* New governor to bring riskier new policies -sources
* More rate cuts, unorthodox tools to boost growth likely
* Radical new measures could risk forint selloff
* Govt, central bank have been at odds over policy
By Krisztina Than and Sandor Peto
BUDAPEST, Jan 10 (Reuters) - Hungarian Prime Minister Viktor Orban has an ace up his sleeve as he tries to revive a recession-bound economy and secure his political future: soon he can take full control of a central bank which has long resisted his will.
By March Orban will pick a new National Bank governor who is likely to flood the economy with cheap credit using unconventional tools - the kind of measures that are controversial enough in giants such as the United States, let alone in a small emerging economy like Hungary's.
With Hungarians still feeling the effects of crisis and commercial banks reluctant to lend, central Europe's most indebted economy badly needs a boost and Orban has little time to lose. He faces parliamentary elections in 2014 and support for his right-wing Fidesz party is crumbling.
Orban is used to getting his way. Since coming to power in 2010, he has filled top public posts with Fidesz loyalists but the central bank has proved a tougher nut to crack.
Last year he tried to curb the bank's independence with new legislation, but had to backtrack on parts of the law under pressure from the European Union and European Central Bank.
Now Orban, whose unorthodox and sometimes unpredictable measures to lower the budget deficit have already drawn fire, has another chance to get his way at the central bank: Governor Andras Simor completes his six-year term on March 2.
Orban has yet to name a successor. However, several sources in central banking and politics told Reuters that the new governor is expected to be close to Fidesz and someone willing to pursue the kind of policies Simor has largely resisted: risky unconventional ideas on stimulating the economy which have been hammered out in government workshops.
Investors, worried that such action could upset Hungary's often volatile forint currency, want to know who will take the helm.
However, a central bank source expected the government to make the real decisions in future. "Markets assign too much significance to the person of the new governor. Monetary policy will not be decided here, but via remote control," the source said on condition of anonymity.
The new governor will serve for six years, well beyond the next elections. Fidesz still leads in opinion polls, but its support has dived to about 20 percent among all voters from over 50 percent of votes secured at the last election.
Sources told Reuters that whoever gets the job, the bank will embark on new measures to push more money into the economy. Options include channeling more funds to the banking sector to boost lending, buying government bonds on the secondary market and even reducing foreign currency reserves.
Orban's office declined comment. "The Prime Minister will make his nomination in appropriate time to allow a smooth transition at the governor's post," his press chief said in an emailed response to Reuters questions.
However, Economy Minister Gyorgy Matolcsy, one of Orban's closest allies, has made clear the new governor must cooperate more on turning recession into growth.
"The real turnaround will come because the central bank's leadership will be the number one strategic partner of the government," he wrote in the weekly Heti Valasz last month.
Matolcsy, the architect of the unorthodox budget policies such as Europe's highest bank tax and the effective nationalisation of private pension funds, is himself seen as a frontrunner to head the bank.
Simor, a former commercial banker and local head of the international accountancy firm Deloitte, was appointed by a previous Socialist government in 2007. He came under fire from Fidesz for keeping interest rates high and doing too little to support growth.
The attacks have become personal, with Fidesz criticising Simor over investments he made in a Cyprus-based firm. Right after his landslide election victory in 2010, Orban said the central bank was "not a shelter for offshore knights".
Simor has withstood pressure to resign. Last month he said he had made policy suggestions to the government in the past two years but "received no answer". The government had asked Simor to consider tools used by major central banks in developed countries to boost growth.
So far the bank has taken only limited action. Last year it began offering two-year loans in exchange for collateral and buying mortgage bonds. However, this achieved little as demand for credit from Hungarian firms is very weak due to the state of the economy, and commercial banks have been holding onto the funds rather than lending them out.
Much larger, wealthier economies have suffered similar problems and central banks in some, notably the United States and Britain, have taken radical action to flood the banking system with funds in the hope of stimulating growth.
The Bank of Japan is also considering a major new wave of monetary easing, sources say, under heavy pressure from a new right-wing government.
However, such tactics are controversial. The ECB has refused to do anything that might push up euro zone inflation and some Federal Reserve policymakers have expressed concern about the longer-term effects of U.S. "quantitative easing".
In Hungary, a country of 10 million people, the central bank has said quantitative easing other than using liquidity-boosting instruments is risky in a vulnerable emerging economy.
Last year the forint was one of the best performing emerging market currencies but it has suffered a number of sharp drops since the global crisis of 2008 as investors took fright about government economic policies.
The central bank fears that radical measures could hurt the currency again. "Tools involving greater risk-taking by the central bank and government bond buying could further erode investor confidence and trigger a capital flight," it said in a 2012 study on the use of unconventional monetary policy tools.
Such objections are likely to be overruled once Simor leaves the bank, which has experienced political meddling from Hungarian governments of both the right and left in the past two decades, even though its independence is enshrined in law.
The question is how fast and deep the policy changes will be, and wobbles in the forint in the past few weeks signal growing uneasiness among investors.
"The strategic cooperation envisaged by Matolcsy means that the bank will have to support growth with all kinds of monetary stimulus measures," said Eszter Gargyan, an economist at Citigroup in Budapest.
"I don't think this has been fully priced in by markets and in case of aggressive measures we could see a bigger selloff in the forint in 2013. The question is how far they will go."
Orban, an avid soccer player, has likened monetary policy to a slow sport and he seems to have used the same tactics in gradually increasing his influence over the bank.
"Monetary policy belongs to the world of slow sports. If someone makes hasty moves there, that could create a situation in markets which has very serious consequences," he said in February 2011.
Later, Fidesz used its large parliamentary majority to appoint four new dovish policymakers who can outvote Simor and his two deputies on the Monetary Council.
One central bank source said dialogue between the two groups on the seven-member council was sparse, saying that policy meetings more resembled "parallel monologues". The Governor and his deputies had found themselves isolated, with the new members calling the shots, especially in the past five months.
In August last year the four pushed through their first interest rate cut to support the economy, outvoting Simor and his deputies who wanted no change due to inflation and the risk of a forint fall. The newcomers have consistently rejected accusations of acting under government influence.
Four more rate cuts quickly followed, taking the bank's base rate to a two-year low of 5.75 percent by the end of last year without substantially weakening the currency, as a global hunt for higher yields boosted appetite for Hungarian assets.
With foreigners' Hungarian government bond holdings near record highs at 5 trillion forints ($22.49 billion), yields are now the lowest in years and markets expect further rate cuts.
However, Hungary's main interest rate remains the highest in the EU and the economy is barely clambering out of recession. GDP contracted 1.5 percent in annual terms in the third quarter of 2012 and economists forecast stagnation this year.
The government officially projects growth in 2013 but unemployment is at 10.6 percent, and negotiations with the IMF and EU on an international loan have collapsed. This weak growth outlook is likely to encourage Orban to take some policy risks.
Orban has said the main problem is that Hungarian businesses have no access to cheap credit. "We must hope that with good economic policy we'll be able to achieve a steady decrease in rates," he told public radio last month.
A second central bank insider said a wider array of economy-boosting policy measures were likely under the new governor. "I think the bank should adopt a much more liberal approach to helping corporate lending," the source said.
Several sources familiar with the central bank's operations described a menu of new measures possible after Simor and one of his deputies, Ferenc Karvalits, leave their posts in March.
The bank will probably boost long-term financing to allow commercial banks to provide cheaper credit, possibly using state-owned banks, they say.
"There is no chapter in textbooks about what to do in small, open economies; the task at hand is to write that chapter," a third central bank source said, adding: "Anything that could help boost lending will be on the table."
Gyorgy Barcza, an analyst at Szazadveg think tank which is close to the government, said he believed Orban's administration understood the risks of a sharp currency fall.
"The central bank has some limited room to move, either by providing preferential refinancing loans to banks similar to the earlier 2-year loans, or by lending out parts of its foreign currency reserves to commercial banks," he said.
Barcza said this way banks could have access to cheaper foreign currency funding. This in turn could allow them to ease the payments of households which took out mortgage loans in euros and Swiss francs due to their lower interest rates, but have since struggled with repayments when the forint fell.
The central bank could also stop paying interest on commercial banks' mandatory reserves, sources and analysts said. Several sources said it might take a more active role in buying government bonds on the secondary market.
In the short term this could drive down yields but the measure could easily backfire if markets perceive it as monetary financing - under which a central bank effectively prints money to fund government spending.
So far the bank has used this tool only to ease market turbulence, the last time being during the 2008 crisis. "We see no disturbances on the fixed income market, hence no need to cure it," said Concorde Securities analyst Janos Samu.
One of the four dovish rate setters, Ferenc Gerhardt, has kept open this possibility. "It's not the National Bank of Hungary's task to intervene in the fixed income market and the need for this has not strengthened. But the possibility is there," he told the daily Magyar Nemzet last month.
Other ideas that came up in Hungarian media are a reduction in foreign currency reserves, and limiting funds that commercial banks can hold in two-week bills, the main tool the central bank uses to drain extra liquidity from interbank markets. Rumours of the bills idea pushed the forint to a five-month low versus the euro in late December, even though central bankers denied it.
Analysts have warned that if banks' access to the bills were limited - in the hope that they would boost lending instead - they could opt to buy government bonds or move cash abroad, creating the risk of capital flight.
A relatively small reduction in the central bank's foreign currency reserves, which stood at 33.9 billion euros at the end of 2012, is conceivable through financing expiring debt from forint issues and then converting these funds at the bank.
But any deeper cut in the reserves, the main buffer to fend off forint falls, could provoke market turmoil. A source familiar with central bank matters said candidates for the governorship would experience reality if they got the job.
"They may have ideas like that on their minds, but as soon as they get there it will be clear that this cannot be done," the source said.