The warning came amid growing fears that this week’s market tremors presage a downward spiral for Hungary’s currency and stock market.
Hungarian bonds and equities sold-off Thursday in response to government plans to cut the budget of the Fiscal Council, an independent budget watchdog, from HUF 835 million to HUF 10 million, effectively disbanding the institution.
Investors dumped Hungarian assets and risk premiums soared across the board. The forint lost 1% against the euro, the benchmark index of the Budapest stockmarket fell 2.9%, 5-year government bond yields widened by 0.2% while a buyers’ strike today led the government to sell less domestic bonds than expected.
The government, led by prime minister Viktor Orban, had announced on Wednesday that private pension holders will no longer receive state pensions, a move aimed at forcing pension savings back to the state in order to ease the fiscal deficit. Authorities also announced plans to grant parliament more power over appointments to the central bank committee, an interest-rate setting board.
“These developments have worsened Hungary’s ratings outlook compared with last month,” said credit analyst Kai Stukenbrock at Standard & Poor’s.
A sovereign downgrade by rating agency Moody’s is “almost certain” following the policy moves – a key plank of the economic agenda of the governing Fidesz party that won a two-thirds majority in national elections last spring – said David Nemeth, a Budapest-based economist at ING.
Moody’s said in October – before the government’s plans came to light – that it would decide this month whether to downgrade Hungary’s sovereign credit rating which, at Baa1, is three notches above junk status.
Nemeth said that although the pensions move could reduce the 2013 to 2014 fiscal deficit from a projected 2.6%, before the pension reform was announced, to 1.2%, the medium term economic impact is likely to be negative.
Standard & Poor’s – which rates Hungary BBB-, the lowest investment grade notch, with a negative outlook – has also sounded the alarm over the fiscal outlook.
The pensions move risks undermining the fiscal balance as government will be tempted to reduce spending cuts, buoyed by the cyclical uptick in the public deficit thanks to the pension fund raid, said Stukenbrock at Standard & Poor’s.
In addition, the risk has increased that the government steps up bond sales, effectively backed by pension fund money. “The pension move may help to consolidate the headline fiscal numbers but the impact on the structural fiscal balance is harmful,” he said.
Fitch has maintained its BBB rating on Hungary, one notch above junk grade, with a negative outlook since March 2009. The agency will release a public comment on the impact of the government announcements on sovereign creditworthiness, said Ed Parker, head of emerging Europe sovereign ratings at Fitch. “We are concerned about economic policymaking in Hungary and these moves are clearly negative.”
Nemeth said that Hungary could retain its investment grade rating as its fiscal deficit – which the government estimates next year will be 2.94% – is less than western European investment grade counterparts.
The headline fiscal balance is just one factor determining sovereign creditworthiness. “The question is about the government’s ability and willingness to address underlying economic problems and reform accordingly,” said Stukenbrock. “The problems of Ireland underscore just how quickly debt and market pressures can build up.”
MARKET IMPACT
The short and medium-term impact of the government’s reforms are mixed, Nemeth said. The changes to the monetary policy committee – with new entrants likely to be sympathetic to the government’s preference for lower interest rates – could boost stocks in the short-term, he said. In addition, the pension reform could lead the government to convert holdings denominated in foreign exchange back into the domestic currency, boosting the strength of the forint.
But the pensions move may reduce liquidity in the equity and bond markets if Hungarian pension funds – the biggest domestic institutional investor base – unwind investments in capital markets, thereby triggering an exodus of foreign capital and an increase in risk premiums, Nemeth said.
The 2011 to 2012 fiscal year will be “critical” in determining whether the government’s declining creditworthiness will be entrenched over the long-term, since the government is likely to be reform-shy in 2013 ahead of general elections the following year, said Stukenbrock.
He added that the government must reform social security and the bloated public sector – as well as committing to fiscal consolidation efforts.