Hungarian Prime Minister Viktor Orban rejected a European Commission request on Thursday to withdraw two disputed laws, in a move which could derail Hungary's talks about a new deal with lenders and may trigger a full-blown market crisis.
European Commission President Jose Manuel Barroso has asked Orban in a letter to withdraw two laws - one on the central bank which is seen infringing on the bank's independence and another so-called stability law, which cements key elements of Orban's unorthodox economic policies, such as a flat tax.
The dispute over the laws led to a premature end to Hungary's informal talks with the EU and International Monetary Fund over a new financing backstop last week and helped trigger a downgrade in the country's debt rating by Standard and Poor's to junk late on Wednesday.
But Orban stated the laws would be passed, although he said Hungary was still intending to sign a new safety net-type deal with the IMF next year.
I told him (President Barroso) that there was no possibility to delay (the laws) as our Constitution will take effect on January 1 ... and both laws are important bricks in the new constitutional order, Orban told HirTV in an interview.
He later added: Brussels is not Moscow ... there are over 700 such disputes between member states and the Commission in which the Commission attacked the given member state and said some of its legislation went against EU law.
But Hungary's second credit ratings downgrade to 'junk' in a month has heightened the risk of a market crisis with investors anxious to see whether it will push the government closer to or further away from an international aid deal.
President Barroso asked for the bills to be withdrawn, because he's concerned that they might contravene the treaty, Commission spokesman Olivier Bailly told a briefing in Brussels earlier on Thursday.
Bailly also said that the European Commission has not decided yet on resuming formal or informal talks regarding financial assistance with Hungary.
Orban told HirTV Hungary would stay on its feet even if there was no agreement reached with the IMF about a new safety net, which he said Hungary needed only because of the deepening crisis in the euro zone.
He reiterated the government aimed to sign a precautionary deal, and did not want to take out a new loan.
If we agree with the IMF, then we have a safety net deal. If we don't, then we don't (have this agreement). The country will nevertheless stay on its feet and will operate, he said.
We could navigate the vessel of the country without it, but it is safer to sail having such an (IMF) insurance.
The government has said it expects official aid talks to start on January 10, but Orban's rejection of the EU demands could now derail this plan.
Late on Wednesday, Standard & Poor's cut Hungary's long-term rating by one notch to BB+, just below investment grade, citing the government's unpredictable policies and renewed meddling with the independence of the central bank.
The downgrade, which further widened the ratings gap with its Central European peers, sent the forint currency lower and lifted bond yields. Analysts said if Hungary fails to clinch a new financing deal with lenders, the punishment could be severe.
The government, however, contended that the downgrade was unjustified.
The disputed central bank law has been amended by the ruling Fidesz party, but the ECB said on Thursday it was still concerned that plans to expand the Monetary Council and increase the number of deputy governors could pose a risk to the bank's independence.
Hungary's five-year bond yield shot above 9 percent in thin trading although the deputy head of the debt agency said he did not expect the news to spark panic selling.
At the moment, (Orban) is sitting in the car in head-on collision mode and is not willing to move, a diplomatic source told Reuters on Wednesday.
While Orban is seeking a funding deal which could help Hungary retain access to markets next year, at the same time he does not want lenders interfering with his economic policies which included big special taxes on banks and a renationalization of private pension assets.
The government has stabilized its budget since it swept to power with a two-thirds majority in April 2010, but recent initiatives have shocked investors and earned the ire of the EU.
The downgrade could, alongside market weakness, push Hungary toward engaging more constructively with the IMF and EU, Barclays said in a note earlier on Thursday.
But there is also a risk that Hungary's government will try to soldier on without outside financial support, instead turning to more unorthodox policy measures, it said.
The opposition Socialists have called on Fidesz to replace Orban, but political analyst Zoltan Kiszelly said Orban's big majority in parliament cemented his position.
He said Orban was unlikely to change course at this stage as he needed a good political exit strategy to be able to make such a marked shift in economic policy.
He is hoping that the other side (the EU) would swerve first, he said.
Rating agency Moody's also cut Hungary's debt to junk in late November, citing the country's weak growth, high levels of debt and uncertainty about its ability to meet fiscal goals.
Hungary aims for one of the EU's lowest budget deficits next year at 2.5 percent of GDP, but a threatened recession could jeopardize that target as well as a government pledge to reduce debt which at 80 percent of GDP is the highest in Central Europe.
Hungary also needs to roll over 4.8 billion euros (4 billion pounds) in external debt - on top of forint-denominated paper - next year.
(Additional reporting by Marton Dunai, Sandor Peto and Rex Merrifield in Brussels; Editing by Catherine Evans, Gary Crosse)