BUDAPEST Hungary faces a fall in its currency and a surge in financing costs due to a failure to agree with lenders on its economic plans and it will need to reach a deal to retain the trust of investors.
Talks with the International Monetary Fund (IMF) and the EU ended prematurely on Saturday without a conclusion of the country's program review, which means Hungary will not have access to remaining funds in its 20 billion euro ($26 billion) loan secured in 2008 until a deal is reached.
This is a risky path for a country which has a poor budget track record and which runs central Europe's highest public debt at about 80 percent of gross domestic product, analysts said.
Although Hungary does not face an immediate pressure on state finances as its 2010 financing seems to be secure thanks to unused loans and cash reserves, it needs the lenders' safety cushion as an external anchor of credibility.
A lack of agreement on the current program also excludes the possibility of a new precautionary deal for 2011 and 2012, which the country needs as a safety net, analysts said.
This will likely force the new center-right government, which took office in May after winning April parliamentary elections, to come to an agreement with the IMF and EU, but the timing of this is uncertain, they said.
"This is fairly bad news and a mistake from the government ... the market impact will be negative with a likely over 1 percent or possibly bigger currency fall and a jump in yields," said Zoltan Torok, analyst at Raiffeisen.
"I'm sure there will be an agreement, as they (the cabinet) simply will be forced to do it, but I don't know when and the later it comes the worse."
Hungary, which had to resort to a rescue loan from the IMF/EU in October 2008 to avert meltdown, has since stabilized its finances but its heavy reliance on foreign funding makes the country vulnerable to negative shifts in market sentiment.
This showed in early June when the government made confusing comments comparing its fiscal problems with the Greek debt crisis, which led to sharp market falls and seriously damaged the government's policy credibility.
Then the cabinet committed to this year's budget deficit target of 3.8 percent of gross domestic product (GDP) in an attempt of damage control to reassure investors.
But lenders said on Saturday further steps were needed to achieve the deficit targets this year and in 2011, and the government needs to work out durable measures and spending cuts to reduce the deficit and ensure sustainability.
While the breakdown of talks with its lenders does not pose an immediate financing risk for Hungary, it is yet another sign of the government's unpredictability in its policies and decisions which could alarm stability-loving investors.
Prime Minister Viktor Orban said after winning elections in April Hungary would not accept "diktats" from the IMF and EU in future negotiations as they are "not our bosses."
The cabinet has been on a collision course with the central bank, mounting pressure on Governor Andras Simor to resign, and pledging to cut his salary which has triggered a strong warning from the European Central Bank (ECB) only last week.
"We doubt fundamentally the new government's commitment to the IMF/EU deficit targets and their stubbornness around enacting their pet policies such as the banking tax and cutting the pay of the central bank," said Peter Attard Montalto at Nomura in London.
"We now have proof that the supranational support for countries is softer and not unconditional ... The IMF and the EU will not allow for moral hazard and free riders."
The European Commission on Saturday urged the government to respect the full independence of the central bank.
While the market reaction is bound to be negative, it will be more on the confidence side rather than fundamentals as Hungary has no immediate need for the IMF's money right now, said Gergely Suppan, analyst at Takarekbank.
Of the 2008 credit line secured from the IMF, the EU and the World Bank, Hungary still has about 3.5 billion euros in hand, and a further 1.4 billion at the central bank, which had total foreign exchange reserves of 35.2 billion at the end of June.
"Hungary's government seems to have sufficient funds at the moment and FX reserves in the National Bank of Hungary (NBH) are high. Therefore, the implication of delay of this review is not that Hungary runs into immediate financing problems--they are not in dire need of the money," said Christian Keller at Barclays.
While the government is likely to resume talks with lenders, uncertainty could prevail until the autumn, when Hungary holds municipal elections on October 3 where the ruling Fidesz party wants to cement its powers at the local level.
That is also when the government will need to finalize the 2011 budget, which the IMF said would be a key issue in any future negotiations.
"We think there is a mutual interest to get the negotiations back on track, but the government may not be willing to make the tough decisions it needs to make for agreement with the IMF-EU until after the local elections in October," Keller said.
(Editing by David Holmes)