Standard and Poor's has placed Hungary's sovereign rating on negative credit watch, citing unpredictable policy moves and a weak growth outlook and increasing the chances of a cut to junk status also threatened on Friday by fellow agency Fitch.
Hungary's centre-right government, which shocked markets with a string of unorthodox policy moves since deciding not to renew a funding agreement with international lenders last year, said a downgrade would not be justified.
Just two days ago the European Commission declared that the Hungarian budget deficit will be below 3 percent, which only seven European Union member states will be able to show next year, the Prime Minister's spokesman, Peter Szijjarto said in a statement.
Analysts said the growing prospect of a downgrade to junk could weaken the forint currency and push government bond yields higher when markets reopen on Monday, even if investors have already factored in the possibility to some extent.
The country is rated just above junk debt status with a negative outlook at all the three main rating agencies and one analyst said a cut to non-investment grade by S&P now looked all but certain.
Unless there is a drastic, unexpected turnaround in government policy or an upside surprise in economic growth, we can take this downgrade for granted, said Gergely Suppan at Takarekbank said. This gives time for the market to prepare.
S&P placed Hungary's 'BBB-/A-3' foreign and local currency sovereign credit ratings on CreditWatch with negative implications late on Friday after a similar move by Fitch earlier in the day.
The rating action reflects our view that a more unpredictable policy environment, stemming from a weakening of oversight institutions and some budgetary revenue decisions, will have a negative effect on economic growth and government finances, S&P said in a statement.
It said downside risks to Hungary's creditworthiness were increasing as the external financial and economic environment was weakening.
S&P added it was likely to decide on Hungary this month pending further information from the Hungarian government regarding how it will address the ongoing economic challenges.
Earlier this week the EU Commission forecast Hungary's 2012 budget deficit at 2.8 percent of GDP but said the shortfall could again rise to 3.7 percent in 2013, undermining government efforts to keep state debt on a declining path.
Fiscal consolidation is further complicated by the prospect of near stagnation in Hungary next year as export demand from Western Europe is dampened by the euro zone debt crisis and domestic demand remains anaemic despite tax cuts.
The forint skirted around 2009 record lows earlier this week, pressured by the euro zone debt crisis as well as a controversial foreign currency mortgage repayment scheme, which is seen weakening the banking system.
S&P said this move, which the government says is part of efforts to reduce Hungary's high external debt levels, would further dent growth prospects by reducing the supply of credit to the economy.
These measures will constrain growth prospects and may put the government's fiscal targets in jeopardy and could prevent a sustained reduction in general government debt levels, it said.
Takarekbank's Suppan said a downgrade to junk would not cause immediate funding problems for Hungary as it already has this year's foreign currency issuance needs covered and the budget is cushioned by a one-off 2011 fiscal surplus.
However, he said a downgrade could make it more difficult and expensive for Hungary to refinance about 4.7 billion euros worth of foreign currency debt next year, when it also begins to repay a 2008 rescue loan to the International Monetary Fund.
With a sufficiently high premium, they will be able to sell it, Suppan said.
Aegon Securities analyst Gabor Orban however was less optimistic, saying it may prove difficult to find buyers for all of the 4.7 billion euros to be rolled over if S&P cuts Hungary's rating into junk.
No one doubts that the budget deficit will be low next year. Hungary's problem, as with Italy, is that it faces near stagnation paired with high debt and a leap in funding costs can drive both countries to the wall, Orban said.
If the Italians can crawl out of this malaise then I do not predict a collapse in Hungary, he said.
(Reporting by Krisztina Than/Gergely Szakacs)