Foreign investment flows are strengthening Hungary's resistance to a new international aid deal and raise the chance of a disappointing 2011 budget that could prompt rating downgrades and a market sell-off.
End-of-summer fears that a U.S. double-dip could trigger a flight from risk have given way to a surge in emerging market bets that have boosted the forint and trimmed bond yields in both Hungary and its less risky emerging European neighbours.
That is likely to embolden Prime Minister Viktor Orban, who has spurned a new International Monetary Fund and European Union safety net despite warnings it will lead to a financing squeeze down the road and a potential market backlash.
The EU and IMF have pushed deficit-cutting measures based on trimming costs or raising revenues rather than strategies aimed at boosting economic growth, worried the latter could not only be unpredictable, but also further prolong structural reforms put on hold since the fall of communism.
Ahead of Oct. 3 local elections where his Fidesz party hopes to consolidate power, Orban's government has pledged to cut the 2011 budget deficit to below 3 percent of GDP as agreed with the EU, after months of suggesting it could overshoot.
Ratings agencies have warned they could downgrade Hungary unless the cabinet presents a credible budget after the vote and on Wednesday a top government official said a detailed plan would be presented next month.
But analysts say that, having shown a penchant for testing the patience of investors and its international lenders since coming to power, Fidesz will probably push its agenda if markets remain supportive and may disappoint those who see austerity as the best way to climb out of a fiscal crisis.
"If we get a solid Fidesz showing in the election, combined with… more inflows, and markets avoid a double dip, you can then see Fidesz push the boundary again," said Nomura analyst Peter Attard Montalto. "I think that's what it's all about, their trying to see what they can get away with."
Barring a swing to global risk aversion, Hungary is expected to continue to attract adequate funding from the huge flows entering emerging markets as investors worldwide look for higher yields outside of developed markets and record-low rates.
ING bank says dedicated emerging market bond funds received more than $16 billion from new money and other investor classes last month, but emerging market bond issuance was only $11.6 billion, pushing those with money to invest into countries deemed more risky like Hungary or Ukraine.
RATINGS STILL VULNERABLE
But risks persist. Standard & Poor's says Hungary's 2011 deficit target, from an expected 3.8 percent this year, was not enough to reverse its negative outlook without more details.
Moody's also said it would downgrade if the government does not address fiscal issues and debt metrics – at 80 percent of GDP, Hungary's debt ratio is among the highest in the emerging EU – after the Oct 3 poll. It is expected to decide in November.
With the economy expected to stay stagnant this year, Orban's officials continue to eschew EU- and IMF-backed cost-cutting in favour of a pro-growth strategy, arguing that more years of belt tightening will choke job creation and prevent budget revenue growth from getting back on track.
They are pursuing measures including a tax on banks, a push for central bank quantitative easing to boost growth, shifting fiscal projects off budget to a state-owned development bank, and gradual income tax cuts, all of which conflict with advice from abroad.
RBC strategist Nigel Rendell said a main risk would be if Fidesz continues to try creative measures to reduce the budget gap or sends fresh confusing signals over its commitments.
"If there's any kind of relapse or miscommunication — which has been a byword for Hungary of late — I think the ratings agencies would probably throw their arms up in the air and say 'enough's enough'," Rendell said.
Moody's rates Hungary's local and foreign government bond ratings at Baa1. S&P rates it BBB-, a notch above speculative, or "junk" grade. A cut to one level lower would cause many funds with strict risk limits to sell Hungarian assets.
The forint hit a five-week high against the euro this week but is still almost 6 percent below the high of 264.8 hit before Fidesz swept to power with a two-thirds majority in an April election.
Bond yields have fallen from a post-election high in July. But CDS prices, the cost of insuring debt against default, have spiked to levels far in excess of neighbours Poland and the Czech Republic.
NO 'WALK IN THE PARK'
Helped by the surge in flows and its pledge to stick to its agreed fiscal targets, Hungary has managed to avoid backlash, but analysts say financing risks still abound.
Barclays Capital estimates that in 2011, Hungary's total financing needs should be close to 24 billion euros, or about 22 percent of GDP, including a first 2 billion euro installment to repay the European Union in the fourth quarter of 2011.
And from 2012, Hungary will have to start paying back around 15 billion euros over three years to the EU and IMF — a huge extra fiscal sum for a country of 10.5 million people.
"Against this backdrop, the government's communication regarding its strong liquidity position and the feasibility of the financing plan appear overly sanguine," Barclays Capital Economist Christian Keller wrote in a research note.
"This will not be a walk in the park."
These vulnerabilities, plus other problems such as a high amount of foreign currency loans, have kept investors on edge. But until global risk sentiment turns, analysts say Orban has won some breathing room.
"In the absence of any triggers in the short term, it may well still take some time for our story to come to the fore," said Nomura's Montalto. "In the interim, however, we keep a few 'blow-up' insurance trades in our portfolio." (
