BUDAPEST Hungary is playing tough now but it will have to accept International Monetary Fund and European Union demands and bring some orthodoxy into economic policy to secure a financing deal for next year or risk being cut off from market funding.
Hungarian Prime Minister Viktor Orban -- who broke ties with the IMF in 2010 to regain "economic sovereignty" -- doesn't want lenders meddling with his unconventional policies to boost the economy even though he is seeking a new financing deal.
Since winning a two-thirds majority in parliament in April 2010, his government has curbed the rights of Hungary's top court and wants to tighten its grip on the central bank, which it believes is not backing its policies with monetary tools.
The centre-right government has said it wants a "safety net" loan deal without tough conditions, a line Orban pursued in an interview on Friday in which he also compared an IMF agreement to an insurance policy:
"We wish to negotiate with the IMF not about Hungary's economic policy," Orban told Kossuth radio, as informal talks were halted by EU Economic and Monetary Affairs Commissioner Olli Rehn because of a dispute over a new central bank law.
"The IMF is a bank ... an organisation which works like a bank whose job is to extend credit, safeguards, if needed to those countries which are its members, and we are a member."
But crunch time may have come for Orban, whose government has slapped Europe's biggest taxes on banks and renationalised $14 billion (8 billion pounds) of private pension assets among other controversial moves.
The row over the new bill, which the European Central Bank has said threatens central bank independence, is the latest in a series of conflicts with Brussels, while his administration has been warned by the United States to respect democratic freedoms.
Failure to reach an agreement with the IMF and EU would trigger a market selloff and could leave Hungary unable to access markets next year, when it must roll over 4.7 billion euros of foreign currency debt on top of maturing forint paper.
"There will be a boxing match but in the end they don't have any other option but to reach an agreement," said Eszter Gargyan at Citigroup in Budapest.
"They will feel the funding pressure and if markets start to think that there is no agreement with lenders, nobody will buy our bonds and then the local debt market will fall apart."
A previous Socialist government was forced to seek an IMF/EU bailout after local debt markets seized up in October 2008.
European Commission President Jose Manuel Barroso asked Orban in a weekend letter to withdraw the central bank bill and another key law, saying the draft law on the bank infringed upon its independence.
Barroso's intervention adds to pressure on Orban to change course, which he opposes fiercely as interference by outsiders. The resumption of relations with the IMF is a big political blow for the prime minister.
Negotiations with international lenders are likely to resume in January after last week's unexpected halt, but the talks are likely to be difficult.
The government has said it will qualify for a precautionary and liquidity line (PLL) from the IMF, but analysts said lenders were more likely to offer a much stricter, stand-by type facility with tough terms attached.
"They will be forced to sign and swallow strict - economically and politically - painful conditionality. But things must get much worse first before the government agrees to this and signs," said Peter Attard Montalto, analyst at Nomura.
Hungary's biggest problem is its sickly economy, which faces a possible recession next year as Europe slows, posing a risk to its budget deficit target of 2.5 percent of economic output and jeopardising a key government pledge to reduce state debt. At 80 percent of GDP, Hungary's debt is the highest in central Europe.
The promise of an IMF/EU deal has shored up Hungary's forint and government bonds in past weeks despite rating agency Moody's downgrade of the country's debt to "junk" late last month. Another rating agency, Fitch, has linked Hungary's ratings to the outcome of talks with lenders.
GRIP ON THE CENTRAL BANK
A key sticking point for lenders has been the new central bank law, which would expand the Monetary Council and curb the rights of Governor Andras Simor, who has been attacked by Fidesz politicians for not cutting interest rates to stimulate growth.
The National Bank of Hungary raised interest rates on Tuesday for the second time in two months to shield the forint and debt until Budapest secures an aid deal.
Orban's ruling Fidesz party proposed changes to the bill on Monday after criticism from the ECB, but left some contentious passages intact, including the expansion of the rate-setting Council and the nomination of a new vice governor.
Desperate to avoid a recession, the government aims to pass the law this year. With the central bank under its influence, it could force the use of monetary policy tools to free up credit and rekindle economic activity, analysts said.
"The government's key promise has been growth and job creation, and practically nothing of this has been achieved," said Peter Kreko at think-tank Political Capital.
"It is now running after its promises and wants to use the central bank as well to kickstart growth."
Economy Minister Gyorgy Matolcsy said on Sunday that, to increase lending to the economy, it would need to be considered "what kind of monetary tools the central bank applies at the recommendation, request of the government."
Orban has also said the bank should take a more active role in bank lending, which analysts said could lead to some form of quantitative easing - opposed by governor Simor.
"It seems Orban's ideal case is still to make it without the IMF and EU, so they try to find other ways to get financing," said Christian Keller at Barclays in London.
"Ultimately, they may have to agree but probably not until another wave of financial pressure on Hungarian assets."
(Editing by Catherine Evans)