BUDAPEST Investors do not like Hungarian Prime Minister Viktor Orban's policies but unless they pull their money out, causing a run on the forint, there is little to make him change course.
After a successful dollar bond issue last month he does not need an international rescue so the European Union, which says he is backsliding on democracy, and the International Monetary Fund cannot impose conditions to stop him.
They are worried that the EU's enlargement since 2004 has brought in countries that do not fully share the same democratic norms as Germany, France, Britain or other big powers and this could eventually undermine the bloc's values.
Investors have stuck with Hungarian assets because of the high yield despite three years of "Orbanomics" that included taking control of the central bank, taxes on some foreign firms and forcing private banks to take a loss on loans.
But if they take fright and sell, Orban may have to rethink as he cannot afford to alienate voters by allowing the currency to fall too quickly ahead of elections in 2014.
"Since the government needs to preserve exchange rate stability, capital flight is a constraint on policy initiatives," said Daniel Hewitt, economist at Barclays.
Orban this week took control of the central bank via his former economy minister, promised to set up a state-owned banking system and stepped up rhetoric characterizing Hungary as a country embattled by foreign influences.
The combative prime minister also said small firms should be allowed to convert euro- and Swiss franc-denominated debt into forint loans, a move that could force further losses on banks, many of which are foreign owned.
Analysts say the biggest policy risk now is that the government will try to win the election by writing off some of the foreign currency households and small businesses loans.
Doing that could win Orban votes, but could shift market sentiment if it involved switching the burden from borrowers to private banks, or using a big chunk of central bank reserves.
"The new wave of concern is the new central bank governor and the potential plan to use reserves to help out the private sector that has non-HUF (non-Hungarian forint) loans," said Sam Finkelstein, head of emerging debt at Goldman Sachs Asset Management in London.
"If sentiment towards emerging markets deteriorates, the Hungarian government policies will make bondholders more uncomfortable."
The government itself has not said specifically what further economic policy tools it plans to use. It says the period of drastic measures is over and it will focus instead on rebuilding its credibility with the business community.
Bankers and government officials say the idea of a mass conversion of foreign currency loans has not been discussed.
"No plan like this is on the government's table, this is a hoax with no grounds in reality. Even raising the idea is harmful and dangerous for Hungary's international interests," the press chief of the Economy Ministry, Viktoria Csorba, wrote to Reuters in an email on February 20.
Orban is driven by winning next year's election and according to a source who knows him he will put aside economic orthodoxy if that is what it takes. He has already shown that he can be pressured by financial markets.
On January 6 2012 after the forint hit an all-time low versus the euro and Hungary's borrowing costs soared, Orban said an International Monetary Fund deal was in the interest of the country and his government would make efforts to secure a deal. After the forint recovered, though, his government went back to its previous anti-IMF rhetoric.
This year, market reaction to Orban has been muted because Hungary's high returns relative to other markets make it attractive. It has one of the highest foreign ownership in the bond markets of any emerging market at around 45 percent.
Despite predictions from the IMF and analysts that Orban was wrecking the economy, Hungary still sold $3.25 billion worth of dollar bonds last month, tapping international markets for the first time since 2011.
Some market insiders even say sentiment has improved in the last few months as it has become clear that Hungary is reining in its budget deficit and does not need an international loan. Investment lawyers in Budapest point to an upturn in corporate deals coming across their desks.
That echoes the argument of Orban's government, which says it fixed an economic mess inherited from his Socialist predecessors and stopped Hungary following Greece into collapse.
But sentiment could quickly change. The forint dropped more than one percent on Tuesday after Orban said there were too many foreign-owned banks in Hungary, railed against foreign currency loans and called for lower interest rates.
The forint dropped to 9-month lows versus the euro at 307.50 on Wednesday, but regained some strength after the foreign minister said the currency was too weak.
Adding to the general sense of unease among investors, Hungary's parliament, dominated by Orban's supporters, has also reduced the powers of the constitutional court. It was one of the few institutions that has stood up to Orban, and the move was roundly criticized by Brussels.
"I am surprised how well Hungary has held up as the story has been deteriorating for a while. There still seems to be a buy and hold attitude," said Claire Dissaux, investment strategist at Millenium Global Investments.
"Bond positioning is very heavy, as it is a high yielder, Hungary has a current account surplus and risk appetite is good, but there is a limit to that and that limit is the currency. As they cut rates the currency will react and if anyone has not hedged, that is a risk."
Orban's success in financing Hungary's needs from the market has certainly blunted the ability of the EU and IMF to rein in the policies it believes are risky.
The EU still has some levers. Hungary's economy needs European aid. If its deficit goes above the 3 percent of gross domestic product set out under EU rules, it could forfeit this money. That constrains Orban from adopting an "election budget" packed with inducements for voters.
Orban will look instead to the central bank, now run by his close associate Gyorgy Matolcsy.
Experts close to the government say one option being discussed in ruling party circles is for the central bank to persuade private banks to soften terms for foreign exchange loans. The banks would foot the bill.
The more radical option would be to dip into central bank reserves, currently at 35 billion euros, to convert foreign exchange loans into forint.
This carries high risks because a healthy level of reserves is important for market confidence and if combined with a general shift in the flow of money away from emerging markets could trigger a big sell-off in the forint.
Orban has little sympathy for foreign investors, but a falling forint would make imported goods and foreign currency loans more expensive for voters.
"Anti-capitalist, anti-foreign ownership rhetoric is popular for the electorate," said Daniel Bebesy, analyst at Budapest Fund Management.
"For the ordinary people EUR/HUF exchange rate is going to remain a key barometer for the success of economic policy, so an extremely weak level could trigger discontent within the public."
(Additional reporting by Sujata Rao in London; editing by Anna Willard)