What next after Hungary breaks ties with IMF?

With its 2010 financing plans secured, Hungary's government looks determined to go into next year without a new precautionary financing deal with the International Monetary Fund (IMF).

Without an IMF safety net, markets could demand a higher premium on Hungarian debt — Hungary will have to start repaying its international debt with a 2 billion euro tranche to the EU in the fourth quarter of 2011. It also has foreign bonds worth roughly 2 billion euros maturing next year, on top of domestic debt.

The country will be more exposed to market volatility due to its high debt — although its access to market funding looks safe in the short term.

The big question mark hanging over the market is next year's budget deficit target. This was set at 2.8 percent of GDP in the country's latest euro convergence program, but the new target will remain unclear until the 2011 budget is drafted in October.

The economy minister has to submit the draft 2011 budget to government by Oct. 15 — about two weeks after a municipal vote — where the ruling Fidesz party will seek to consolidate its power after April's sweeping parliamentary election victory.

The government's main challenge will be to squeeze more time out of Brussels to bring Hungary's budget deficit below the EU's 3 percent ceiling after having spent six years under the bloc's excessive deficit procedure (EDP).

Budapest wants a single timeframe for all EU members, some of whom are running double-digit budget deficits — theoretically giving the new government several more years of looser fiscal policy.

Hungarian Prime Minister Viktor Orban seems confident that EU leaders will agree on this uniform timeframe. He has said such an agreement, backed up by a credible economic policy package, could render any IMF safety net unnecessary.

With some more budget room, the government could take steps to boost ailing growth in a sustainable way, but delaying fiscal cuts would raise question marks over Hungary's debt trajectory.

It is unclear if the EU would agree to give any leeway to Hungary, which has been in the sin bin for six years, even though the country had one of the lowest deficits in the bloc last year despite a deep recession.

Hungary's bargaining position with the EU is also weakened by a spat with the European Central Bank, which has criticized a government decision to cut the central bank governor's salary by 75 percent under a broader public sector pay ceiling.

Bringing the budget deficit below 3 percent of GDP in 2011 from an expected 3.8 percent this year would require fiscal tightening worth hundreds of billions of forints — most likely killing tax cut plans flagged for next year.

That could stabilize Hungary's finances further and put state debt on a falling path from about 80 percent of GDP this year, but at a price of stifling a fragile recovery.

Whether or not the EU lets Hungary off the hook on the deficit, the government will need to present a credible economic policy package — backed up by firm targets — soon to sustain market confidence.

The worst-case scenario for the government would be if a ratings downgrade followed by a major sell-off of Hungarian assets this year forced it back to the negotiating table with the IMF.

In this case the Fund would probably set tougher conditions for Hungary to consolidate its finances in return for renewed assistance, but given the prime minister's recent rhetoric on the IMF, this option seems to be only a last resort for the government.

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