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      Scope downgrades Hungary's credit ratings to BBB; Outlook revised to Stable.
      FRIDAY, 24/02/2023 - Scope Ratings GmbH
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      Scope downgrades Hungary's credit ratings to BBB; Outlook revised to Stable.

      Deteriorating economic prospects amid weaker policy predictability and governance challenges drive the downgrade. High investment and a resilient debt profile against external shocks are key credit strengths.

      Rating action

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

      Summary and Outlook

      The downgrade of Hungary’s credit ratings to BBB from BBB+ reflects:

      1. A material deterioration in the near-term economic outlook, including expectations of a slowdown in output growth in 2023 continued elevated inflationary pressures and exchange rate volatility constraining fiscal and monetary policy flexibility. This is accompanied by significant downside risks related to external vulnerabilities and the country’s high reliance on Russian energy imports.
         
      2. Reduced policy predictability and ongoing uncertainty surrounding the disbursement of EU funds due to governance challenges and inconsistencies in the government's policy mix, which have limited the effectiveness of monetary policy and weighed on public finances. Unresolved disagreements between Hungarian authorities and EU institutions over the rule of law have prevented the disbursement of sizable EU funds, adding significant uncertainty to the medium-term fiscal outlook.

      The downgrade reflects changes in Scope’s assessments in the ‘domestic economic risk’, and ‘ESG risk’ categories of its sovereign methodology.

      The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

      The rating/Outlook could be upgraded 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 above Scope’s expectations in the medium term.

      Conversely, the rating/Outlook could be downgraded if, individually or collectively: i) Hungary’s GDP growth prospects and/or external metrics worsened materially due, for example, to significant cuts in the disbursement of EU funds and/or notably constrained energy supplies as a result of escalating geopolitical risks; and/or ii) protracted fiscal deterioration weakened debt sustainability.

      Rating rationale

      The first driver underpinning the downgrade of Hungary’s ratings from BBB+ to BBB is a significantly weaker near-term domestic economic outlook, with expectations of persistent inflationary pressures, high interest rates and subdued output growth.

      Scope predicts Hungary's real GDP growth will decrease to 0.5% in 2023, a significant drop from the estimated 4.6% in 2022 and well below Scope’s September 2022 projection of 1.5%. This slowdown comes amid weakening private demand, weak agricultural output following severe drought and soaring global energy prices that resulted in a large trade deficit, leading to a large negative contribution from net exports. Additionally, the fiscal consolidation process will lead to significant cuts in government investment. The deceleration of growth momentum among Hungary's key European trade partners will also weigh on the recovery of the trade balance, partially offsetting positive contributions from lower energy imports and expectations of robust industrial export performance.

      Inflation, which is the highest in the EU, reached multi-decade highs of 25.7% YoY in January 2023, primarily driven by food prices. Scope expects inflationary pressures to remain elevated given strong wage growth, heightened inflation expectations and the continued pass through of higher production costs and tax hikes. Core inflation stood at 25.4% YoY in January, reflecting the strength of domestic price dynamics. As a result of decreasing purchasing power, private consumption is expected to contract, and heightened uncertainty and tight funding conditions will hinder business investment decisions. The construction sector is expected to decelerate markedly, amid high input costs, slowing housing market transactions and lower mortgage lending. Scope expects real growth to recover to 3.2% of GDP in 2024 before gradually returning to its medium-term potential of 2.5%-3.0% per year.

      Hungary's high reliance on Russian energy imports, which make up around 40% of its energy consumption, creates significant uncertainty for its near-term economic outlook. While current weather conditions and gas stock levels have alleviated supply risks for now, these could resurface during the 2023-24 winter season. Efforts to diversify the energy mix have been hindered by infrastructure and production limitations, leaving the country with few alternative supply options, either from domestic energy production capacities or external supply routes. Despite the European Commission's exemption from the embargo on Russian oil imports, this dependence makes Hungary vulnerable to further supply cuts from Russia. This could lead to higher energy prices and inflationary pressures, supply shortages, inflationary pressures, reduced industrial output, and balance-of-payments and currency risks.

      The second driver supporting the downgrade of Hungary’s ratings is the reduced policy predictability and ongoing uncertainty surrounding the disbursement of EU funds. This is due to governance challenges and inconsistencies in the government's policy mix, which have limited the effectiveness of monetary policy and weighed on the fiscal balance, and a prolonged period of disagreement with EU institutions regarding the rule of law within the country.

      The Hungarian National Bank (MNB) was among the first European central banks to start an interest rate hiking cycle, raising its base rate from 0.6% in June 2021 to 13.0% by September 2022. Despite this significant monetary tightening to address rising core inflation, the impact was lessened by expansionary fiscal policies in the first half of 2022, including direct transfers to households and a 20% increase in the minimum wage. This fueled domestic demand, worsened macroeconomic imbalances and contributed to fiscal and current account deficits. These factors raised risk perceptions in markets and put pressure on the currency, which depreciated nearly 14% against the euro by November 2022, exacerbating imported price pressures.

      In the second half of the year, the government introduced measures to tighten the fiscal balance, including windfall taxes on specific sectors such as energy and banks, and postponed capital expenditures. However, despite some adjustments and rollbacks, certain regulatory policies have remained in place, hindering the transmission of monetary policy. The provision of state-backed investment loans and maintenance of price caps on energy and food products as well as caps on interest rates for mortgages, SME and student loans and large deposits have limited the effectiveness of monetary policy at controlling inflationary pressures. Although these policies have helped shield households from energy price shocks, they have delayed necessary demand adjustments and maintained costly energy imports at elevated levels. This situation creates pressure to maintain high policy rates, which could adversely affect the recovery in private demand and hinder the government's fiscal consolidation strategy.

      The government deficit was 6.1% of GDP in 2022, including the exceptional charge for natural gas stockpiles (amounting to about 1.2% of GDP). This represents a slight decline from the previous year’s deficit of 7.1%. Scope expects the deficit to decline to 4.1% of GDP this year, slightly above the government’s target of 3.9%, due to fiscal adjustment measures and continued revenue growth. After moderating in 2022 to 72.9% (down 3.9 pp from 2021), the government debt-to-GDP ratio should remain broadly stable in 2023 and decrease to around 71.0% in 2024, before gradually declining to about 64.0% by 2027. This trajectory is driven by expectations of robust nominal growth offsetting the impact of growing interest payments and persistent primary deficits.

      The fiscal outlook faces significant downside risks in relation to the release of EU funds. Hungary is expected to receive sizable inflows this year, primarily related to remaining allocated funds under the 2014-20 Multiannual Financial Framework (amounting to about 3.5% of 2021 GDP). However, uncertainty remains around the disbursement of funds allocated under the country’s Recovery and Resilience Facility and 2021-27 Cohesion funds, which together account for nearly 20% of 2021 GDP. Disbursement of these funds is conditional on the fulfillment of reform milestones related to the rule of law, and further material delays or reduced amounts could increase financing costs and negatively impact medium-term growth prospects, limiting the Hungarian government’s budgetary flexibility.

      Despite these structural weaknesses, Hungary has strong credit strengths, including high medium-term economic growth and investment, strong foreign direct investment, and diversification and competitiveness in the services exports sector. Hungary’s public debt profile and external liability structure are resilient against external shocks, with moderate foreign currency-denominated public debt and external liabilities being largely made up of direct investment and equity.

      First, Hungary’s economy has a strong history of high growth and investment, driven by foreign investment and EU funding. Prior to the pandemic, the country experienced average annual output growth of 4.1% between 2015-19, supported by increased investment and structural improvements. These changes led to a rise in employment and activity rates. The country’s economy has also diversified and become more competitive, particularly in the services exports sector. In addition, the country has received significant investment in the electric mobility and battery industries over recent months, supporting its manufacturing agenda and growth in high-value sectors.

      However, the ageing population poses a challenge to long-term growth as the working age population is expected to decline over the next decade. The labour market is tight, with high vacancies and low unemployment rates. To continue growing, Hungary will need to shift its growth model and focus on productivity gains. In 2022, the European Commission estimated that the productivity of Hungarian workers remained 32% below the EU average1.

      Second, Hungary’s public debt profile and external liability structure are resilient to external shocks. The government's debt profile is resilient due to a high proportion of domestic financing and a moderate amount of foreign currency-denominated public debt. The share of foreign currency-denominated central government debt has decreased in recent years, from 33.5% at end-2015 to about 25.0% currently, while the use of derivatives has limited the risks stemming from cross-currency exchange rate movements. The treasury has strong access to foreign and domestic financing, including through a sizable domestic retail programme. While funding costs have moderated somewhat in recent months, they remain elevated relative to peers and pre-pandemic levels.

      External liabilities mostly consist of foreign direct investment and equity rather than debt, which mitigates risks associated with the country’s external debt burden. The net international investment position improved from around negative 90% of GDP in 2013 to negative 37% of GDP in Q3 2022, supported by private-sector deleveraging, an increase in Hungarian companies’ assets abroad and stable pre-pandemic current account surpluses. The current account balance dipped to a deficit of 7.3% of GDP in the year to Q3 2022 due to the energy crisis, causing net borrowing to rise to 6.6% of GDP, which was mostly financed by robust FDI and EU funds inflows2. Gross external debt as a share of GDP remained broadly stable at about 85%, partly reflecting favourable revaluation effects and strong nominal growth3. Adequate international reserves of around 140% of short-term external debt in January 2023 also help 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 ‘bbb+’ 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.

      A rating committee has discussed and confirmed these results.

      Factoring of environment, social and governance (ESG)

      Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and 20% weighting in the qualitative overlay (QS).

      With respect to environmental factors, Hungary receives high CVS scores for having 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 personal income. The transformation of the country’s coal region, which produces up to 15% of electricity, and energy-intensive industries presents 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. The country faces several environmental challenges, including low water quality and high air pollution (reflected by persistent breaches of water and air quality standards) and weak energy efficiency in the residential sector. Hungary’s reliance on Russian fossil fuel imports, with limited plans for a scale up of domestic renewable energy capacities in the near term, constitutes a significant exposure to energy supply shortages in a context of high uncertainty with regard to the escalation of the Ukraine war.

      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. A shortage of affordable rental housing hinders social mobility. Educational outcomes are below the EU average, with large differences in certain areas. Basic skills among Hungarians under the age of 15 are well below EU and regional averages and have declined over the last decade. The country’s adverse demographic trends represent additional social-related credit challenges. Over the 2023-30 period, the United Nations expects Hungary’s working age population to decline by 0.7% annually on average. Accelerated population ageing represents a key constraint on the country’s long-term growth prospects and public finance outlook.

      With respect to governance risks, Hungary scores poorly relative to peers under Scope’s CVS. Scope assesses Hungary’s QS adjustment for governance risks as ‘weak’. This assessment reflects weaknesses via below-average checks and balances between public institutions and government branches, weighing on policy predictability. Hungary scored 77th among 180 countries in Transparency International’s 2022 Corruption Perceptions Index, the lowest rank among EU members4. Governance issues relating to the primacy of the rule of law and the independence of the judicial system have led to a pronounced worsening of relations with EU institutions, which have reacted by withholding a set of EU funds.

      Rating Committee

      The main points discussed by the rating committee were: i) budget performance and outlook; ii) growth and inflation prospects; iii) external environment, financial stability and macroeconomic sustainability; iv) energy security and v) institutional developments.

      Rating driver references
      1. European Commission - 2022 European Semester: Country Reports, Hungary 
      2. MNB – Report on the Balance of Payments, January 2023 
      3. IMF – Hungary: 2022 Article IV Report
      4. Transparency International – 2022 Corruption Perceptions index

      Methodology
      The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
      The model used for this Credit Rating and Outlook is the Core Variable Scorecard (version 2.1), available in Scope Ratings’ list of models, published under 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    YES
      With access to internal documents                                  NO 
      With access to management                                           YES
      The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity.
      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 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 2 September 2022.

      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
      © 2023 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis 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.

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