A selloff in Hungarian financial markets is forcing investors to weigh the possibility of a default in the European Union state and the risk of contagion to other regional economies.
The rising cost of insuring government and bank debt in neighbouring euro zone member Austria because of exposure to Hungary is a case in point.
Hungary needs to find around $16.5 billion (10.6 billion pounds) this year to repay debt owed to bondholders and the International Monetary Fund but is effectively cut off from global capital markets as growing mistrust in its policies pushes up borrowing costs.
Controversial new laws that are seen as undermining central bank independence and democratic checks have put Hungary on a collision course with the European Union and the IMF, jeopardising an aid deal.
Common sense would say a default cannot happen but now we can no longer exclude this possibility. It is a marginal risk, but it is a risk, and cracks have appeared in investor confidence, said Viktor Szabo, a fund manager at Aberdeen Asset Management, which has $7 billion in emerging debt.
Like most fund managers, Szabo does not see a 2012 default as the main scenario and expects Hungary to eventually meet IMF conditions and sign a loan deal. The government said on Wednesday it might moderate some of its widely-criticised policies to please international lenders.
Szabo said he is extremely underweight Hungarian hard currency bonds and the forint.
The question is how far the market must push Hungarian assets ... It's hard to guess what level of exchange rate and bond yield will make the government change their mind, he said.
Market moves have been unforgiving already. The forint is at record lows while local 10- and five-year bond yields have shot past 11 percent, 2.5 percentage points above month-ago levels.
Investors are also demanding a record high premium of almost 800 basis points over U.S. Treasuries to hold Hungarian dollar bonds, JP Morgan's debt index shows.
The problem is Hungary's numbers don't add up.
According to central bank data, the government had 1.5 trillion forints ($6.04 billion) in deposits at the central bank in November. It has around 600 billion forints ($2.41 billion) worth of assets left from last year's pensions grab and could sell its stake in oil and gas group MOL if needed.
That should be enough to cover payments for at least the first half of the year. But government bonds are only the tip of the debt iceberg.
Less well known is the fact that Hungarian banks, for years reliant on credit lines from foreign parent banks and hit by government measures including taxes and a foreign exchange mortgage repayment scheme, have external debt liabilities worth $25 billion this year.
Against a backdrop of stress caused by the euro zone crisis, Hungary will struggle to get through 2012 without a substantial IMF loan.
If aid does not materialise, market stress will intensify with further rating downgrades, another 200 basis point sell-off in bonds and a rise in (euro/forint rate) to 340 levels, BNP Paribas said, predicting a 2012 economic contraction of more than 3 percent.
NO DEFAULT PRICED YET
Judging by the relative costs of hedging short- and medium-term Hungarian debt, markets are not yet pricing in a default. While credit default swaps imply a record $700,000 cost to insure $10 million of Hungarian debt against default for five years, one-year CDS costs are still well under that level.
But investors are in panic mode, with few takers for 11 percent-plus yields. Analysts note that this week's big sell-off affected Hungarian cash bonds - including some in dollars - far more than CDS prices, suggesting that sellers were long-only investors rather than fast-money traders.
There is a possibility we will continue to reduce positions as we view Hungary as a momentum-negative trade, says Jeremy Brewin, a fund manager at Aviva Investors who cut Hungarian dollar bond holdings sharply in November and December.
Positioning on local debt is at the minimum level possible.
At the moment we are not expecting a default, Brewin said. But it seems like the administration are in denial, not realising that the situation is becoming quite dire and could easily tip into something more problematic.
The unfolding crisis in Hungary is starting to take a toll on neighbouring markets though the effect is still muted.
Debt insurance costs in Poland and the Czech Republic are up 30 basis points this week while CDS in Austria, where banks are heavily exposed to Hungary, have also started rising. But these markets have not surpassed highs hit at the end of November.
The zloty, central Europe's most liquid currency, is down 1 percent this year but has merely touched three-week lows while 10-year Polish bond yields have been stable.
Equities have been even less affected, with emerging stocks up 2.2 percent this year and bourses in Poland, the Czech Republic and Turkey also posting gains.
That is unlikely to continue if the uncertainty in Hungary drags on. Societe Generale analysts already suggest taking off bets on cuts to Polish interest rates this year as markets take a hit from Hungary. They also advise selling the Czech crown to position for contagion from Hungary.
But Hungary constitutes just 0.3 percent of the MSCI emerging equities index and less than 3 percent of the emerging Europe index <.MIEE00000PUS>, suggesting reaction may be limited.
Secondly, public as well as private debt ratios in all neighbouring emerging countries are much better than in Hungary.
Policymaking is different, currencies and bond yields are moving differently, said Marcus Svedberg, a fund manager at East Capital who has cut Hungarian equities in his portfolio but raised Poland's share.
The market acknowledges that these issues stem from government polices rather than anything else. Hungary is not a game changer.
(Additional reporting by Carolyn Cohn and Krisztina Than)