BUDAPEST Hungary could become the favoured destination for investors' cash in Central and Eastern Europe this year on the back of an expected return to investment grade debt rating and concerns about main rival Poland's new right-wing government.
The Hungarian government of Prime Minister Viktor Orban has often unnerved investors' since 2010 by clashing with the European Union over curbs on the media and other independent institutions, and by imposing new taxes on banks, telecoms firms and retailers.
Over the past year, however, the country has become a more attractive proposition for foreign investment; it has pledged to cut bank taxes from 2016 in an attempt to further boost an improving economy, and analysts expect an upgrade this year to its sovereign debt rating, which has been "junk" since 2011.
Poland, on the other hand, could be losing some of its lustre, say fund managers and analysts.
While its economy is still the region's strongest and has a solid investment grade debt rating, the election victory of the conservative Law and Justice (PiS) party late last year with its Eurosceptic rhetoric has raised some concerns in the European Commission over the rule of law and free speech.
This has contributed to increasing investor unease that helped drive Warsaw's blue-chip index to its lowest level in almost seven years this month. By contrast, Hungary's main index has risen to near a five-year high.
The European Union launched an unprecedented inquiry on Wednesday into whether Poland's new government has breached EU democratic standards.
"In previous years I would have always bet on Polish (assets) but now this is far from certain as it depends very much on what they will do (politically)," said Viktor Szabo, portfolio manager at Aberdeen Asset Management in London, when asked if Polish or Hungarian assets would fare better in 2016.
Poland and Hungary are the biggest draws for investors in Central and Eastern Europe (CEE), with the largest, most liquid, fixed-income and currency markets.
In the second half of 2015 the Hungarian forint outperformed the Polish zloty as jitters over Poland's elections and the new PiS government intensified, reversing the trend from the first half of the year.
Spreads between Hungarian and Polish bond yields narrowed significantly in 2015, and analysts say this could continue this year.
Hungarian 10-year forint-denominated bonds traded with yields of 3.23 percent on Wednesday and Polish 10-year local papers at 2.79 percent. That compared with 3.51 percent and 2.41 percent in mid-March last year.
Commerzbank analyst Simon Quijano-Evans said the narrowing of the spread between the countries' domestic currency bonds was down to the "political noise in Poland".
"We remain overweight Hungarian, Romanian and Serbian eurobonds, but more cautious on Polish external bonds, given the tight spreads versus peers and the current domestic political noise," he added.
Measures launched by the Hungarian central bank since 2014 to encourage local banks to buy more government debt, such as gradually phasing out its two-week deposit facility, have also helped drive down bond yields and shore up the economy - making it more attractive to foreign investors.
Hungary's 2015 budget deficit has fallen to 2 percent of economic output and is forecast to decline further in 2017 and 2018. It runs a big current account surplus and its external debt has declined markedly over the past five years, even though its overall public debt remains stubbornly high.
The central bank, which has also cut its main benchmark interest rate to a record-low 1.35 percent to stimulate economic growth, on Tuesday announced further measures aimed at driving long-term bond yields lower.
"If we look at only the government debt market, then the relative improvement of Hungary's risk assessment and the relative worsening of their (Poland's) assessment had a role and in addition, a special feature of Hungary is the demand (for debt) generated by local banks," said Eszter Gargyan at Citigroup.
UniCredit analysts said Hungarian bonds could outperform regional peers this year thanks to the central bank's measures, which could also prevent a negative impact on the forint currency from further bond outflows.
Last year, foreigners' holdings of Hungarian domestic bonds fell by about 20 percent, with local banks buying the papers.
But with the U.S. Federal Reserve tightening and U.S. yields rising, analysts say overall capital flows into the region could dry up even though the European Central Bank's bond-buying mitigates some of the Fed impact.
"All in all, I think we won't see much inflow into CEE, we will rather see outflows, and the question is how stable markets would stay," said Citigroup's Gargyan, who is based in Budapest.
But she added: "We could perhaps suffer from this outflow less than Poland since foreign investors' holdings in the Hungarian local bond markets already fell by 20 percent in 2015."
(Writing by Krisztina Than; Editing by Pravin Char)