* EU finmins prepare to freeze development funds for Hungary
* OECD sees economic contraction, urges new fiscal measures
* Report criticises Hungarian cbank law, other unconventional reforms
* Says further fiscal consolidation could create room for rate cuts
By Krisztina Than and Robin Emmott
BUDAPEST/BRUSSELS, March 13 The European Union prepared to freeze half a billion euros in aid to Hungary on Tuesday, for the first time punishing a member state for flouting budget rules
Hungary was trying to block the move, a diplomat said, as a report from the OECD group of developed nations predicted the country of 10 million would slide into recession this year.
A decision to hold back 495 million euros in EU cohesion funds raises the stakes in Prime Minister Viktor Orban's struggle to secure funding from Brussels and the International Monetary Fund that he needs to stabilise the economy and prop up the ailing forint currency.
The EU charges that some of Orban's policies clash with its rules.
"Our understanding is that the suspension decision is going to go ahead," said one diplomat close to the talks.
"Hungary is seeking support to block the suspension but it would probably need the backing of all of Eastern Europe, and that is something it is not going to get."
Although 23 of the EU's 27 states have exceeded the bloc's deficit ceiling of 3 percent of gross domestic product, Hungary is the first to face the freezing of development funds aimed at helping it catch up with richer EU members.
The Commission has struggled to impose the limit since 2003, when Germany and France both missed budget deficit targets and rejected being disciplined.
Analysts say Tuesday's move is aimed at making an example out of Budapest after Orban ignored warnings from Brussels and used his two-thirds majority in parliament to pass Europe's highest banking tax, a new central bank law, and other policies criticised as ineffective and potentially undemocratic.
But some diplomats said a more uniform approach was needed.
"We would have preferred to give Hungary some time to fall into line," Austrian Finance Minister Maria Fekter said in Brussels. "We must treat all states in the same way."
EU officials say Hungary's deficit could hit 3.6 percent of GDP in 2013 if Budapest does not take new measures. Orban has argued the dispute is "a technical issue" and that Hungary will not lose any funds next year.
The Organisation for Economic Cooperation and Development agreed more fiscal consolidation was needed, particularly in cutting the government spending that makes up 50 percent of output. It painted a grim picture for Hungary's economy.
"Overall, the economy is projected to be in recession in early 2012, with a weak recovery starting in the second half of the year as confidence improves somewhat and global financial and economic conditions improve," it said.
The grouping of more than 30 industrialised countries, predicted a contraction of 0.6 percent this year and growth of 1.1 percent in 2013. Budapest sees 0.5 percent growth in 2012.
The OECD said the only way to return to growth would be to pursue structural reforms, reduce the high level of foreign currency debt burdening its households, among other moves.
It also urged Orban to close a funding deal with the EU and the International Monetary Fund as soon as possible.
"Rapidly reaching an agreement with multilateral organisations for new financial assistance is a key first step to help restore investor confidence, stabilise the exchange rate and relieve some pressure on households, who are heavily indebted in foreign currency," it said.
The government has said it could clinch a funding deal in the second quarter, but Budapest is still contending some conditions the EU's executive has set for talks to start.
Ratings agency Moody's said the suspension of cohesion funds and Budapest's del ay in securing an IMF deal were pressur ing the country's credit rating, which is rated the "junk" level of Ba1. It said it could stabilise its ratings outlook if Hungary were to embark on sustainable budget reforms.
"Clearly with these comments, the pressures on the Orban administration to cut a deal with the European authorities so as to eventually secure an EU/IMF financing deal are growing," said Tim Ash, head of emerging European research at bank RBS.
The delay in the talks has hammered the forint, which has fallen 22 percent since mid-2008 to 294 per euro on Tuesday.
That has caused a spike in loan payments for households who borrowed in the lower interest rates of the euro and Swiss franc before the crisis.
The OECD said an end-2011 drop in the forint had rendered useless an effective nationalisation of $14 billion in private pension assets last year. Orban used the funds to pay back debt, but the weaker forint pushed the debt's value back up.
The report said a recently approved flat tax hit poorer earners, and its reduction of taxes for rich Hungarians should be cancelled, and it highlighted an extraordinary tax on banks - the highest in Europe - which it said had restricted credit to the economy, and taxes on utilities and retailers.
"The 'crisis taxes', in particular the bank tax, are highly distortive," it said. "They should be removed no later than 2012 or 2013 (bank tax), as planned."
The OECD criticised the government's disbanding of an independent fiscal council that studied budget performance and replacing it with a smaller body with inadequate funding.
It said changes to a central bank law that raised the number of board members, removes the governor's right to name his deputies and gave it to the prime minister, and allows for the merger of the central bank and financial regulatory authority marked a "clear departure from best practices".