By Kristina Than

BUDAPEST (Reuters) – The Hungarian forint fell to an all-time low against the euro on Monday, exposing vulnerabilities in the economy and putting pressure on Prime Minister Viktor Orban to reach an agreement with Brussels on the release of frozen European Union funds.

Unlocking access to around €15.5 billion in grants and loans from the EU Recovery Fund, pending EU Executive Commission approval, could boost the forint and trigger a liquidation of short positions formed against the currency, while driving down government bond yields, analysts said.

Without a deal, the forint will remain on a weakening path, complicating efforts to rein in double-digit inflation and exposing Hungarian assets to any shift in negative sentiment amid the war in neighboring Ukraine and of soaring energy costs.

EU funds are also needed to support the Hungarian economy which is expected to slow in the second half of the year due to rapidly rising interest rates and inflation.

Like most EU countries, Hungary presented its action plan last year on how it would use EU subsidies to make its economy more environmentally friendly and high-tech after the COVID-19 pandemic.

But unlike most other countries’ plans, Hungary has yet to receive approval due to EU concerns over corruption, judicial independence and the rule of law.

Hungary’s vulnerabilities have increased this year. Its current account deficit has widened mainly due to its high energy import bill at a time when the government has only just started to bring a huge budget deficit under control, after a spending spree that helped Orban to win a landslide victory in the April elections.

“With the uncertainty over EU funds and the emerging market backdrop, we prefer to keep a hawkish stance on HUF,” Morgan Stanley (NYSE:) said in a note on Friday, referring to the currency.

“Recent FX underperformance and rising HUF yields are increasing pressure on the government to strike a deal,” Citigroup (NYSE:) analysts said.

On Monday, a day before the BNH raised interest rates again, the forint fell to a record low of 404.50. It has weakened 8.6% so far this year, decoupling from its peers in the region.

The Polish zloty fell 2.2%, while the Czech koruna gained 0.5%, supported by sharp rate hikes and, since May, central bank interventions to avoid weakening.

The Czech National Bank has enough ammunition, holding 156.1 billion euros in international reserves at the end of May.

The NBH, which has raised its base rate by more than 500 basis points in the past 12 months, is expected to raise the rate another 50 basis points to 6.4% on Tuesday, but some analysts have forecast a bigger hike . The bank, which raised its one-week deposit rate to 7.25% on June 16, had 34 billion euros in international reserves at the end of May.

On June 9, Hungary issued foreign currency bonds worth $3.8 billion, which boosted reserves, but these remain low compared to Czech levels. The BNH never communicates its movements on the foreign exchange markets.

“It’s no coincidence that the forint has become so decoupled from the region. Until there’s an agreement with the EU, that won’t change,” said Peter Virovacz at ING in Budapest.

NO DEAL YET IN SIGHT

In recent weeks, senior Hungarian government officials have signaled that a deal with Brussels is imminent, but nothing has emerged yet.

Last Thursday, Balazs Orban, the prime minister’s political director, told Reuters that Budapest would welcome detailed recommendations from the European Commission on exactly what it needs to change in its laws to get EU funds flowing.

Orban, who is not related to the prime minister, said Hungary was “open to compromise” to reach an agreement.

“We are ready for all scenarios – we can act quickly if needed, but we are also ready to have to survive without the funds,” he said. “It’s not a good scenario for us but we are ready financially.”

But analysts say this is a scenario Hungary should avoid or risk a sell-off in the market.

“We expect a move to 420 by year-end and negative returns versus futures. The risk is towards sharper/faster selling amid thin liquidity and in periods of negative sentiment swings,” Societe Generale (OTC:) said last week. “These may occur in response to negative developments in the rule of law.”

On Monday, the government did not respond to questions emailed to Reuters about the status of talks with the EU.

This month, the European Commission approved billions of euros in COVID-19 recovery funds for Poland after suspending approval for a year on the grounds that Warsaw has damaged democracy. But the money will not flow until Warsaw reforms its judicial system.

($1 = 381.0100 forints)