Credit rating agency Moody's cut Hungary's sovereign rating by two notches, to just above junk grade, on Monday and said it may cut further if the government fails to put public finances on a sustainable footing.
Hungary's government has rejected austerity and aims to close its budget deficit with hefty new taxes on banks and other businesses as well as a diversion of private pension savings into state coffers.
Today's downgrade is primarily driven by the Hungarian government's gradual but significant loss of financial strength, Moody's Investors Service analyst Dietmar Hornung said in a statement.
The negative outlook reflects the uncertainties regarding the government's financial strength, as the country's structural budget deficit is set to increase and external vulnerabilities make the country susceptible to event risk.
Hungarian assets have been hit in the last month as the spreading euro zone debt crisis has driven a decline in global appetite for risk.
While expected, the two-notch downgrade, which puts the Moody's rating on a par with that of rival Standard & Poor's, is another signal that markets are not happy with the government's unorthodox economic policies.
The Moody's action is in line with our view that recent economic policy decisions in Hungary resulted in a deterioration of the medium-term fiscal outlook and less predictable business environment, Piotr Kalisz at Citigroup said in a note.
Fitch Ratings -- whose BBB rating for Hungary is now the highest of the three big rating agencies -- has said it expects to conclude a review on Hungary soon. It already has a negative outlook on the rating.
A mix of rating downgrade, disappointing fiscal adjustment and high external vulnerabilities could lead to higher FX volatility in the coming weeks, especially if the euro area sovereign debt crisis intensifies, Kalisz said.
The forint fell nearly one percent from its Friday close in early Monday trade versus the euro but is holding at around the 280 level for now, dealers said.
The currency is only about 5 percent off September's record lows versus the Swiss franc, the funding currency for trillions of forints of household mortgages.
Analysts said any rating cut into sub-investment grade territory could spark a bigger sell-off in the forint, potentially undoing the impact of personal income tax cuts to be launched next year to boost domestic consumption.
It could also trigger forced selling of Hungary's sovereign debt, which is already seen as vulnerable to contagion from the euro zone debt crisis.
Investors have also been unsettled by squabbling between the government and central bank, which unexpectedly hiked interest rates last week [ID:nLDE6AS0VZ].
NEGATIVE LONG-TERM IMPLICATIONS
While the government's measures should help it meet deficit targets this year and next, they have unnerved markets and raised concerns over long-term sustainability.
The center-right Fidesz government plans to effectively eliminate mandatory private pension funds, which will lower its near-term funding needs and help it cut the budget deficit to below the European Union's 3 percent of GDP limit next year.
But even if the near-term deficit targets are met by means of pension changes, the longer-term implications of the weakening of the private savings scheme are negative for public finances, warned Moody's in Monday's ratings statement.
S&P also said last month it was concerned that budget measures were short-term and that deficits and debt could creep up again after 2013.
Economy Minister Gyorgy Matolcsy will address parliament on amendments to the 2011 budget on Monday and lawmakers will vote on its cornerstone figures on Tuesday.
We reiterate that we do not like what is happening in Hungary and see the HUF as one of the most vulnerable currencies in the region, said Elisabeth Andrew at Nordea.
Nevertheless, we believe market forces to some extent will prevent the government from doing even more harm -- a weaker HUF will hurt households and corporates with a large share of FX loans.
(Writing by Gergely Szakacs; Editing by Catherine Evans)