By Jakob Suwalski, Director and Levon Kameryan, Senior Analyst, Sovereign Ratings

The European Commission’s decision to notify Hungary about triggering the conditionality mechanism - linking EU funds to respect for the of rule of law - puts at risk a substantial share of EUR 35bn (22.8% of 2021 GDP) which Hungary could expect in the 2021-27 long-term budget. EU is also withholding EUR 7.2bn (4.7% of 2021 GDP) in pandemic recovery funding requested by Hungary.

The negative consequences for Hungary (BBB+/Stable) are potentially material.

On the diplomatic front, the EU’s bold, coordinated response to Russia’s war on Ukraine is now mirrored by equally forthright policies within the union, with the spotlight on Hungary. By formal notification of Budapest of the start of the conditionality mechanism, Brussels puts more pressure on Hungary’s Prime Minister Viktor Orbán, just days after his emphatic re-election, for lack of progress in tackling deficiencies in the rule of law.

Rule of law in Hungary weakened since Viktor Orbán became the Prime Minister in 2010

Source: Macrobond, World Bank, Scope Ratings

We expect Hungary’s negotiations with the EC to be lengthy but pragmatic. The EC runs the risk of provoking a Hungarian veto of EU decision-making while Hungary is under pressure to improve relations with allies in central Europe, especially Poland, which have criticised Hungary’s approach to Russia. Mr. Orbán’s agreement to meet Russia’s demand for gas payments in roubles further increases Hungary’s risk of isolation – and shows the urgency for the EU to create an ‘energy union’ to allow the member states to determine a common approach to Russia.

Whatever Poland’s and Hungary’s differences over Russia’s war in Ukraine, the governments have some mutual understanding over the rule of law. Poland could decide that the risk of Article 7 being used against itself is too high, but the two countries will continue their close cooperation given reliance on each other’s vetoes to prevent further punitive EU action.

However, the economic consequences of the deepening dispute with the EU are not negligible for Hungary, even before taking into consideration the lingering impact of the Covid pandemic and the war in Ukraine.

The government in Budapest has likely used up an additional EUR 4.5bn in foreign currency debt raised in its modified 2021 budget to partly pre-finance expenditure this year after the previously delayed release of Hungary’s share of EU recovery funds. Pre-war pressure on government finances was visible in only a modest narrowing of the budget deficit to an estimated 6.8% of GDP last year despite the economy’s solid rebound from the pandemic.

Budgetary pressures are building up again this year after pre-election fiscal largesse, including personal income tax refunds and pensioner and public-sector bonuses. The handouts will also accelerate inflation, which we project to reach 10% this year following the lifting of price caps on food and fuel which, under current plans, will remain in effect until May. The Finance Ministry plans to revise the 2022 budget to factor in the less buoyant economic environment.

The government in Hungary needs to address the rising budgetary pressures just as the economy is set to slow amid rising inflation, sanctions on Russia and supply-chain disruptions of the country’s exports, notably in the automotive sector. We expect Hungary’s economy to grow by 3.5% in 2022, revised down from 5.4% in December.

Unlocking recovery funds withheld by the EU will play a key role in fixing Hungary’s budget and preventing a sharper slowdown in economic growth. Without progress in rule-of-law talks with Brussels, a prolonged suspension of EU funds on top of the supply-chain disruptions could materially slow down FDI inflows and ultimately weigh on the country’s macroeconomic stability and credit ratings.

Download latest round-up of Scope’s rating actions and analysis of the unfolding political and economic crisis caused by Russia’s war in Ukraine.