Hungary's markets sold off on Monday after the government rebuffed lenders' calls for tougher austerity measures, bringing weekend talks on further aid to a premature end and rattling investor confidence.
Analysts said the new center-right government, which has spooked investors before when officials compared Hungary's problems with those of Greece, could be playing for time by seeking to put off unpopular announcements about spending cuts until after municipal elections on October 3.
But a surge in borrowing costs and weakness in the forint currency, which plunged over 3.3 percent versus the euro to 291.60 by late Monday, may well push the Fidesz government to reach a deal sooner.
Fidesz is scoring domestic political points in its battle with the IMF and EU, Eurasia Group analysts said in a note. In response, the EU is sending a clear message that Europe is in a new era (post-Greece) of fiscal austerity, and that Hungary needs to get with the program. This is a recipe for ongoing tensions and market concerns.
Hungarian government bond yields rose 30 basis points on Monday and the cost of insuring the country's sovereign debt rose to a six-week high after the breakdown of the talks, which were intended to review the financing deal Hungary struck in 2008 with the International Monetary Fund and European Union.
Without a deal, Hungary, which runs central Europe's highest public debt at about 80 percent of gross domestic product (GDP), will not be able to use remaining funds in its 20 billion euro ($26 billion) loan secured in 2008.
Even though Hungary is not under immediate financing pressure, such delays would raise its financing costs, potentially forcing the central bank to raise interest rates and putting pressure on Hungary's ratings, analysts said.
The central bank kept rates on hold at 5.25 percent at its regular rate meeting on Monday but it made clear that it would try to limit any big moves in the forint, and even hike interest rates if it becomes necessary.
A sustained increase in risk premia may make it necessary to raise the central bank base rate, it said in a statement.
'NO MORE AUSTERITY'
Credit-rating agency Moody's said on Monday it expected the government to reach an agreement with lenders in the autumn and was not about to change Hungary's Baa1 credit rating with a negative outlook.
The negative outlook reflects uncertainties related to, first of all, the economic activity but speaking about the events of the weekend, also about the course of policy action that is to be expected, Moody's Senior Analyst Dietmar Hornung told Reuters in an interview.
The IMF and European Union both said the government needed to take tougher measures to rein in the budget deficit.
The IMF remains open to resuming talks with Hungary but the timing of this has not been fixed with the government, the IMF's Hungarian representative Iryna Ivaschenko said.
As you know, the current arrangement expires early October so the window is getting smaller but we definitely remain open, Ivaschenko told Reuters Insider TV.
Economy Minister Gyorgy Matolcsy told CNBC earlier on Monday that Hungary's government expected to reach agreement with the lenders and resume talks in September.
Matolcsy told television m1 that the IMF and EU also voiced concerns over a 200 billion forint tax the government plans to contain the deficit and a bill which would cut the central bank governor's salary.
But Hungary's government, which took office in May, had insisted on the tax and rebuffed calls for further austerity. Matolcsy said the size of the bank tax was negotiable only for 2011 and 2012, but not for this year.
We have told our partners that further austerity packages were out of the question, Matolcsy said, adding the government wanted to meet this year's budget deficit target of 3.8 percent of GDP, but needed the planned tax on banks to do so.
Shares in Hungary's OTP OTPB.BU and the foreign lenders most geared to the country -- Austria's Erste Group Bank (ERST.VI) and Raiffeisen International (RIBH.VI) -- fell on Monday.
We believe market pressure will force the government to present a detailed economic program for 2011 in the coming weeks, Citigroup said. The lack of agreement means Hungary's access to market funding may freeze, especially if European financing conditions deteriorate.
(Writing by Krisztina Than; Editing by Ruth Pitchford)