BUDAPEST Jan 27 Hungary's recovery from recession will be modest this year and next and its economy needs reforming to boost a potential growth rate that remains worryingly low, the OECD said in on Monday.
Hungary should also show "extreme caution" about cutting interest rates further and scale back special taxes, including levies on the banking system that have depressed lending activity, the Paris-based body said in a country survey.
The Organisation for Economic Cooperation and Development forecast growth in central Europe's most indebted nation at 2 percent this year and 1.7 percent in 2015, both unchanged from its November projections.
"Growth potential is held back by weak investment, low employment among low-skilled workers and shortcomings in labour and product markets, making further structural reforms essential," it said.
"Enhancing competition and the business environment is key to stronger investment and productivity."
The OECD forecast Hungary's budget deficit just below the European Union's 3 percent of economic output ceiling for both 2014 and 2015.
It said easing fiscal policy in 2014 - an election year - looked unnecessary given rising activity. "Budget slippages would signal the return of an electoral cycle in fiscal policy, which should be avoided as in 2010."
It forecast debt edging down to 78.4 percent of GDP this year and further to 77.8 percent in 2015.
Prime Minister Viktor Orban, who has stabilised the budget with a string of unorthodox measures that include Europe's highest bank levy and special taxes on the energy, retail and telecoms sectors, will fight for re-election in early April.
Orban says he has saved Hungary from fiscal collapse but his policies have drawn much criticism from abroad.
The OECD said while Hungary's special taxes, worth a combined 1.8 percent of GDP in 2013, helped wrestle down the deficit, they have also harmed bank lending and undermined the predictability of the tax system.
"In the longer term, the authorities should scale down special taxes and replace them with more growth-friendly fiscal instruments," it said.
The OECD said Hungary's access to international bond markets had improved but the high share of foreign currency debt would keep it vulnerable to market volatility and the country should maintain fiscal discipline to preserve market access.
Hungary should also tread carefully over monetary policy, having cut interest rates from 7 percent in August 2012 to 2.85 percent now to help the economy recover.
"Volatile external conditions together with the fact that domestic demand is picking up in any case call for extreme caution as regards continuing the easing cycle," the OECD said.
"Further rate cuts could increase the risk of a forint depreciation, which has been avoided over the past two years."
The forint sank to 10-month-lows last week in an emerging market sell-off.
Hungary - whose government is in a drive to cut household utility bills - should also move towards cost-reflective and market-based pricing in electricity and gas.
($1 = 223.56 Hungarian forints) (Reporting by Gergely Szakacs; Editing by John Stonestreet)