Two top ratings agencies said on Friday they might downgrade Hungary's sovereign debt after its prime minister snubbed the IMF and rejected austerity measures in favor of a pro-growth policy to woo voters.
Moody's placed Hungary's Baa1 local and foreign currency government bond ratings on review, citing increased fiscal risks after the International Monetary Fund and the European Union suspended talks over their 20 billion euro ($25 billion) financing deal with Budapest at the weekend.
Ratings agency S&P said later it revised its outlook on Hungary to negative from stable, while affirming its BBB-/A-3 rating, which is already lower than Moody's.
Prime Minister Viktor Orban, whose center-right Fidesz party swept into power in April, has spurned warnings that Hungary could face market pressure and currency weakness without support from international lenders.
Orban, whose party holds a more than two-thirds majority in parliament, has pledged to end the belt-tightening pursued by the previous Socialist government.
He has his eye on October 3 municipal elections, where he plans to consolidate his party's grip on Hungarian politics.
Moody's said it expected the government would resume talks with lenders after the municipal vote and that it was likely to confirm Hungary's current rating if there is a credible commitment to the IMF's previously proposed fiscal targets.
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.
Moody's told Reuters it would decide within four months on whether to downgrade Hungary.
Orban has said the government would meet this year's deficit goal specified in the current IMF deal but would allow the deal to expire in October, and that Hungary only needed to talk with the European Union about the 2011 budget.
The IMF has said it is open to resume talks but wants Hungary to abandon some steps approved by parliament on Thursday including a bank tax which it says will squeeze lending and hamper growth, and has called for structural reforms.
Hungarians, worn out by a deep recession last year, appear to have embraced the government's tough stance versus the IMF as well as the bank tax, although foreign currency loan holders are concerned about the forint.
There are more important interests than financial, said Imre Vida, a pensioner in Budapest. The prime minister was right to go to Berlin (to meet Chancellor Angela Merkel)...The IMF has caused only difficulties, whether we speak about South America, Africa or eastern Europe.
Analysts have said that Orban, whose government faces no immediate financing pressure, is likely to soften his rhetoric after the October vote.
But they have also said Hungary is playing a dangerous game and could be forced to come back to the IMF if markets turn negative and the forint falls sharply.
Markets have recovered from sharp falls early in the week after the breakdown of the talks. The Moody's and S&P warnings triggered a relatively muted reaction, with the forint dropping about one percent to the euro.
Five-year credit default swaps (CDS) -- the cost of insuring Hungary's debt -- rose 14 basis points to 343.
Hungary can probably survive without a new IMF/EU program for the remainder of this year, said Neil Shearing at Capital Economics in London. But we suspect it will eventually be forced to re-engage with the Fund either later this year or early in 2011 -- and on much stricter terms. In the meantime, financial markets are in for a rough ride.
Right after the April election, markets rallied in the hope that the new Hungarian government would pursue deep reforms, which analysts had hoped for before the vote, as a Reuters poll showed in February.
Analysts said the forint would remain volatile due to uncertainty over the fiscal and policy outlook.
Hungary sold all the bills it had put on offer at a 12-month Treasury bill auction on Thursday, although yields rose. But analysts said a 50-billion-forint bond auction next Thursday
would be a better indicator of investor sentiment.
The hundreds of thousands of Hungarian households who have borrowed heavily in foreign currency, mainly Swiss francs, in the past years will suffer if the forint weakens further.
Sandor Kovacs, who has a Swiss franc mortgage and has seen his loan repayments rise continuously due to the franc's recent strength even before talks with Hungary's lenders halted, said he was worried about the potential impact on the forint.
It (forint depreciation) affects me too because I have a foreign currency loan, I started off with paying 50,000 forints a month, now I am paying 80,000, he said.
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(Additional reporting by Gergely Szakacs, Editing by Sonya Hepinstall)