the core part of ACRA’s sovereign model. A number of modifiers in the modifiers part of the model allow the Indicative credit rating to be decreased. These include the following, which are determined by the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale:

  • Potential economic growth;
  • Sustainability of economic growth;
  • Contingent liabilities;
  • Fiscal policy framework and fiscal flexibility;
  • Debt sustainability;
  • Balance of payment vulnerabilities;
  • External debt sustainability.

Modifiers that could serve as grounds to increase the Indicative credit rating have not been identified.

In view of the abovementioned modifiers, Hungary’s credit rating has been decreased by two notches. Therefore a Final credit rating of BBB has been assigned. There are no extraordinary factors that could result in an adjustment of the Final rating. In connection with this, the Assigned credit rating remains at BBB.

Issue ratings

No outstanding issues have been rated.

Regulatory disclosure

The sovereign credit ratings have been affirmed to Hungary under the international scale based on the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale and the Key Concepts Used by the Analytical Credit Rating Agency Within the Scope of Its Rating Activities.

The sovereign credit ratings of Hungary were published by ACRA for the first time on October 28, 2019.

The sovereign credit ratings were affirmed based on information from publicly available sources, as well as ACRA’s own databases. The sovereign credit ratings are unsolicited. The Government of Hungary did not participate in the credit rating affirmation.

ACRA provided no additional services to the Government of Hungary. No conflicts of interest were discovered in the course of the sovereign credit rating affirmation.

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