Hungary - Deficit on the fast lane

We reduce duration exposure on Hungarian local currency bonds as the market
may continue to re-price the risk premium for the state of public finances.
Our concerns lie with the complacency and populism of the government, and
the 2006 budget. The HUF may settle at weaker levels, which we still see as
compatible with interest rate cuts and position on the short end of the
curve. External debt issuance is likely to take the burden of fiscal and
quasi-fiscal deficits next year.

ECONOMIC AND FISCAL OUTLOOK:
The Hungarian economy enjoys a balanced GDP growth close to 4% in 2005-06.
The Budapest Bourse outperformed its peers, as real sector shows healthy
growth and good prospects. Fiscal measures will maintain the vigour in the
growth cycle next year.

A 5% cut in the VAT rate will reduce inflation to near 2%, which could
cement a low inflationary environment if expectations adjust to low levels.
We think that the low inflation backdrop eliminates upside risk to NBH rates
next year, even at a weaker level of exchange rate, but not the downside.

The government\'s initial response to the ongoing Ecostat deficit revisions
was negative; critical of the NBH and complacent about the deficit. PM
Gyurcsany is due to raise fiscal targets for 2006. Fiscal policy will
continue to keep stability risks elevated. The neck-to-neck political race
rules out the required scale of fiscal adjustment, thus the correction of
the twin deficit.

INVESTMENT OUTLOOK:
The re-pricing of the risk premium on Hungarian assets in light of the
actual size of the fiscal deficit may bring about an exchange rate
adjustment. The sources of foreign debt for funding the deficits remain
available, thus the HUF should settle even if at weaker levels
(250-255/EUR). Exchange rate depreciation is seen relatively ineffective in
re-balancing the economy.

We do not see risk to short-term interest rates. The curve currently prices
no more rate cuts, while we match our FX outlook with around 50bps cuts in
3-6M, due to the level of monetary conditions, interest rate differentials.

Net sovereign and quasi-sovereign EUR debt issues could double next year to
around EUR 5bn, while domestic debt supply is likely to rise more
moderately.

As fiscal transparency is established in the coming days, it will certainly
test investor resilience. Institutional investments, however, are likely to
be sticky. Yields or the currency would have to rise sharply to erase gains
of the past 6 or 12M and dislodge bond investments in volumes. In the
mid-term we expect a flat curve, coming down slowly with NBH rates.