UPDATE 2-IMF puts Hungary on short leash, funds banks

(New throughout, adds analyst quotes)

By Balazs Koranyi and Gergely Szakacs

BUDAPEST Nov 6 (Reuters) - The International Monetary Fund's rescue deal for Hungary will demand it cut spending and keep debt at bay while providing nearly $3 billion to shore up banks as its economy heads for recession, the government said on Thursday.

The outline of Hungary's deal with the IMF, which led a $25.1 billion rescue package for Hungary last month, will assign Hungary strict economic targets and reporting requirements, the country's letter of intent, signed by the government and central bank, showed on Thursday.

Hungary will be required to make its first progress report by February 15 and a second by May 15, and has to consult IMF staff if it fails to meet targets or economic conditions deteriorate further, the government said.

Hungary's export-driven economy, along with other states in the region, is already suffering from the global financial crisis and its industrial output shrank by an annual 5.3 percent in September based on working-day adjusted figures.

Hungary is the first of the EU's ex-communist economies to turn to the IMF for aid since the start of the global financial crisis but analysts fear others will follow as growth slumps across the previously fast-growing region.

The Czech central bank on Thursday slashed rates by 75 basis points -- much more than expected -- as concerns over growth grew.

Analysts have said that the outlook for Hungary remains bleak as the external environment deteriorates further and domestic spending cuts along with a dearth of bank credit will hurt both households and corporations.

"We will consult (the) IMF staff on adjustments to the primary (budget) balance target and on eventual corrective measures in the event of a larger-than-expected shortfall in government financing, (and) the level of public debt exceeding its indicative target path by more than 300 billion forints," the government said.

The government also agreed to consult the IMF and take measures if inflation breaches its target band and if economic conditions deteriorate further, and said that risks to its economic assumptions are to the downside.

As part of the deal, the government agreed to cut its budget deficit to 2.6 percent of GDP from a projected 3.4 percent this year through curbing pensions and cutting public sector wages.

For a Factbox on the details of the IMF deal, click on [ID:nL6465762].

SHORING UP THE BANKS

Through the IMF deal, Hungary's government will provide 600 billion forints ($2.95 billion) in funding for Hungary's biggest banks considered to be of systemic importance.

Banks who have at least 200 billion forints in warranty capital may use a fund of up to 300 billion forints for recapitalisation and those who take the equity injection may also use a 300 billion forint fund to roll over debt.

The equity funding will give the government non-voting, dividend-preference shares to be held only temporarily and is primarily open to banks whose parents have not received similar funding through the EU, Finance Minister Janos Veres said.

The equity funding, to be used by January 31, is expected to lift banks' capital adequacy ratio up to 14 percent.

"The main candidate is OTP Bank, but one or two foreign banks may also use it," Unicredit analyst Gyula Toth said. "Obviously it also depends on how much dividend they will have to pay on these shares."

OTP OTPB.BU, Hungary's biggest lender, was not immediately available to comment but analysts have said that its capital adequacy ratio is already above 14 percent.

Central Bank Governor Andras Simor said the funding should boost confidence in the entire sector.

"If we can tell the markets that not only is a bank doing well but we can back it up with a guarantee, it can borrow at a cheaper rate," Simor said.

"With these shares, the government will get rights that provide it with appropriate guarantees", Simor said.

(Reporting by Balazs Koranyi and Gergely Szakacs; editing by David Stamp and Andy Bruce)