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 cuts until after municipal elections on Oct. 3.
But a surge in borrowing costs and weakness in the forint currency, which plunged over 2.5 percent versus the euro early on 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 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 20-30 basis points 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.
However, by later in the day, the forint had firmed off the session's weakest bid at 290.20, and the central bank kept interest rates on hold at 5.25 percent at its regular rate meeting.
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.
Economy Minister Gyorgy Matolcsy told television m1 on Monday that the IMF and EU also voiced concerns over a 200 billion forint ($916 million) 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 the calls for further austerity.
"Hungary has experienced a program of austerity over the past five years, we inherited this from the previous governments and we would like to do away with the unfortunate consequences of these steps," Matolcsy said.
"We have told our partners that further austerity packages were out of the question." Even so, Matolcsy told CNBC later on Monday that Hungary's government expected to reach agreement with the lenders and resume talks in September.
Matolcsy confirmed the government wanted to meet this year's budget deficit target of 3.8 percent of GDP, but he said for this the planned tax on banks was necessary.
Shares in Hungary's OTP and the foreign lenders most geared to the country — Austria's Erste Group Bank and Raiffeisen International fell on Monday.
Erste Group and Raiffeisen fell 2.3 and 4.6 percent, respectively.
"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."
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