In the past week Hungary's bonds have become junk, the forint has slumped to a near-record low against the euro and the OECD has said the economy is headed for recession next year.

Yet unlike other European capitals where economic decline has led to street protests and political upheaval, there is little visible sign of hardship in the capital Budapest, where Spanish tourist Roberto Diaz, 46, was taking coffee and cake in one of the city's atmospheric, old-world cafes.

I cannot see the crisis, all I can see is the luxury shops and hotels, Diaz, a hotel director from Madrid, said before heading off to tour a restored art nouveau luxury hotel near the Danube River. You don't see poverty.

Things look a lot different in Inke, 220 km (140 miles) southwest of Budapest. Here the impact of the rising cost of imports, stagnant growth, the failure to bring down unemployment and, of special concern, the overwhelming debt burden, the highest per capita in Central Europe at about $9,000 a head, comes home to roost.

Some 1,300 people live in the village which has no industry, no big employers, no large supermarkets or discount stores and only a sprawling video arcade cum bar and roadside rest area for trucks showing signs of life after 8 p.m.

Unemployment is 60 percent, and 30 percent of the population is Roma, who remain second-class citizens in Hungary despite decades of efforts to end discrimination.

Last week, to make matters worse, the only school was shut for lack of heat because the local government was 180 days overdue on its heating bill. To make up shortfalls Inke, like almost everyone and every entity in Hungary, has borrowed, but when it reached 23 million forints ($100,000), banks would lend no more, Mayor Sandor Rozsa, 58, said.

That meant the thermostat went down and the children stayed home, cut off from school-cooked food that for some is their main meal, and left to amuse themselves in dwellings ranging from modest to downright squalid.

Things are just going to get worse, it is not going to get better, whatever they say or promise, said Tibor Bogdan, 26, cradling two bawling infant boys in his arms to calm them.

Bogdan and his four children, ranging in age from 2 to 8, live in a tiny room crammed with cribs, a bed and a small table that serves as a cooking area. The house, located on a back street, with mud for a front yard and a festering drainage ditch right outside the door, is home to 23 people.

There are eight to 10 such homes in the village, Rozsa, mayor for 14 years, said.

If they don't take steps to drastically change things, it is over, said Bogdan, who is Roma, unemployed and gets 25,000 forints ($108) a month for himself and the same for each of his children. He said he has had to borrow 30,000 forints, to buy pharmaceuticals for two of his children who are asthmatic.

Everybody will become so poor that it is hard to say... the situation is inhuman.

There are dozens if not hundreds of Hungarian schools - and towns - in similar straits or worse. The irony is that Inke sits atop one of the estimated 1,300 thermal springs that riddle Hungary, affording the country the luxury of its world-renowned thermal baths..

Inke's source, about a half mile from the school, was discovered in the 1960s and has almost the same level of salinity as the Dead Sea. The village has concocted plans to put up a structure at the site resembling the Pyramid of Cheops, Rozsa said, but despite investor interest from as far away as Israel, Norway and Spain, no one has come up with the money to use the hot water, which is 145 C when it reaches the surface, for a spa that would provide much-needed employment, or for heating.

With no alternative to gas heat, banks refusing to lend more and energy company e-Star demanding 3 million forints for its overdue bill, Rozsa said he had to let the company turn down the thermostat, so the system would not be damaged, and send the 124 schoolchildren, 31 nursery-care infants and 15 teachers and aides home.

The fact that a children's foundation came to the rescue and paid the bill, so the school could reopen on Tuesday, did not change Rozsa's view that the market economy that supplanted communism in 1989 had, for the week the school was shut, failed the children of Inke.

As a private person, I would say it was safer in the previous system, and more secure but it was more unjust. But we don't have the fairest system today either, and it's also very unstable, he told Reuters in an interview.

HEAVILY INDEBTED

Hungary, once the star pupil of post-communist economic and political reform in Central Europe, is nothing if not an example of instability. Not only has its debt been downgraded to junk for the first time since 1996, but its forint currency has plunged by 14 percent in value against the euro since June 30.

In part this is because of the economic chaos gripping the euro zone, but it also is due to what one credit rating agency has called the unpredictable policies of populist center right Prime Minister Viktor Orban.

Orban became a household name in Hungary in 1989 when, at the reburial of Imre Nagy, who had been prime minister during the failed 1956 revolution against Soviet rule, he called for the Russian troops stationed in then-communist Hungary to go home, a brave and unprecedented clarion call to the people.

More than 20 years later, long after the collapse of communism and reincarnated as arguably Hungary's most successful post-communist politician, Orban's knack for knowing what was on the mind of the average Hungarian translated into criticizing banks and Western financial institutions.

Shortly after taking office, his government announced it was breaking off a restructuring deal with the IMF, which along with the European Union injected 20 billion euros ($26 billion) into Hungary at the height of the global financial crisis in 2008 to prevent a default by the wildly unpopular Socialist government, whose former prime minister had been quoted as saying he had lied to the people about the state of the economy.

Orban's rationale was that the IMF/EU deal was too restrictive, attached too many conditions and Hungary knew better how to boost economic growth. We are going to go our own unorthodox way, he said.

It didn't hurt his popularity within Hungary, but it did hurt Hungary's reputation in financial circles.

I think this cuts to the heart of the problem, which is policy unpredictability, Neil Shearing, an analyst with Capital Economics in London, said in a telephone interview. He (Orban) is a populist nationalist and there are obvious sensitivities with that kind of policy-making within Central Europe. So I think it starts to ring alarm bells.

Where Orban may have gone a step too far was in trying to alleviate the pain of hundreds of thousands of Hungarians who had taken out mortgage loans denominated in hard currencies, particularly the Swiss franc, the euro and the Japanese yen, as opposed to the weak forint, where loans were subject to relatively high interest rates.

The fact that so many people took out such loans to buy flats, houses and consumer goods was fueled by the notion that countries of the former communist bloc were going to become rich, and converge with wealthier Western Europe into one happy consumer family, analyst Gabor Orban of Aegon Fund Management in Budapest said.

The way this was reflected in Hungarian public sentiment is very simple - we're getting richer and richer, and it can be justified that we consume more and more of our permanent income, to use a technical term. Our outlook is very bright so we might as well bring forward some of our consumption to the present, Orban said.

The flaw in this logic became apparent in 2008 when the global economic crisis hit. Hungary's economy weakened, along with its currency, and became so bad that the Socialist government needed a bailout.

Hungarians who had taken out loans when they could get exchange rates of 140 forints to the Swiss franc suddenly were having to pay 200 forints per franc or more.

The howls of outrage did not go unheeded by Viktor Orban, whose Fidesz party won a two thirds majority in parliament in 2010. His government came up with a plan for the banks to eat the losses, instead of the citizenry.

In one of those offers that sounds too good to be true, the government said it would let people pay off the mortgages, before the end of 2011, at a one-time-only exchange rate as much as 25 percent lower than the market level, in Swiss franc terms, with the banks absorbing the difference.

The local banks, many Austrian owned, cried foul. One analyst estimated that if every Swiss-franc-denominated mortgage in Hungary were converted, losses to the banking system would amount to 1.1 trillion forints.

Eight affected banks, some of which said they would report losses in part because of the scheme, sent a letter to the EU commissioner in charge of regulating finance in mid-November, calling the plan a blatant violation of their rights and asking the EU Commission to support them in fighting what they called treaty violations by Hungary.

But the Hungarian public -- even people who had qualms about the ethics and legality of it all -- gobbled it up.

LURED BY LUXURY

It's the only decision in my favor in the last four and a half years, said Andras, a managing director of a company who is in his mid-30s and did not want his last name used due to the sensitivity surrounding the scheme.

He said that like many Hungarians, he had been lured by the siren call of luxury and used a foreign currency-denominated mortgage to buy a bigger flat when the rate of exchange was 143 forints to the Swiss franc, instead of today's rate of about 255.

Hungarian households hold about 4.8 trillion forints worth of foreign currency-denominated mortgage loans, equivalent to 17 percent of GDP, on which repayments have soared due to the Swiss franc's rise. Many companies and local governments also are indebted in francs.

In this country everyone likes to buy a car one or two sizes bigger than they can afford, a big apartment, a plasma TV and a smart phone, Andras said over brunch at one of Budapest's swank cafes, where three different types of champagne in ice coolers tempt customers from atop a display case.

He was fully aware, however, that while he personally would benefit from the deal, it had its downside.

In a country where former contracts can be redesigned on an ad hoc basis, who will come here to invest?

This is precisely the position that the angry Austrian, as well as Italian and other foreign bank-holding companies, find themselves in as they survey the financial carnage wreaked upon them by Fidesz over the past year and a half, and with the uncertainty about what is to come.

Banking sources say that whatever may appear on the surface, foreign-based top management are viewing the futures of their Hungarian affiliates with concern. Decisions on whether to invest for the growth of these affiliates, or to leave them to wither on the vine, could well be determined by future Hungarian government policy, they say.

Zoltan Csefalvay, state secretary to Economy Minister Gyorgy Matolcsy, downplayed that likelihood.

I said I think one month ago that no bank would leave Hungary, and this was a headline in Hungary, but I say the same, no bank will leave Hungary, because the banks look a little bit further and banks know one thing, the crisis will be over, he told Reuters in an interview.

He said the government had instituted structural reforms, cut the deficit and boosted economic growth, though the European Union and analysts think the growth forecast of 1.5 percent of GDP for next year is optimistic. The OECD said it actually expected the Hungarian economy to contract by 0.6 percent.

Csefalvay said steps were being taken to solve at least some of the problems of places like Inke by taking back financial control from local governments, which he said in future could only get loans with the permission of the central government. That would stop Inke from borrowing, though of course it might still not have money for heat.

He deflected a question about whether Orban, or his own boss, Economy Minister Gyorgy Matolcsy, should step down, even though prime ministers of Italy, Greece and some of the other European countries hit by economic turmoil either have resigned or been thrown out in the polls.

That is not my responsibility to discuss this kind of personal question, he said. There is a party, certainly, the ruling party, and I think the ruling party should decide it.

Fundamentally, Hungary was at the mercy of the economic turmoil sweeping Europe, he said, and that is why having broken with the IMF, Hungary was going back to try to forge a new deal, not because its policies had failed.

If you look at what is happening in the whole of Europe, how the crisis is deepening ...you can see that such a country as Hungary needs an additional safety net, he said. And if you compare the whole situation between 2008 and today, 2011, you can see there are many changes also in the IMF, you can see the IMF can provide much more flexible solutions to these kinds of problems and on the other hand, if you look at the Hungarian economy, I think it is in much better condition.

NOT ALL DOOM AND GLOOM

Hungary, despite the grinding poverty of places like Inke, is on the whole better off in pure economic terms than it was in the 1990s, or even a few years ago.

The Orban government, in part because of its unorthodox measures, has brought down the budget deficit to just under 3 percent of GDP. Total GDP in 2010 was 27 trillion forints, or about $130 billion, double what it was about a decade ago.

I can't imagine that Hungary can go bankrupt, analyst Gergely Suppan at Takarekbank in Budapest said.

In western Hungary, the massive investment by German automaker Audi on the outskirts of the city of Gyor, starting in the 1990s has grown into an enterprise whose turnover of 4.8 billion euros in 2010, as reported in the affiliate's annual report, is roughly equal to five percent of GDP. Those revenues grew by 23 percent from the previous year, and the company has announced plans for further expansion.

Audi is in the midst of building a new, 900-million-euro car factory that will create 2,100 jobs in the next two years, company spokesman Peter Lore said in an emailed response to questions submitted by Reuters.

Workers flowing out during a shift change recently said they liked working at Audi, compared to some Hungarian companies which, after communism, were privatised, restructured, downsized or even effectively closed down.

Audi is a company that plans for the future, worker Istvan Toth said.

But to the extent the downgrade and negative sentiment about the country is tainted by Orban's unorthodoxy, Hungary will pay a heavy price for his populism. The day of the downgrade, Hungarian bond yields initially soared more than 100 basis points to between 9.5 and 9.8 percent, to 738 basis points above the benchmark 10-year German bund, boosting Hungary's costs for refinancing its massive debt that much higher.

It is not because of this measure only that the currency depreciated, all the currencies in the region are under heavy pressure, Rafal Kierzenkowski, the OECD's senior economist for Hungary, said in a telephone interview, speaking about the mortgage-payoff scheme.

It's true that this early repayment scheme at discounted exchange rates may have somehow amplified the effect and hence is increasing the burden on the economy. The public debt is growing and households who continue to be indebted in foreign currencies feel the pinch as well.

So it's true that they are taking unfortunate measures in a period of heavy market stress, which is very much linked to the euro zone debt crisis, leading to an amplifying effect.

Attila Mesterhazy, the president of the defeated Socialist party, who had been its prime minister candidate at the time of its crushing defeat in the 2010 elections, said he sensed a mood of change, even if there still are few demonstrations of anger on the streets of Budapest, or anywhere else in the country, and he thinks that in part has spurred the government to return to the IMF, and to start talking to banks about the mortgage repayment scheme.

The government is playing now with the life of the people, in a sense, he said. And that's why I very much believe that the government wants to do this change in its economic policy.

(Additional reporting by Sandor Peto, Krisztina Festo, Gergely Szakacs and Marton Dunai in Budapest and Sylvia Westall in Vienna; editing by Janet McBride)