KEY RATING DRIVERS

Hungary's 'BBB' rating balances strong structural indicators, a stable banking system, and a stronger track record of growth relative to peers against high general government debt and risks from a track record of unorthodox macroeconomic policy. While the economic impact of the coronavirus crisis will sharply worsen fiscal metrics, Fitch expects an improvement beyond 2020, given expectations of a return to growth and fiscal consolidation post pandemic.

Following years of above trend growth, the disruption to economic activity caused by the COVID-19 pandemic is set to result in a contraction of real GDP by 5.9% in 2020. Tourism, which accounts for 10% of GDP (including related activities) was among the worst hit sectors, with arrivals falling by 61% yoy in 1H20. Overall, the economy contracted by 13.6% yoy (14.5% qoq in seasonally and calendar adjusted terms) in 2Q20. As a highly open economy (trade openness (average of current account receipts and outflows) amounted to 95.2% of GDP in 2019, more than twice the current 'BBB' median), Hungary's exposure to external demand - particularly from the EU - is relatively high. Exports of goods and services contracted in March-April but have been recovering since May (June: -14.4% yoy, euro terms). Fitch expects real GDP growth to recover to 5.4% in 2021 and 4.3% in 2022.

Notwithstanding a drop in fixed investment by 2.6% yoy (36.9% qoq) in 1Q20, the outlook for investments (public and private) in Hungary over the forecast horizon appears relatively stable. Authorities estimate a pipeline of planned/announced private sector investments (mostly foreign investor-led) worth over HUF4,000 billion (8.5% of 2019 GDP). Fitch expects that expansion of the capacity of the auto production sector to produce electric car batteries and vehicles will largely remain on track, with positive implications for potential growth in the medium term (through both the capital investment and productivity channels).

The Hungarian central bank (MNB) has cut rates by a cumulative 30bp since May 2020 to 0.6% despite inflation remaining high (July 2020: CPI was up 3.8% yoy). Furthermore, in April, the MNB decided to introduce a new one-week deposit instrument, whose yield would fluctuate in a 'symmetric' corridor on either side of the policy rate. In Fitch's view, this reflects a more predictable and transparent approach to monetary policy.

The government's anti-crisis stimulus package, including fiscal, quasi-fiscal and central bank measures, amounts to 20% of GDP, one of the largest in the EU. However, direct fiscal measures are much smaller and the take-up of some measures remains uncertain or has been below expectations (e.g. loan moratoriums). Key revenue-side fiscal measures include a 2pp cut to the social security contribution rate, effective 1 July 2020 and waiving of several taxes, including the tourism development contribution for the tourism industry.

Fitch expects that expenditure measures - notably the Kurzarbeit wage support scheme - will collectively add 2.8pp of projected 2020 GDP to the headline deficit (which reached 4% of GDP as at 2H20). Fitch projects Hungary's fiscal deficit to reach 5.8% of GDP in 2020 (2019: 2%; current peer median: 6.4%) before improving to an average of 3.4% of GDP in 2021-22. This assumes that spending to support the economy is concentrated in 2020. Further, Fitch expects that authorities will be bound by the fiscal rule, which obliges the government to target falling debt/GDP, beyond 2020. Given the uncertainty over the size of allocations under the EU's Next Generation package, Fitch assumes contributions from them will be minimal in 2021-22.

In view of the recession and the government's pandemic response, general government debt (GGD) levels will increase in 2020. Hungary revised up its gross financing needs for 2020 by 4.7pp of GDP to 18.7% of GDP, and issued HUF2.17 trillion (4.8% of GDP) in net terms in 1H20. Fitch expects GGD/GDP, which has consistently been well above the peer median, to increase from 66.6% at end-1Q20 to 78.3% by end-2020 (current peer median: 52.6%) and average 73.8% in 2021-22. This assumes that up to 20% of government guarantees provided under the anti-crisis package crystallise onto the sovereign balance sheet in 2021 and 2022.

While overall debt levels are a rating weakness for Hungary, the composition of government debt has improved in recent years. The FX proportion of central government debt fell from a peak of 37.9% in 2015 to 19.1% as of 2Q20, and is set to reduce further to 11.9% by 2022. Debt maturities in 2020-22 are also lower compared with previous years.

Hungary is also actively pursuing a strategy of increasing the proportion of domestically-held domestic retail securities, most notably the MAP+ instrument launched in 2019. Retail securities reached 27.8% of total central government debt outstanding as of end-2Q20, and have a higher debt servicing cost but they represent a stickier domestic investor base compared with international investors. As of 1Q20, government securities (including MAP+ and other retail instruments) accounted for 13.6% of Hungarian household assets (end-2018: 10.6%).

Fitch projects the current account balance will fall sharply from -0.8% of GDP in 2019 to -2.2% in 2020 and average -2.9% in 2021-22 (current peer median: -2.2%). This will largely be driven by the worsening goods balance as a projected rise in investments will lead to higher capital goods imports. Fitch expects that from 2021, EU capital transfers will ramp up sharply in line with the funding cycle of the current Multi-Annual Financial Framework (which formally ends in 2020) - authorities estimate that the EU funds absorption rate will rise from 44.5% in 2019 to 81.3% by 2022. Foreign direct investment (FDI) levels are also expected to be relatively stable in 2021-22, with the auto sector an important destination for investment (the sector accounted for nearly 32% of inward FDI in 2019). Strong capital inflows and FX reserve levels will help reduce net external debt to an average of 4.4% of GDP over the forecast horizon (current peer median: 11.4%).

The banking sector is liquid and well-capitalised (total capital ratio: 21.2% as of 1Q20) with relatively strong asset quality (1Q20: non-performing loans ratio of 3.5%). However, the worsening of the operating environment due to the sharp hit to economic growth will cause bank profitability and asset quality to deteriorate. Banks have started to increase provisioning for expected credit losses. As part of the economic response to the pandemic, banks have suspended loan repayments for a large share of their customer loan books ('opt-in' approach as default), easing pressure on borrowers. Overall household indebtedness is low, at 22.4% of GDP as of 1Q20, and household savings remain robust (2019: 9%), mitigating risks.

Hungary outperforms its rating peers in the World Bank Governance Indicators, although the gap has reduced in recent years. Perceptions of corruption and undue state influence remain high for an EU country. Fitch expects relations with the EU to remain tense, given fundamental disagreements over rule of law issues. Potential escalation of such rifts to levels where investor confidence in Hungary is fundamentally undermined or access to EU funds for domestic investment is credibly threatened is not our base case currently, but could weigh negatively on Hungary's rating.

ESG - Governance: Hungary has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Hungary has a medium WBGI ranking (68th percentile), reflecting its track record of peaceful and relatively stable political transitions, balanced with perceptions of weakening rule of law in some respects.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Hungary a score equivalent to a rating of 'BBB+' on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Macroeconomic performance, policies and prospects: -1 notch, to reflect policy credibility that is assessed to be weaker than peers in view of a track record of unorthodox fiscal and monetary policies.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR.

Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to positive rating action, are:

- Public Finances: A sustained decline in general government debt/GDP to levels closer to the peer medians, post-pandemic.

- Macro: Increased confidence and predictability in macroeconomic policy management over the economic cycle.

- Macro: Stronger medium-term growth prospects aided by an improved business environment, without the emergence of macroeconomic imbalances such as large current account deficits or prolonged, high inflation.

The main factors that could, individually or collectively, lead to negative rating action, are:

- Public Finances: Worsening of fiscal metrics that leads to adverse debt dynamics, notably a failure to reduce government debt levels as expected post-pandemic.

- Structural: Weakening of the institutional framework that leads to a deterioration in governance indicators or relations with the EU over rule of law issues, jeopardising flow of EU funds.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579].

KEY ASSUMPTIONS

Fitch assumes eurozone growth of -8% in 2020, 4.5% in 2020 and 2.8% in 2021 (in line with its June 2020 Global Economic Outlook).

Fitch assumes that under severe financial stress, support from Hungarian subsidiary banks would come first and foremost from their foreign parent banks.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Hungary has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are highly relevant to the rating and a key rating driver with a high weight.

Hungary has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.

Hungary has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as strong social stability and voice and accountability are reflected in the World Bank Governance Indicators that have the highest weight in the SRM. They are relevant to the rating and a rating driver.

Hungary has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Hungary, as for all sovereigns.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.