Ratings agency Moody's put Hungary on review for a possible downgrade on Friday, citing increased fiscal risks after it suspended talks with the IMF and EU on its existing $25 billion aid deal.
The new government halted the talks last weekend. Prime Minister Viktor Orban said on Thursday he would likely not renew the safety net and would row back on a commitment to cut the budget deficit to European Union-prescribed levels next year.
Moody's decision to initiate this review was prompted by the increased uncertainty regarding Hungary's fiscal outlook and economic prospects, the agency said.
This uncertainty is the result of the recent breakdown of Hungary's talks with the IMF and EU (after a disagreement over the country's 2010-11 fiscal deficit targets), which in turn led to a suspension in the next disbursement from the IMF/EU EUR20 billion loan programme for Hungary.
Orban has spurned warnings that Hungary -- where households have a large stock of foreign currency debt -- could face market pressure and currency weakness without support from its lenders.
He said the current EU and International Monetary Fund deal would expire in October, and while Hungary would meet its 2010 budget target under the agreement, the government would negotiate with the EU about how and when to bring the deficit below 3 percent.
Some analysts say concerns about the scale of Hungary's current deficit are overblown given it looks set to cut the shortfall to 3.8 percent of GDP this year. But markets have been concerned by the government's rhetoric and public railing at the IMF.
The forint slipped 0.8 percent versus the euro after Moody's warning to 286, but climbed back to 285.45 by 0808 GMT.
Moody's said a review of Hungary's sovereign ratings would focus on the willingness of the government to formulate a coherent reform agenda that could stabilize the economy and the government's financial strength.
But, in line with many analysts, it said it expected Hungary to resume talks with lenders after a municipal vote on October 3 which the ruling Fidesz party is expected to win -- after it swept into power at parliamentary elections in April.
Moody's expects the Hungarian government and the EU and IMF to come to an agreement following the local elections (scheduled for October 3), as all sides are aware of the negative consequences of a complete breakdown in the programme, it said.
The agency is likely to confirm Hungary's current rating of Baa1 if there is a credible commitment to the IMF's previously proposed fiscal targets, it said.
However, if the new fiscal targets that emerge from the next round of talks imply a less rapid fiscal consolidation path, then a one-notch rating downgrade is likely, it said.
Zsolt Kondrat, analyst at MKB said the possibility of a rating downgrade was a direct consequence of the breakdown of talks between the government and the IMF and hints from Orban that they are still looking for ways to go with a looser budget next year.
I think the big issue is whether the original deficit path is adhered to or not and if not what happens to the debt trajectory, he said.
(Reporting by Krisztina Than, editing by Patrick Graham)