For the updated report accompanying this review, click here.

Rating action

Scope Ratings GmbH (Scope) has today affirmed Hungary’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at BBB+ and revised the Outlook to Negative from Stable. Hungary’s short-term issuer ratings have been affirmed at S-2 in local and foreign currency with Stable Outlooks.

Summary and Outlook

The revision of the Outlook for Hungary’s credit ratings to Negative, from Stable, reflects the following two credit rating drivers:

1. The country’s growth prospects have weakened as a result of external risks including prolonged supply chain disruptions, weaker demand from key export markets, currency weakness related to Hungary’s high exposure to the fallout from the Ukraine conflict and elevated dependence on Russian energy. Coupled with increased borrowing costs and inflationary pressures, this could negatively affect Hungary’s policy flexibility and fiscal consolidation plans.
    
2. Ongoing institutional challenges in view of worsening governance indicators, amplified by frequent regulatory and budgetary changes and increasing risks to the country’s competitiveness including to the public sector’s growing market predominance in various economic sectors, which are weighing on Hungary’s policy predictability.

The BBB+ ratings are supported by Hungary’s: i) strong record of robust growth supported by high investment; and ii) resilient external position and public debt profile against external shocks.

The Outlook revision reflects Scope’s updated assessments of Hungary under the ‘domestic economic risk’, ‘external economic risk’ and ‘environmental, social and governance’ (ESG) risk’ categories of its sovereign methodology.

The Negative Outlook represents Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months.

The rating could be downgraded, if individually or collectively: i) growth prospects weakened more-than-expected, due to, for example, further delays or significant cuts in disbursement of EU funds and/or intensified energy price shocks; ii) Hungary’s external debt structure materially worsened, weakening resilience to external shocks; and/or iii) protracted fiscal deterioration weakened debt sustainability.

Conversely, the Outlook could be revised to Stable if, individually or collectively: i) medium-term growth prospects improved, supported by improving external metrics; and/or ii) public finances improved, resulting in a significant reduction in public debt in the medium-term.

Rating rationale

The first driver of the Outlook change reflects the marked deterioration of Hungary’s medium-term growth prospects due to the repercussions of the Russia-Ukraine war and global supply chain disruptions. A high reliance on Russian energy amplified by an economic structure dominated by energy-intensive businesses with complex value chains coupled with weaker external demand from key export markets makes Hungary one of the most exposed countries to the fallout from the Ukraine conflict.

Following a substantial pandemic-related decline in output of 4.5% in 2020, Hungary’s economy rebounded strongly in 2021. Real growth reached 7.1% on the back of fiscal stimulus via tax relief, increased transfers and social spending, resulting in GDP recovering to the pre-pandemic level in Q2 2021. The momentum continued into Q1 2022 thanks to a strong policy response to the crisis, including public loan guarantees grants and subsidised financing for private investment.

Scope expects the Hungarian economy to enter a technical recession in H2 2022, reflecting the impact of the Ukraine war. Growth will remain strong at 4.9% in 2022, largely reflecting a high carry-over effect and quick post-pandemic rebound supported by substantial fiscal stimulus in H1, before slowing to around 1.5% in 2023 due to inflationary pressures, prolonged supply chain disruptions and ongoing fiscal and monetary tightening.

Inflation rose markedly in recent months, with core inflation reaching 16.7% in July 2022, among the highest rates in the EU. This has been fuelled by the spike in global food and energy prices in the wake of the Ukraine conflict. The significant weakening of the forint, a tight labour market and recent wage increases add further pressure to price dynamics. In response, the National Bank of Hungary rapidly tightened monetary policy, increasing its benchmark interest rate to 11.75% in August 2022.

Inflationary pressures and currency weakness are weighing on the country’s external metrics. Following a period of steady surpluses averaging 1.8% of GDP over 2010-18, the current account balance turned negative in 2019 (-0.7%) on the back of a widening deficit in the trade of goods. The deficit widened further in recent months in a context of rising global fuel prices pushing up energy prices and global supply chain disruptions dampening the performance of some key export industries. While the direct trade exposure to Russia is moderate at around 1.5% of exports, the weakening growth outlook among key European trading partners will materially weigh on external demand in the medium term.

The second driver of the Outlook change reflects Hungary’s ongoing institutional challenges in view of worsening governance metrics (compiled by the World Bank), compounded by increasing risks to the country’s competitiveness including the public sector's growing market predominance in various economic sectors. In Scope’s view, the government’s frequent application of regulatory and budgetary changes – along with tense relations with the EU due to fundamental disagreements in relation to the rule of law - are limiting Hungary’s policy predictability and budgetary flexibility.

The Hungarian government needs to address rising budgetary pressures just as the economy is set to slow amid rising inflation, sanctions on Russia and supply-chain disruptions to the country’s exports. However, recent regulatory changes including modifications in the fuel price cap regulation and the utility bill support scheme add further pressure to price dynamics and weigh on policy predictability. In Scope’s view, the growing domestic control of key economic sectors in Hungary including energy, media and the banking sector (with three banks being merged into a state-linked Hungarian Bank Holding) may also potentially weigh on the efficiency of allocation of capital, and further dampen the country’s long-term growth prospects.

From 2024, Scope expects Hungary’s growth to return towards the medium-term potential of 2.5%-3.0% a year, supported by the expected EU funds from the Recovery and Resilience Facility. This expectation is lower than growth rates before the pandemic, which reflects rising long-term risks to the country’s competitiveness because of a tight labour market with structural employment gaps between skills groups, which remain wide in an EU comparison. Further, a rapidly ageing and declining working age population will exacerbate the skills shortage and wage pressure, potentially weighing on productivity.

The delayed disbursement of EU Recovery and Resilience Facility funds over rule of law concerns is also weighing on budgetary flexibility and limiting the Hungarian government’s financial capacity to deliver public investment. Hungary’s budget balance improved somewhat in 2021, with a 1pp reduction in the headline deficit to 6.8% of GDP on the back of the strong economic recovery. Public expenditure remained high in H1 2022, driven by a personal income tax refund and measures to alleviate the impact of rising inflation on the private sector. Recent budgetary modifications seek to delay a significant share of public investment and partially alleviate fuel price cap regulation and other changes of regulations to contain the deficit. In June 2022, a new fiscal consolidation package, including windfall taxes on specific sectors, is expected to deliver additional resources equating to about 1.4% of GDP over 2022-23 as well as spending cuts (mostly public investment) at around 2.3% of GDP, limiting the government’s financial capacity to deliver public investment. Scope notes that previous periods of fiscal consolidation were mainly achieved through high economic growth while the structural balance remained in deficit (-3.8% of potential GDP in 2019), reflecting the pro-cyclical budgets of the past. In addition, Hungary modified its 2021 financing plan to finance discretionary expenditure in 2021 and pre-finance some budgetary expenditures in 2022, reflecting only limited availability of budgetary reserves.

Scope expects the headline budget deficit to decline to its target in 2022 (4.9% of GDP), supported by strong nominal GDP growth and investment cuts. Hungary’s public debt is high among peers, at 76.7% of GDP in 2021, up 11pp from the 2019 level. Scope expects the debt-to-GDP ratio to marginally decline to 77% in 2022 and remain on a gradual downward trajectory in the medium term. This will be supported by recovering tax revenue growth (largely taxes on consumption), a gradual reduction in discretionary spending and a moderate interest-payment burden (2.3% of GDP in 2021) thanks to previously issued securities at cheaper rates.

The triggering of the EU’s conditionality mechanism, a budgetary tool established at the beginning of 2021 to protect the EU budget against breaches related to the rule of law, could also weigh on Hungary’s debt sustainability and growth prospects given its high reliance on foreign funding and external demand. Further substantial delays in the receipt of EU funds could slow or even reverse the declining trend of Hungary’s debt-to-GDP ratio. The way in which the EU applies its conditionality mechanism to Hungary will define their relations over the coming years.

Despite these structural weaknesses, Hungary retains considerable credit strengths.

First, Hungary has a record of robust growth and high investment, driven by foreign direct investment and projects co-financed with EU funds. In recent years, this has created high value-adding jobs and supported average real growth rates of 4.1% over 2014-19, among the highest in Europe. Growth has been underpinned by higher employment rates, structural improvements in economic diversification and increasing production capacity. Another critical development contributing to Hungary’s economic strength relates to the rising services exports, reflecting its improving competitiveness in commercial services and the rise of the services sector globally. The growth of the services sector’s output has led to strong employment growth.

Hungary’s rating is supported by a strong investment share, at 30.6% of GDP in 2021. The long-term economic outlook is supported by significant policy support in the form of grants via the Multiannual Financial Framework (EUR 10bn) and EU funds from the Recovery and Resilience Facility (EUR 30bn or 20% of GDP in 2021). Subject to the disbursement of EU funds from the Recovery and Resilience facility, Scope expects investment to grow markedly from current levels. However, rising macroeconomic imbalances and ongoing monetary tightening will constrain the effectiveness of public investments.

Second and finally, Hungary’s public debt profile and the country’s external liability structure are resilient against external shocks.

The public debt profile benefits from a high share of domestic financing and a small share of foreign-currency-denominated public debt. The share of foreign-currency-denominated central government debt significantly declined in recent years, from 31.3% at end-2015 to 20.6% at end-2021. The average debt maturity increased to 6.1 years at end-2021. Although the government re-entered external bond markets in 2020, the first time since 2018, debt continues to be held predominantly by domestic financial institutions and households. Hungary benefits from good access to foreign and domestic financing, including through a sizeable domestic retail programme. Funding costs have increased markedly in recent months as they also have with peers, with the 10-year benchmark yield rising to 8.5% on average in July 2022, up from 2.8% a year before.

External liabilities mostly consist of foreign direct investment and equity rather than debt-creating flows, mitigating risks associated with the country’s external debt burden, at 91% of GDP in Q2 2022. In addition, the country’s net international investment position improved from around -90% of GDP in 2013 to -40% in 2021, supported by private-sector deleveraging, an increase in Hungarian companies’ assets abroad and stable current account receipts . Adequate international reserves making up of around 129% of short-term external debt in June 2022 also help to protect against external shocks.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative rating of ‘a-’ for Hungary. This indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Hungary, the following relative credit strength has been identified: i) external debt structure. Relative credit weaknesses are: i) macroeconomic stability and sustainability; ii) vulnerability to short-term shocks; iii) social risks; and iv) institutional and political risks.

Combined relative credit strengths and weaknesses generate a one-notch downside adjustment via the QS and signal a ‘BBB+’ sovereign rating for Hungary.

The results have been discussed and confirmed by a rating committee.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the qualitative overlay (QS).

With respect to environmental risks, Hungary receives high CVS scores for having a low natural disaster risk and a high biocapacity surplus. Scope assesses Hungary’s QS adjustment for ‘environmental risks’ as ‘neutral’. Energy consumption in Hungary is above the EU average, largely due to high per-capita consumption despite considerably lower incomes among Hungarians. The transformation of the country’s coal region, which produces up to 15% of electricity, and Hungary’s energy-intensive industries represent transition risks. Electricity consumption is expected to increase over the next decade, in parallel with the electrification of the economy. By 2030, low-carbon technologies (nuclear and renewables) could generate up to 90% of Hungary's electricity, with a low share of renewables. In the EU, Hungary is among the lowest emitters of greenhouse gases per person. Hungary faces several environmental challenges, including weak water quality and air pollution, reflected by persistent breaches of water and air quality standards and weak energy efficiency in the residential sector.

Regarding social risks, Hungary scores low in the CVS for old-age dependency. Scope assesses Hungary’s QS adjustment for ‘social risks’ as ‘weak’. While the general labour market situation has been improving in Hungary in recent years, Scope notes persistent employment gaps, which remain wide in an EU comparison. Income inequality has increased over the past decade and inequalities in access to public services remain high. Housing also remains inadequate for much of the population. The shortage of affordable rental housing hinders social mobility. Educational outcomes are below the EU average with large differences in certain areas. By the age of 15, basic skills are well below both EU and regional averages and have decreased over the last decade.

With respect to governance risks, Hungary receives low CVS scores. Scope assesses Hungary’s QS adjustment for ‘governance risks’ as ‘weak’. This assessment reflects i) weaknesses via below-average checks and balances between public institutions and government branches, weighing on policy predictability; and ii) tense relations with the EU due to fundamental disagreements in relation to the rule of law.

Rating Committee
The main points discussed by the rating committee were: i) budget performance; ii) growth prospects; iii) external environment, financial stability and macro-economic sustainability; and iv) institutional developments.

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation NO
With access to internal documents                               NO
With access to management                                        NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Jakob Suwalski, Director
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003.  The Credit Ratings/Outlooks were last updated on 10 December 2021

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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