Credit rating agency Moody's cut Hungary's debt to junk grade late on Thursday, dealing a blow to Prime Minister Viktor Orban's unorthodox economic policies and prompting his government to denounce the move as a financial attack.
Moody's lowered Hungary's sovereign rating by one notch to Ba1, just below investment grade, with a negative outlook, hours after rival Standard & Poor's held fire on a flagged downgrade after Budapest said it would seek international aid.
The move followed warnings from all three major ratings agencies that Orban's policies, which have eschewed traditional austerity in favour of revenue-boosting steps like a special bank tax and the nationalisation of $14 billion (12 billion pounds) in pension assets, had put Hungary's finances at risk.
It also came after Orban relaunched aid talks this week with the International Monetary Fund, a dramatic reversal after he cut cooperation with the Fund short last year after sweeping a 2010 election on a vow to regain economic sovereignty.
Moody's cited rising uncertainty about Hungary's ability to meet fiscal goals, high debt levels and what it called increasingly constrained medium-term growth prospects.
Moody's believes that the combined impact of these factors will adversely impact the government's financial strength and erode its shock-absorption capacity, it said in a statement.
Hungarian bond yields soared by about a full percentage point, lifting its entire bond curve above 9 percent, but yields dropped by about 20-30 basis points in afternoon trade as high yields prompted buyers to enter the market.
The cost of insuring Hungarian debt against default jumped to new record highs at 635 basis points, eclipsing earlier highs hit in March 2009. The forint rebounded from morning falls of about 1.6 percent to trade at 314.10 by 12:59 p.m. (British time).
The Czech crown fell to a 17-month low and the Polish zloty dipped beyond the 4.50 per euro level and briefly approached a 27-month low of 4.537 hit in September.
Nicholas Spiro, managing director of Spiro Sovereign Strategy, said that although most of central and Eastern Europe was better off than southern Europe, fears over the euro zone debt crisis and the Hungarian downgrade indicated turmoil ahead.
There's no question that sentiment towards the region is deteriorating rapidly and that even the most resilient economies are in for a rough ride in the months ahead, he said.
The downgrade is a major setback for Orban, whose Fidesz party ousted Socialists he has blamed for economic mismanagement by winning a two-thirds majority in last year's election.
He has cut taxes for families and small firms and raised tariffs on banks, utilities and other big, mainly foreign-owned, firms, putting the country of 10 million on track to run one of the European Union's only budget surpluses this year.
But his policies have failed to spur growth and irked voters who resent his aggressive tactics and oppose his seizing private pension savings to fund an inefficient public sector.
The government's unpredictability and rising pressure from the euro zone crisis have hammered investor sentiment.
The forint has fallen 16.3 percent since July 1, versus 12.6 percent for its regional peer the Polish zloty and 6.7 percent for the Czech crown.
The Economy Ministry has blamed the currency's plummet -- which has hit Hungarians who have borrowed in foreign currency -- on market speculators. It said the downgrade was unwarranted, the latest in a string of financial attacks against Hungary.
Obviously, the forint's weakening is not justified by either the performance of the Hungarian economy, or the shape of the budget, the Economy Ministry said in a statement.
The government cited its commitment to keep the budget deficit below 3 percent of economic output next year, 1 percent of GDP's worth of reserves in the 2012 budget, and an expected decline in debt levels, as arguments against the rating cut.
But Moody's said the government's 2.5 percent of GDP budget deficit target for next year may be difficult to meet due to high funding costs and low economic growth.
The weak forint pushed Hungary's government debt to 82 percent of economic output by the end of the third quarter, undoing the impact of Orban's $14 billion pension asset grab.
Hungary must roll over 4.7 billion euros in external debt next year as it starts repaying part of its 20 billion euros, 2008 bailout from the IMF -- something that could be solved with a new financing deal.
In his unexpected about face on potential IMF support, Orban made clear that he would not accept any demands in exchange for cash at the ready should the need arise. but Moody's said the request to resume talks illustrated Budapest's funding challenges.
Even with such an arrangement, the government's debt structure will remain vulnerable to shocks in the medium term, which are inconsistent with a Baa3 rating, Moody's said.
The European Commission forecasts the economy will expand by only 0.5 percent at most next year, far lower than the 3 percent initially forecast in Orban's medium-term budget plan.
Complicating that further is high unemployment, weak bank lending and 5 trillion forints in mostly Swiss franc denominated foreign currency mortgages which have seen repayments soar due to the franc's strength and forint's slide.
Orban has introduced an option for families to repay loans at exchange rates below market levels, but that has roiled markets and inflicted billions of forints of losses on the bank sector, undermining growth and lending.
Economists said the gloomy economic outlook could combine with the downgrade and increase pressure on Budapest to accept an IMF deal with the monitoring and policy recommendations Orban has spurned.
As the economy will tumble into recession by around the turn of the year, we expect that it will have no other choice than to accept any IMF proposal, even if this would include conditionalities, said Michal Dybula at BNP Paribas.
Moody's said it would further lower Hungary's rating if there was a significant decline in government financial strength due to a lack of progress on structural reforms and implementation of a medium-term plan.
The ratings cut came just hours after S&P deferred its decision on a possible downgrade of Hungary to non-investment grade until end-February, pending IMF talks.
Fitch, another rating agency which has Hungary in the lowest investment-grade category, has said an agreement on a new IMF programme could reduce downward pressure on Hungary's rating.
(Additional reporting by Gergely Szakacs; Writing by Michael Winfrey; Editing by Catherine Evans, Ron Askew)