ANALYSIS - Rough road ahead for forint as Hungary spurns IMF

A clerk counts money at OTP bank, Hungary's largest, in Budapest June 7, 2010.

Economics correspondent, Central Europe and the Balkans

PRAGUE (Reuters) - The breakdown in Hungary's talks with international lenders may be chiefly a domestic political ploy but the Fidesz government is likely to end up suffering for its failure to take more account of its reputation abroad.

Markets have wasted no time in punishing Budapest for its refusal to pursue more of the austerity prescribed by the European Union and International Monetary Fund, the second time Fidesz had shocked the financial world since coming to power in May.

But while ruling Fidesz officials managed some damage control in the earlier misstep -- backtracking on comparing Hungary with Greece in June -- analysts said this week's events had cemented doubts over the government's policy-making ability.

That opens up risks to Hungary's economy and its various assets, ranging from higher debt costs to deterioration in the country's huge, troubled foreign currency loan market and has raised some fear of contagion in other emerging European states.

"Effectively, Hungary is now without any support from international lenders," said Lars Christensen, chief analyst at Danske Bank.

"We fear that the government's confrontational style could trigger more volatility in the Hungarian markets going forward."

The forint rebounded on Tuesday from an over 3 percent fall against the euro a day earlier when it traded at its lowest levels since early May 2009. Bond yields rose slightly after climbing 25-30 basis points on Monday, and some analysts say they could still jump half a percentage point higher.

CONFIDENCE GONE

Budapest's economy minister has said he expects talks to resume with the EU and IMF in September and analysts say the government has likely walked away at this stage simply to avoid unpopular belt-tightening ahead of an Oct. 3 local election.

Prime Minister Viktor Orban has said he would stick to a commitment to achieve a fiscal deficit of 3.8 percent of gross domestic product this year.

But Orban, a stubborn politician with a strong domestic focus, is also fighting to differentiate his cabinet from a Socialist administration that enacted four years of austerity. He has made clear he does not want advice from lenders on how the deficit will be reduced.

The conflicting messages have wounded the government's credibility with investors, always nervous about policymaking given Hungary's history of fiscal blowouts. The European Bank for Reconstruction and Development has also warned of the risk of spillover to other countries in the region.

"Hungary's case carries a contagion risk for other east European countries, but they can protect themselves from this to the extent that they continue their reforms and restructuring," EBRD President Thomas Mirow told Germany's Handelsblatt daily.

Although Budapest has managed to stabilise its finances over the past 18 months and is far from the dire situation of euro zone laggard Greece, the economy is still struggling to grow and investors have raised the premium it costs it to borrow.

The Finance Ministry cut a 3-month Treasury bill offer by 10 billion forints ($44.49 million) on Tuesday as yields rose 19 basis points from a week earlier.

Barclay's strategist Koon Chow said the forint could also fall to 300 per euro -- 12 percent down from March when markets had cheered an imminent Fidesz election victory -- where the central bank could intervene to prevent even deeper weakness.

"We'll get a lot swings on the forint in between 280-300 per euro," he said. "We'll get weaker, they'll intervene, then we'll get stronger, then down again."

NO TOLERANCE

Austerity-minded Czech Prime Minister Petr Necas, whose country has fought off contagion from Hungary's economic woes since the start of the global crisis, called for prudence.

"The fiscal stabilisation of budgets is crucially important and I am glad to know that we are all aware of this responsibility," he said at a news conference in Budapest.

But Fidesz argues that more austerity will only extend a period of low growth and weak budget revenues, which will not help the country resolve its budget deficit and reduce a debt pile that amounts to 80 percent of gross domestic product.

The experience of other states that have pursued such a path shows they may be right. Moody's cut Ireland's credit rating on Monday, saying two-years of belt tightening would hit growth.

"At best, Hungarian financial markets look set for an extremely bumpy ride over the coming weeks and months," wrote David Oxley, an economist at London-based Capital Economics. "At worst, Hungary could be muddling into a future fiscal crisis."

Market watchers said a number of factors should force Fidesz to eventually agree with the IMF on austerity measures.

A weaker forint currency will directly hit Hungarians who hold mortgages in Swiss francs -- almost half of all household debt -- and could hurt Fidesz in the October vote.

And although the government had not planned to tap the aid funds, its rising debt costs could, as in Greece and other countries, eventually force them to embrace austerity.

"It may take until after the local elections for the necessary decisions to be taken, and it may require more market pressures to convince the government to take them," analysts Barclay's said in a note.

(Reporting by Michael Winfrey; editing by Patrick Graham)

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