For the rating action annex, click here.

Scope Ratings GmbH has today upgraded Hungary’s long-term issuer and senior unsecured local- and foreign-currency ratings to BBB+ from BBB, with a Stable Outlook. The short-term issuer rating has been affirmed at S-2 in both local and foreign currency with a Stable Outlook.

Rating drivers

The drivers for today's rating action reflect Hungary’s: i) sustained public debt reduction resulting from high growth and low interest payments; ii) increasing resilience to external shocks; and iii) strong investment – driven by inflows of foreign direct investment and projects co-financed with EU funds – creating high value-added jobs and supporting growth potential. The Stable Outlook reflects Scope’s assessment that the risks from credit strengths and weaknesses are now broadly balanced. The factors driving the rating upgrade relate to changes to Scope’s assessment of ‘public finance risk’ but also changes under the ‘domestic economic risk’ and ‘external economic risk’ methodological dimensions.

The first driver underpinning the upgrade is the country’s sustained debt reduction by 8 pp (from 77% of GDP in 2015 to 68% in 2019). Fiscal consolidation was mainly achieved by high real economic growth (averaging 3.7% between 2015-18) and lower interest payments (down from 4% of GDP in 2014 to 2.5% in 2018). Over the coming years, Scope projects continued, albeit more moderate, debt reduction towards the EU’s debt threshold of 60% of GDP by 2025. While growth is expected to moderate from 4.1% in 2019 to 3.3% in 2020, the government plans a tighter fiscal stance, with a planned budget deficit of only 1% of GDP in 2020, after this year’s estimated 1.8% of GDP deficit, leading to a structural adjustment in the direction of the European Commission’s medium-term objectives. In addition, the government intends to increase the size of emergency budget reserves by around 1% of GDP (HUF 488bn) in 2020. The year-to-date budget deficit in August 2019 amounted to 1.17% of the projected end-year GDP (HUF 511bn), around 3 pp below the previous year’s, thanks to strong revenue growth and EU fund receipts.

The second driver of the upgrade relates to Hungary’s increasing resilience to external shocks. This is reflected in a small share of foreign-currency-denominated debt, a very low net external debt ratio, supported by current account surpluses in consecutive years, deleveraging in the private sector, and improvements in the net international investment position. Foreign-currency-denominated government debt declined from 40% in 2010 to 17.2% of GDP in 2018, following the treasury’s strategy to reduce reliance on external creditors whilst expanding the domestic debt market. The current debt repayment schedule shows that the remaining face value of foreign-currency debt will almost halve by 2023. Hungary’s net external debt decreased from a peak of 70% of GDP in 2012 to a record low of 5.3% of GDP at year-end 2018. At the same time, the country’s net international investment position improved from -90% of GDP in 2013 to -53% in the second quarter of 2019. This is reflected in part by private-sector deleveraging, with total debt down from 252% of GDP in 2010 to 174% in 2018. In addition, Hungary has accumulated current account surpluses averaging 3.1% of GDP between 2016-18, mainly based on net exports averaging 7.6% of GDP between 2015 to 2018. High international reserves making up 184% of short-term external debt (with maturity up to 2020) further protect the country against adverse economic shocks.

The third driver of the upgrade relates to Hungary’s strong investment share, at 25.7% of GDP in 2018 and projected at 27.3% of GDP by year-end 2020. Capital formation is mainly driven by business investment, at 62.5% of total investment in 2017. Hungary’s strong investment share and growth is reliant on its absorption of EU funds (equivalent to around 2.9% of GDP annually) and foreign direct investment, with the latter averaging 1.5% of GDP per year since 2015. In 2018, 39% (EUR 2.75bn) of FDI inflows were reported to be into manufacturing, with a large share coming from Germany (around 30% of the FDI stock in Hungary). These investments have strengthened labour productivity in manufacturing (12% annual growth since 2014), supporting the country’s substantial rise in growth potential, by 1.7 pp to 3.7% of GDP in just three years. Hungary’s absorption of EU structural funds, at a cumulative 39% as of September 2019, is the fourth highest such ratio among Central and Eastern European economies, after that of the Baltics. Looking at the 2021-27 budget, the EU Commission expects a reduced allocation for Hungary by around 20% compared to the current 2014-20 period.

Despite these credit-positive developments, Hungary’s ratings remain constrained by: i) a high public debt level; ii) non-price competitiveness issues; and iii) uncertainties in the regulatory environment.

Although on a continued downward trajectory, Hungary’s public debt remains relatively high, at 68% of GDP in 2019, compared to that of middle-income-country peers. Furthermore, fiscal consolidation is mainly being achieved through high economic growth, while the structural balance remains in deficit (at -2.6% of GDP in 2019), reflecting the pro-cyclical budgets of the past. These resulted in a Significant Deviation Procedure being opened in 2018 by the European Commission, which recommended adjustments in structural primary expenditures by 1 per cent of GDP per year towards medium-term objectives. The government’s budget draft for 2020 is more ambitious than previous ones; however, the 1% of GDP nominal deficit objective will require greater fiscal effort once the economic cycle slows. The government’s growth projections for 2020 is reported at 4% while the central bank has revised its forecasts downwards to 3.3%. Also, the treasury’s strategy to refinance an increasing share of its debt with retail bonds (25% of total debt), to be sold at an estimated premia of 200-300bp, adds to refinancing costs. Going forward, Scope anticipates a gradual improvement in the structural deficit, towards 2% of GDP over the medium term, while further debt reduction will continue to hinge on economic performance.

Another constraint to Hungary’s ratings is the economy’s relatively poor non-price competitiveness, a result of high wage increases in the non-traded services sectors. While productivity and wages move in parallel with high-skilled and exporting manufacturing sectors, smaller non-exporting corporates and the public sector have raised salaries despite low or stagnating productivity growth. As a result, while terms of trade for manufactured goods have remained stable since 2015, they worsened by around 3% for other traded goods such as food and beverages or crude materials. The government has partly compensated for this through tax cuts and reductions in employers’ contributions to secure the profit margins of less competitive firms while raising the minimum wage to prevent worker emigration. Thus, it remains important for Hungary’s economic convergence process to raise SME productivity towards the levels of larger exporting firms. This also requires a better-educated and trained workforce, which has not been built up to date.

Finally, regulatory-related uncertainties constrain Hungary’s ratings, including anti-competitive procurement practices, ineffective judicial and general administration systems, as well as frequent legislative changes, including protective measures through special taxes and subsidies. The Hungarian government has initiated several reforms to strengthen procurement practices and to lower market entry barriers. However, progress has been limited with the government continuing to follow its industrial policy to protect low-productivity Hungarian companies while providing tax incentives for foreign multinationals. Also, Hungary’s tax system remains among the most complex in Europe, characterised by many sector-specific taxes and tax exemptions, reflected in high compliance costs for corporates.

Scope’s risk analysis of Hungary’s financial sector reveals that banks benefit from the adequate capitalisation and liquidity of the banking system, supported by a favourable macro-economic environment and earlier private-sector deleveraging. Credit growth has picked up since 2016 after a long period of stagnation, but lending requirements remain strong, also thanks to the central bank’s use of macroprudential instruments. While households in Hungary usually borrow local-currency-denominated fixed-rate loans, the commercial real estate sector remains vulnerable to unhedged currency risk, with 82% of loans granted in euros. Overall, risk of spillover from the financial sector to the sovereign balance sheet remains limited.

The political environment in Hungary continues to be dominated by the conservative Fidesz Party, despite the results in the latest municipal elections, which brought the liberal opposition to power in major cities including Budapest. Political polarisation remains high under Prime Minister Viktor Orbán, especially on migration and social policies. The government’s strong presence in the corporate and financial sectors, its increasing intervention in the judiciary and the media as well as its asylum policies have led to ongoing legal disputes with the European Commission.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned an indicative ‘BBB’ (‘bbb’) rating range for Hungary. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis. For Hungary, Scope identified the following relative credit strengths: i) macro-economic stability and sustainability; and ii) external debt sustainability. No relative credit weaknesses have been identified. The combined relative credit strengths and weaknesses generate a one-notch upward adjustment and indicate a sovereign rating of BBB+ for Hungary. A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, under which Hungary has above-average performance among Central and Eastern European countries as assessed by the World Bank’s Worldwide Governance Indicators.

Hungary’s performance across social dimensions reflects its position as an emerging market economy, characterised by strong wage and income growth but also its substantial catch-up potential in public services in terms of the protection of minority groups, the development of its public education system, and the provision of social benefits. Against this background, Hungary has a relatively low income inequality compared to the EU-28 average and is among the four eastern European economies with the lowest quintile share ratio (S80/20).

The adoption of environmental standards remains a key policy challenge for the government. Despite the achievement of lowering emissions by 9% between 2005 and 2017, energy consumption of Hungary’s households is around 12% above the EU average. Typically, it is less costly to reduce emissions that are at high levels (e.g. by shutting down old coal plants) than to reduce emissions at lower emissions levels (e.g. refurbishment of buildings, investment in green technology). An overview of the investment needed to adhere to climate goals will be presented by the government towards the end of the year (National Energy and Climate Plan). Hungary also faces challenges in the areas of water quality and waste management, despite first steps taken towards becoming a circular economy. The share of recycled waste remains 11 pp below the EU average.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that the risks at the current ratings are now balanced between increased fiscal and external resilience on the upside and recurrent structural challenges, such as the wide productivity gap and regulatory barriers in the corporate sector, on the downside.

The ratings could be upgraded if, individually or collectively: i) a material reduction in public debt, supported by a reformed fiscal framework, is seen; ii) a broad-based improvement in international competitiveness takes place; and/or iii) structural reforms, especially in the areas of education and healthcare, improve growth potential.

Conversely, the ratings could be downgraded in the event of: i) a deterioration of public finances and/or the fiscal framework; ii) a strong decline in foreign investment; and/or iii) high wage-productivity disparities that lower Hungary’s growth potential.

Rating committee
The main points discussed by the rating committee were: i) Hungary’s growth outlook; ii) fiscal performance and debt sustainability; iii) external sector developments; iv) productivity developments; v) political developments; and vi) peers.

Methodology
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com. The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party. The following substantially material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: the Hungarian Ministry of Finance, Central Bank of Hungary (MNB), European Commission, Eurostat, IMF, ECB, OECD, WB, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Bernhard Bartels, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first released by Scope in January 2003. The ratings/outlooks were last updated on 23 February 2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.

Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Directors: Torsten Hinrichs and Guillaume Jolivet.