By Jakob Suwalski, Director, Sovereign and Public Sector Ratings

The government’s frequent regulatory and budgetary shifts – alongside Hungary’s slide in the World Bank’s governance rankings, reflected in soured relations between Hungary and the EU – are limiting fiscal flexibility and create longer-term uncertainty.

Public finances are under pressure as the economy is set to slow due to rising inflation, Russian retaliation to EU sanctions and supply-chain disruptions to Hungary’s important export sector.

Hungarian output rebounded 7.1% in 2021 and should still rise by 4.9% this year despite a likely second-half contraction. Growth will revert towards medium-term potential of 2.5%-3.0% a year, supported by funds from the EU’s Recovery and Resilience Facility, disbursement of which are currently on hold. 

Compromise with EU over funding, rule of law crucial for economic outlook

Unlocking funds withheld by the EU will play a central role in funding Hungary’s budget and preventing a sharper slowdown in economic growth, hence Hungary’s recent efforts to protect its share of EU budget and recovery funds and address concerns over the rule of law. However, Budapest’s latest proposals are likely to fall short of averting financial sanctions, albeit in the form of symbolic cuts to some EU funding.

Any penalties imposed on Hungary for legal breaches will be proportionate to the damage they cause so a total suspension of EU funds is unlikely.

Room for compromise exists. The EU wants to preserve a united front in its support for Ukraine, notwithstanding Hungary’s resistance to EU sanctions, while Hungary needs EU financial support as the economic outlook darkens.

Rising inflation is a near-term economic challenge, up at annual rate of 13.7% in July, with inflation expectations running high. Drought, surging energy prices and changes to energy-market regulation have all contributed. More reassuringly, industrial production has remained robust, with most companies still working through order backlogs.

Rising risks to competitiveness saps longer-term growth potential

Longer term, Hungary’s growth potential is diminishing compared with pre-pandemic expectations partly due to declining competitiveness. Skills shortages are above EU averages. An ageing population and shrinking number of people of working age are aggravating factors, pushing up wages and potentially limiting productivity gains.

In addition, the state’s growing control of important economic sectors including energy, telecoms, media and banking – with three banks being merged into a state-linked Hungarian Bank Holding – may reduce efficient capital allocation and further curtail long-term growth prospects.

Fiscal handouts before general elections in April this year and the delayed disbursement of EU funds have limited the Hungarian government’s financial capacity to deliver on public investment, illustrating the importance of good governance in maintaining sovereign creditworthiness.

Uneven record of fiscal consolidation

In common with other governments, the Hungarian authorities fear the political effects of high energy prices coinciding with rising interest rates. But recent regulatory changes including modifications in the fuel-price cap, thereby increasing costs of public services and support for utilities, are a sign of budgetary constraints and have made inflation worse in the short term while increasing the risk of more unpredictable policy making.

Plans to delay a significant share of public investment will allow the government to reduce the headline budget deficit to 4.9% of GDP this year from 6.8% in 2021. Also helping are planned windfall taxes on specific sectors.

Even so, Hungary has an uneven record of fiscal consolidation which has tended to happen only during periods of rapid growth. There is a tendency to run pro-cyclical fiscal policy, ensuring the structural deficit has proved difficult to narrow, standing at 3.8% of potential GDP in 2019.

Hungary’s public debt is high relative to other CEE countries at 76.7% of GDP in 2021, up 11pp from 2019. We expect the debt-to-GDP ratio will be little changed at 76.6% in 2022 though remain on a downward trajectory in the medium-term, supported by a moderate interest-payment burden. Further substantial delays in the receipt of EU funds coinciding with higher borrowing costs could weigh on Hungary’s consolidation plans and flatten or even reverse the trajectory of Hungary’s debt-to-GDP ratio.

Scope affirmed Hungary's BBB+ ratings on 2 September, with the Outlook revised to negative, noting the ratings remain supported by robust, investment-led growth and a resilient external position and debt profile, with a high share of domestic financing and little foreign-currency public debt.