Standard & Poor's cut Hungary's long-term credit rating by a notch to BB+ on Wednesday to "junk", citing unpredictable policies, adding to pressure on the government to change its unorthodox policy and clinch a deal with international lenders.
S&P, the second rating agency within a month, after Moody's, to cut Hungary's debt to below investment grade, put a negative outlook on the rating and said there was a one-in-three possibility of another downgrade in the coming year.
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Hungary's centre-right government has stabilised its budget with a series of ad hoc taxes and nationalised pension assets since it swept to power with a two-thirds majority in April 2010. Several of its measures have shocked investors and earned the ire of the European Union.
Facing a 5-billion-euro rollover of external debt next year, it now risks falling into yet another market crisis if talks with the International Monetary Fund and the EU on a financial backstop are unsuccessful. A new financing deal would help maintain Hungary's access to market funding next year.
But lenders cut short informal talks on aid last week over a controversial central bank bill seen infringing upon the bank's independence. Hungary said earlier on Wednesday it would not bow to pressure to withdraw the law.
"The downgrade reflects our opinion that the predictability and credibility of Hungary's policy framework continues to weaken," S&P said in a statement.
"We believe this weakening is due, in part, to official actions that, in our opinion, raise questions about the independence of oversight institutions and complicate the operating environment for investors," it said.
"In our view, this is likely to have a negative impact on investment and fiscal planning, which we believe will continue to weigh on Hungary's medium-term growth prospects."
S&P said new central bank legislation -- which the government aims to push through parliament before the end of this year -- would further compromise the central bank's independence.
The agency also said Hungary would benefit from a new financing agreement with the IMF and EU.
"In our view, both policymaking and creditworthiness could be bolstered from participation in a multilateral program."
The forint weakened to 306.60 to the euro, from around 304 before the downgrade, and analysts said more falls in both the currency and bonds were likely on Thursday when local markets reopen.
"Certainly markets will fall but the size of any lasting impact will depend on the outcome of the IMF talks," said Eszter Gargyan, analyst at Citigroup.
"This underpins that Hungary has no other choice than agreeing with the IMF," added Zsolt Kondrat at MKB. "Clearly the stakes have been lifted and as it looks Hungary cannot get along without IMF backing. This strengthens market pressure. Hungary is clearly a non-investment grade country now."
RISK OF MARKET CRISIS
Hungary's government does not agree with S&P's move to downgrade the country's rating to "junk" as it does not take into account efforts to stabilize finances, Economy Ministry Secretary of State Gyula Pleschinger said.
"We don't agree with either the timing or the content of the move. We are puzzled," he told Reuters, adding that the agency had earlier signalled it would wait until the outcome of the IMF/EU talks.
He said the downgrade was "not a Hungary-specific move, S&P is downgrading European countries in a series."
Hungarian Prime Minister Viktor Orban -- who broke ties with the IMF in 2010 to regain "economic sovereignty" -- doesn't want lenders meddling with his unconventional policies to boost the economy even though he is seeking a new financing deal.
His government has curbed the rights of Hungary's top court, extended controls over the media and wants to tighten its grip on the central bank, which it believes is not backing its policies with monetary tools.
S&P said changes to the country's constitution and the functioning of the central bank and the top court "have undermined Hungary's institutional effectiveness."
Analysts said the government would likely stick to its guns and not change policy -- but market pressure would force it back to the negotiating table next year.
"They will change it sooner or later, the question is how far they are ready to go," Gargyan said. "But no doubt the market will force them into a change."