Tim Gosling in Prague -

Hungary's combative prime minister, Viktor Orban, has infuriated the EU and investors with his “unorthodox” economic policy since returning to office in 2010. For his critics, this is the year that it's all meant to catch up with the Fidesz government as the state-driven momentum in the economy runs out of steam. The signs so far suggest otherwise.

With the Eurozone finally perking up, the region looks like it's on the way towards a sustained recovery from the crisis. Growth in 2014 was generally healthy, if subdued, around the Visegrad countries, but Hungary was a standout performer, leading the pack with economic expansion of 3.6%.

Yet the chickens will still come home to roost, most analysts were still insisting late last year. Orban's rough treatment of the mostly foreign-owned banks and high special taxes on other sectors should see the country struggle to keep pace as the European recovery continues. 

Indeed, the state has been keeping the economy afloat over the past couple of years, replacing dwindling bank lending via the central bank and leading investment. That economic Potemkin village was seen crumbling this year as the state's efforts, and the EU financing underpinning them, ebbs away. A sharp slowdown was widely predicted for Hungary. The European Commission forecast in February that Hungary’s 2015 GDP growth would slow to just 2.4%, with a further fall to 1.9% next year. The views of other international institutions were in similar territory.

Yet Hungary ignored the script in the first quarter of 2015. Following hugely impressive industrial production and retail sales growth, the finance ministry in early May raised its estimate for the economic growth this year by 0.6 percentage points to 3.1%. Brussels pushed up its outlook to 2.8% around the same time.

Bank analysts are busy following suit. Noting “positive surprises”, Eszter Gargyan at Citibank says she's just raised her 2015 economic growth forecast to 2.9%. And Anders Svendson of Nordea says, “I've been surprised by the momentum of the economy and don't really see it decreasing significantly in the short term.”

Investors appear equally surprised. The Budapest Stock Exchangeʼs main BUX index hit a four-year high in April, having risen close to 40% since the start of the year.

Luck of the Hungarian

Can the momentum last? That probably depends on how much it's part of a well-calculated plan; or alternatively, how long Orban's luck can hold out. Yet as one cliché from the PM's favourite sport goes: it's better to be a lucky football manager than a good one. Gyozo Eppich at OTP Bank dryly notes that, “policymaking is 'good' when economic performance is good.”

The Hungarian PM's good fortune has been remarkable at times. In January, the Swiss National Bank removed its cap on the Swiss franc against the euro, causing the franc to soar and sending banks and borrowers holding Swiss franc mortgages across the region into a panic. Hungary would have been hit hardest of all, except for the fact that just a month earlier the government had finally forced the banks to convert all forex loans to forint, at huge cost to the lenders.

Eliminating that risk for Hungarian households was of course a driver for Budapest's long and vicious fight with the banks over the issue. However, Orban was so busy driving the populist angle, and ridding the central bank of the constraint that Swiss franc mortgages put on monetary policy, that it took years to complete the job – and he only just ducked under the unexpected deadline.

Fate seems to be smiling on Hungary again, just as fading EU funding limits the government's ability to support the economy. The recovery in the Eurozone – Hungary's vital export market – low oil prices and quantitative easing are all helping the economy. The European Central Bank's huge bond buying programme has not only pumped up confidence, but also the forint, allowing the Magyar Nemzeti Bank to return to monetary easing. “He's been lucky with the external environment,” says Gargyan. “But Hungary has paid a huge price through the crisis due to financial deleveraging.”

That adds another perspective on the current pace of growth. Vladimir Vano at Sberbank Europe notes the low base on which it stands. “The economic malaise in Hungary started in 2006, ahead of global turbulences,” he points out, and the climb to recovery is still ongoing. That means it will be harder to maintain the pace as the effect fades.

Indeed, the domestic consumption driving growth currently includes pent-up demand, say analysts. An improved labour market and low inflation helped retail sales hit their highest levels in over a decade in the first quarter of the year.

Eppich notes that the state's action on the forex loans issue – which on top of lowered monthly loan payments saw lenders forced to compensate borrowers for charges ruled as unfair – has seen the equivalent of 1.5% of GDP returned to households. Consumption is set to grow at 3% this year, suggests the OTP analyst.

The need for deleveraging was set before Orban started his second term in office in 2010, and the Fidesz government has undeniably improved the country's fiscal indicators, although state debt remains relatively high. Yet unlike the Baltic states, whose harsh austerity measures to pull their economies out of the crisis are praised by some and decried by others for the pain inflicted on the population, Hungary made the banks and foreign investors pay.

Suspicious minds

That is the potential Achilles’ heel of the recovery. Hungary will need the return of private investment, and especially bank lending, to sustain the economic momentum, and that's far from certain.

Battered by government policy, the banks cut their lending from 75% of GDP in 2009 to just 53% last year, says Gargyan. Having taken on the role of the economy's main lender in 2013, the central bank will have pumped over HUF2 trillion into cheap credit for small businesses by the end of this year. But the central bank can't keep up that pace.

As soon as it forced the forex loan conversion, the government turned to trying to solve the issue of falling lending. It has promised to reduce the tax burden on the banking sector and to free up business conditions. However, many remain wary.

Moody's Investors Service and the other big rating agencies – whom Hungary is desperate to convince it deserves a return to investment grade after they cast it into junk status in 2012 – have expressed scepticism it will follow through on its promises. That suspicion wasn’t helped by the government announcing in early April that the banks would have to cover around €1bn in losses stemming from a brokerage scandal. Orban has also suggested the reduction in the levy could be conditional on an increase in lending.

However, there is an insurance policy of sorts. Hungary has bought three major banks in the past few months, meaning it now has skin in the game. “The role of the government in the bank sector makes a huge difference,” suggests Eppich. “I think that ensures the government is serious.”

However, it will be hard to win trust back. “I seriously doubt that any foreign bank will look towards Hungary for as long as the current government remains in place,” says Svendson.

The risk, then, is that despite the strength of the economy right now, the fundamental damage from Orban's policies has only been kicked down the road. “My major concerns are not with the economy in the near term, but in the medium to longer term,” the Nordea analyst says. “Markets are way too complacent at the moment. I see a major risk that the current government will cross that invisible line and really rattle them.”

With the headline data pushing onwards and upwards at the moment, then, investors may do well to watch the background closely. A trend of weak foreign direct investment (FDI) over a longer period would be an issue. “Foreign investors are very cautious,” notes Gargyan, “and it will take time to rebuild confidence. That will be seen in differences in FDI between Hungary and others in the region.”

“If some of the big Austrian banks take out capital, that would be bad news,” Svendson notes.

One potential warning on that front was delivered in late April, when Raiffeisen International Bank announced it would significantly reduce its retail banking operations in the country.