Poland and Hungary came close to agreeing to a compromise solution over linking the incoming EU budget and COVID-19 recovery fund with rule of law on December 9, hours before the EU summit expected to announce the bloc’s financial framework for 2021-2027.

Warsaw and Budapest have so far dug in their heels over a proposal to link access to EU money with adhering to rule of law. For several weeks, both countries said they would veto the EU’s next budget and the recovery fund if the rule of law clause was inserted in the final agreement.

Linking access to EU funds with rule of law would create an arbitrary and politicised mechanism of pressure on member states, Poland and Hungary said.  

Governments in both countries have long been at odds with the rest of the bloc for attacks on the judiciary and undermining the independence of the media.

Vetoing the budget and the recovery fund would, however, result in Poland and Hungary losing billions in EU funding in the next seven years, a period spiked with difficulties of emerging from the coronavirus pandemic and implementing bold EU-wide reforms, such as the transition to a low-carbon economy.

On Wednesday, however, a deal appeared close after Poland and Hungary reportedly agreed for the rule of law clause in the budget deal, hedged with “assurances from EU leaders in an explanatory declaration that the regulation would be applied objectively and could be tested before the EU’s top court before implementation,” a senior EU diplomat told Reuters.

Guarantees to be given to Hungary and Poland 

The rule of law mechanism will be put in place in a similar way to the version approved by the European Parliament and the European Council in early November, which was completely unacceptable to the Polish and Hungarian governments at the time. However, Hungary and Poland managed to put additional guidelines into the text, which significantly limit the enforcement of sanctions.

The two countries were given guarantees that sanctions won't be used until the EU court decides whether they are in line with EU law. Such a decision could take years. In other words, the rule of law mechanism can't be applied before the 2022 parliamentary elections. According to independent media, this was a very important request by Hungarian Prime Minister Viktor Orban, although this had never been discussed in public.

Under the current agreement, the rule of law mechanism can only be applied for fraud, corruption, and conflicts of interest involving the use of EU money and not for perceived rule of law breaches in general. To sanction countries, the procedure must prove that the EU's financial interests were harmed.

Similarly, Hungary and Poland won't have to fear the overhaul of the judiciary as the compromise agreement will only allow financial sanctions if courts had been involved in specific embezzlement of EU money, for example.

This had been an important concession from Brussels. Hungary has vehemently opposed any rule of law mechanism that contains what it perceives as vague definitions that can be used for political purposes.

Another important element of the compromise agreement is the strengthening of the "safety brakes" in case a country faces financial penalties. The European Council in that case would strive to formulate a common position. The draft says that the suspension of payment would not require unanimity from EU leaders.

Mixed response at home 

In Poland the compromise could cause internal political tension. United Poland, one of the parties in the coalition government led by Law and Justice (PiS), keeps pushing for a veto. Linking the budget with the rule of law strips Poland of its sovereignty and must not be accepted, the party said.

Meanwhile, Hungary’s government and its loyal media have hailed the preliminary agreement reached by EU ambassadors on December 9 as a major victory. Pro-government media celebrated what it called a victory by the Polish and Hungarian governments in defending the country’s sovereignty. State media covered the news with factual inaccuracies and misrepresentations, including the content of the regulation.

Independent sites pointed out that Budapest and Warsaw did not achieve their core aims of not linking the rule of law mechanism to the payout of EU money. The two CEE allies could still face the full weight of the mechanism, just later than originally planned.

This has not stopped government officials from claiming "victory".  "Once again, it has been proven that it is always worth standing up for the Hungarian interests in all situations. It was worth fighting for financial subsidies not to be tied to ideological expectations during a pandemic. The agreement respects the EU treaties, our national identity, and provides protection against political blackmailing. We will always and every time, fight for Hungary. We won! The Polish-Hungarian friendship won!" wrote Justice Minister Judit Varga on her Facebook page.

Opposition parties also tried to spin the leaked agreement in their favour, although they acknowledge that the EU had made major concessions to Orban.

Independent MP Akos Hadhazy, who had uncovered many corruption cases linked to the ruling Fidesz party, claims that the EU conceded to Hungary’s strongman. By delaying the implementation of the rule of law mechanism, Brussels is telling Orban that "you are free to steal EU money for at least another two years and use it to fund an autocratic policy that seeks to dismantle the EU."

Hungarian assets rally on news of compromise

News of the compromise deal lifted share prices on the Budapest Stock Exchange. The benchmark BUX index surged 2.57%, making the Budapest bourse one of the best-performing bourses in Europe on Wednesday.

Shares of CEE's leading bank stock OTP shot up 4.39% to a session high of HUF12,840 on HUF14.3bn turnover. Oil and gas giant MOL also gained ground adding 3.4% to its value to end the day at HUF 2,066. The other two blue chips, MTelekom and Richter edged down. The agreement also led to a rally in the forint, which was trading above the 361 level versus the euro. On Wednesday night the currency pair was quoted at 357.

The state debt manager held its weekly auction on Wednesday, before the news of the compromise agreement. The AKK sold HUF15bn of discount twelve-month T-bills in line with the original offer after receiving HUF22.5bn in bids. The average yield was 0.47%, or 1bp lower than at the previous auction and 2bp below the secondary market benchmark.

The AKK also sold HUF30bn of seven-year floating-rate bonds, raising its original offer Ft 10bn after bids reached HUF51.7bn.