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Standard & Poor's affirmed Hungary's sovereign debt rating late on September 19, disappointing Budapest's hopes of an imminent return to investment grade. Despite the strong growth in recent months, the ratings agency kept the country at BB/B, warning that the improvements in the economy are mostly state driven and may not last into the medium term.

Having lost investment grade at all three of the major ratings agencies in 2011/2012 after Budapest dropped plans for an international bailout, Hungarian authorities have spent this year suggesting upgrades are on the way. A central bank official claimed in early June that a return to investment grade was imminent following talks with one of the agencies, although refused to name which one.

However, Fitch blanked that claim as it affirmed its rating at BB+ two days later and rebuffed analyst predictions of a move for the outlook from stable to positive. Moody's announced no change to its Ba1 in July, and the outlook is negative. S&P's outlook remains stable after revision in March, but the agency continues to rate Hungary two notches below investment grade, and the refusal to upgrade completes the set.

As well as government officials, Hungary's struggles to earn an upgrade has surprised several analysts, according to Portfolio.hu. Last week the European Bank for Reconstruction and Development raised its forecast for Hungarian GDP growth this year to 2.8% from the 1.6% it predicted in May.

However, S&P remains wary of the large role played by the government in pushing Hungarian growth, the effect of erratic policymaking on investment and the banks, as well as continued risk attached to the state's large external debt. 

Clouded

"After several consecutive years of acute private sector deleveraging and  fiscal restraint, we estimate that Hungary's domestic economy is starting to  recover," S&P said in its report. "For 2014, we project that real GDP growth will rise to more than 3%. By the end of 2015, we expect the size of the Hungarian economy to  return to just above 2007 levels." However, it adds that "medium-term prospects remain clouded by the government's policy mix and a shrinking population”.

"Part of the increase in growth is due to base effects generated by depressed levels of investment and consumption; part will come from generous EU  transfers (the inflows from which should continue over the next six years); and part reflects government policies, which may boost growth in the short term, but impede growth in the medium term," the analysts pointed out. "Policies include  government-mandated cuts to utility bills, public employment programs, credit easing from the Central Bank's Funding for Growth facility, and household debt relief." 

The trouble is that these programmes cannot last forever, while they are part of a statist bent that has scared off investment and made banks retreat from lending. "Once the impact of these measures wears off, we anticipate that potential  growth in Hungary will weaken to about 1.0%-1.5%," S&P writes. "We consider that  unpredictable policymaking, an expansive public sector, a regressive and  overly complex tax framework, an unprofitable banking system, and a shrinking population, hold back Hungary's economy."

The same government approach complicates Hungary's fiscal position, the ratings agency suggests. While S&P applauds Budapest's efforts to keep a lid on the deficit and borrowing, it worries that discipline is slipping in the face of the drive to nationalise the banking and utilities sectors. "The ratings remain constrained by the country's external position and the government's foreign exchange exposure on its own stock of debt," the analysts continue. "The government has a track record of prioritising state asset purchases over debt reduction."

Junk

The three agencies all moved Hungary to junk in a matter of weeks in late 2011 and early 2012, as Prime Minister Viktor Orban's government dropped talks with the International Monetary Fund and EU over a loan it had been discussing for months. Many analysts had suggested throughout that Hungary was not serious about a rescue package that investors hoped would rein in policymaking.

S&P has since knocked Hungary down another notch. Orban and other senior officials have complained bitterly that the downgrades are part of a market conspiracy. Those objections were led by then economy minister Gyorgy Matolcsy, who now leads the Magyar Nemzeti Bank (MNB).

However, with the economy starting to show signs of recovery last year, Budapest has benefited from strong demand for its bonds, despite the limitations that junk status places on buyers. Many institutional investors need an investment grade from two of the three agencies on an asset.

Recovering investment grade would also likely be heralded by Orban as an admission that his policies - which have included increasing state control in strategic sectors and high taxes on the banks and other large foreign investors - are working. While data shows growth accelerating over the past 12 months as Hungary climbs out of crisis, many suggest the recovery will be short lived because of the lack of new investment. 

With the banks under particular pressure, the central bank is supplying most of the credit being lent in the country right now. Little wonder then that the MNB - now run by close confidantes of Orban - is also keen to talk of an upgrade. 

However, time is running out for this year. September 19 was the last review date for Hungary at S&P in 2014. The country's next scheduled review of its sovereign ratings comes from Moody's on November 7.