The International Monetary Fund criticised Hungary on Wednesday for its new central bank legislation and for enshrining a flat tax in the constitution, highlighting potential stumbling blocks to Budapest's efforts to secure new aid.
The IMF predicted growth in the ex-communist country of 10 million would stagnate this year but it warned a worsening of the euro zone crisis could tilt the economy into a 3.4 percent contraction and send its public debt load higher.
Hungary is aiming for a precautionary funding deal worth around 17-20 billion euros with international lenders to shield its currency and bonds from turmoil in the euro zone and retain market access as it prepares to roll over nearly 5 billion euros worth of external debt this year on top of forint expiries.
Having alarmed investors and irked leaders in Brussels and Washington with a string of unorthodox policy measures since storming to power in 2010, Hungary's prime minister, Viktor Orban, has now launched a charm offensive to win back market confidence and mend frayed ties.
A day after pledging to European Commission President Jose Manuel Barroso in Brussels he would address the EU's concerns, Orban told the Wall Street Journal he was optimistic he could secure a funding deal from the EU and IMF by the end of March.
But the IMF report urged Orban's right-of-centre government to abandon a campaign of unorthodox policies that have triggered a sell-off of the forint currency in early January and driven borrowing costs to an eye-watering 9 percent.
A well-crafted policy mix that avoids the ad hoc interventionist measures of the past year and strengthens economic institutions can reduce the likelihood of an adverse scenario where Hungary loses market access, the IMF said in its staff report, compiled before Orban's trip to Brussels.
Orban's visit failed to clinch a quick agreement to resume aid talks that Budapest had hoped for and revealed that stumbling blocks remain, as Orban disagreed with certain points of Commission criticism of his government's legislation.
But Orban, who has also seen his public support cut in half over anger at his policy approach, said he could push necessary changes on disputed laws through parliament by the end of February.
We're ready to consult on all issues, Orban told the paper. The situation is clear, that would help Hungary to stay on the financial markets.
The IMF's forecast for 0.3 percent growth this year was better than a projection from the EBRD development bank a day earlier, which saw a 1.5 percent contraction. The government expects 0.5 percent economic growth in 2012.
Orban told the Wall Street Journal that even though Hungary would be able to raise money from markets for the next year or two without an agreement, in the long run current borrowing costs of around 9 percent would be unsustainable.
The forint has seen wild swings this year, falling to a record low of around 324 per euro at the start of the month before rallying by more than 3 percent on investors' hope that Orban can secure a financing deal.
But analysts say the market will remain wary until they see concrete proof that Orban will change legislation.
The Commission has launched infringement procedures against Hungary relating to the laws, saying they undermine the independence of the central bank and courts. It has set a February 17 deadline for Budapest to respond or face legal action.
EU finance ministers also opened the way to freeze development funds to Budapest on the grounds that the government's measures had not sustainably cut the budget gap to below the bloc's ceiling of 3 percent of gross domestic product.
Those unorthodox reforms include Europe's highest banking tax, seizing $13 billion in private pension assets to pay off debt, and enshrining a flat income tax into a new constitution.
On Tuesday, Barroso also stressed there were wider political concerns on the approach of Orban's government and said the Commission must ensure that EU law must be respected both in letter and in spirit.
The IMF said a precautionary arrangement could help rebuild investor confidence but added that a new central bank law, which derailed informal talks on aid last month, pointed toward risks of a material erosion of central bank independence.
Orban has since pledged to modify the law on most contested points.
The IMF also recommended new fiscal measures such as changing a flat tax, cutting crisis taxes on banks and other firms, and other measures that could be points of conflict if it and Budapest agree to enter a financing deal together.
A more systematic approach could include revisiting elements of the flat tax, reducing the outsized crisis taxes, means-testing universal transfers, rationalising public employment (especially at the local government level), and strengthening the forint exchange rate, the Fund said.
(Reporting by Gergely Szakacs, Sandor Peto; Writing by Michael Winfrey; editing by Stephen Nisbet)