With concerns increasing over the international risk-appetite for emerging market assets, Hungary appears at first glance to be one of the less-vulnerable candidates. Real GDP growth came in at a comfortable 4.2% last year, underpinned by a good export performance, and accelerated to 4.5% on the year in the first quarter of 2006 as private consumption picked up. Inflation has improved steadily, coming in at 3.3% in December (down from 5.5% in December 2004), and falling to 2.3% in April. Prices have eased thanks to relatively-high real interest rates in recent years and to moderate real wage growth. The main stock price index has soared over the past two years.

Things even appear more stable on the political scene. The (tortuously-complicated) two-round parliamentary election in April led to the re-election of the outgoing center-left coalition - the first time that an incumbent government has been re-elected since the advent of democracy in 1989. Upon his triumphant return to office PM Ferenc Gyurcsany, of the Hungarian Socialist Party (MSZP), promised sweeping fiscal reforms to get Hungary's public finances in order. His oft-repeated plan is to prepare the way for the forint to enter the ERM-2 pre-euro waiting room in 2008, and so to adopt the euro in 2010.

But look a little closer, and the picture is far less sanguine. In fact, Hungary is one of the key emerging markets to watch for signs of a shift in the international risk appetite - and the likelihood of it joining ERM-2 in 2008 is slim indeed.

Hungary is suffering from the classic "twin deficits" problem. Last year the current account deficit came in at 7.3% of GDP, down from 8.8% the year before, but still substantial. Export growth has accelerated, but the external shortfall continues to be driven by rising levels of imports and by a substantial income deficit (thanks to profit repatriation and to debt servicing costs). To date, Hungary has been able to cover its current account deficit, thanks largely to foreign direct investment inflows (FDI), but these are now slowing.

Meanwhile, the country's overall external debt level is rising rapidly and the debt service ratio remains high, at 23% of exports of goods and services. This means that Hungary must either continue to attract high levels of FDI or be faced with ever-higher levels of external borrowing. However, that borrowing is getting more expensive. Fitch downgraded its sovereign rating a notch, to BBB+, in December 2005, citing concerns over the size of the fiscal deficit and lack of credible plans for reform. Similar concerns led S&P and Moody's to put their respective A- and A1 ratings on negative watch earlier this year.

Indeed, it is the inability of successive governments to get a handle on the public finances that is the root cause of concern about Hungary. The general government budget deficit climbed from 5.4% of GDP in 2004 to 6.1% last year - the highest in the EU - while public sector debt reached 57% of GDP at end-2005. Of the six newest members of the EU with large fiscal deficits, Hungary is the only one that has been judged by the European Commission to not have a viable medium-term fiscal strategy. The Commission has given Hungary until September 2006 to come up with a credible plan.

Final details on the re-elected government's coalition agreement and legislative program are not likely to be made public until mid-June. PM Gyurcsany has promised substantial spending reforms and tax hikes, and has forecast a fiscal deficit at 4.7% of GDP this year, falling to 3.0% in 2008. However these targets are highly unlikely to be met. Successive governments from both the left and right of the political spectrum have repeatedly missed their respective budget deficit targets in recent years. The budget deficit for the first four months of this year has already reached 72% of the full-year target. Part of the reason that Q1 GDP growth picked up so smartly was the usual pre-election giveaways by the government in the form of tax cuts and higher public spending. Meanwhile, local government elections are due in October. Will the government parties really risk alienating the voters by reversing their own policies so abruptly?

With some 8% of the population and a hefty 20% of the workforce employed in the large state sector, spending cuts will be deeply unpopular with a large percentage of voters, not to mention many within the ruling Socialist party. In addition, many of the laws governing the operation of the state sector - including spending on healthcare, education and local government - require a two-thirds parliamentary majority to be amended. Hence, even with a large parliamentary majority (the MSZP and the Alliance of Free Democrats together control 209 of the 386 parliamentary seats), the re-elected coalition government will require co-operation from large numbers of opposition MPs to implement structural reforms.

Pre-election market jitters led the forint to fall around 7% in nominal terms against the euro in March/April. Since then, the currency seems to have stabilized, but with the markets uneasy over the size of the fiscal and current account deficits, and over the negative sovereign rating outlooks, the risk of a marked depreciation over the coming year remains high.

This is all the more disconcerting because foreign currency-denominated loans account for a substantial portion of new borrowing, both business and household -nearly one-half of all credits to non-financial corporations and some 60% of all long-term borrowing by households (specifically, over 20% of household mortgages and nearly half of personal loans of over five years' maturity). With foreign investors reportedly holding some US$13 billion in Hungarian state bonds and Treasury bills, a large-scale sell-off in Hungarian assets could quickly accelerate. External debt levels could increase markedly this year and next, as investor inflows start to slide and new borrowing surges. Hungary's debt servicing ability, and the economy as a whole, remain vulnerable to a currency depreciation.

Citing lower-than-expected inflation and the strong forint the National Bank of Hungary (NBH) cut its base rate by a total of 650 basis points between February 2004 and August 2005. Since last August the rate has been left at 6.00% with the NBH's Monetary Council concluding at each meeting that inflation risks remained balanced. With the economy growing strongly, no more rate cuts are likely to be forthcoming from the NBH this year. In fact, rate hikes may be in the cards before the year is out. At its meeting today the central bank's Monetary Council once again left rates on hold, but reportedly there was a "heated debate" on whether a hike would be needed "in the future" to counter rising inflation. In addition, given the negative effects of a marked currency depreciation on the private sector and banks, the NBH may act aggressively to defend the currency, particularly in the face of any speculative attacks.

All told, Hungary is approaching a crisis point. Without a demonstration of credibility and determination investors will flee, triggering a drop in the currency and a jump in debt service costs, both domestic and external. The newly-re-elected PM has vowed fiscal reform, but this is likely to be far more difficult than the political rhetoric implies. Once it becomes apparent that Hungary will not enter the ERM-2 in 2008 and adopt the euro in 2010, sentiment could rapidly deteriorate.