EU finance ministers suspended on Tuesday Hungary's access to half a billion euros in aid from next year for failing to keep its budget in check, but told Budapest it could escape the sanctions if it takes remedial fiscal action by June.
Following a report from the OECD group of developed nations predicting the country would slide into recession, the finance chiefs agreed to rule in June whether or not Hungary can win back the 495 million euros ($649 million) if it makes progress on its deficit.
The move puts pressure on Prime Minister Viktor Orban's government as it struggles to win funding from the EU and International Monetary Fund to underpin the economy and prop up the weak forint currency.
"This provides a strong incentive for Hungary to conduct sound and sustainable fiscal policy," EU Economic and Monetary Affairs Commissioner Olli Rehn told reporters in Brussels.
"Action by the Hungarian authorities would lead to the lifting of the suspension before it becomes effective in case of course Hungary takes effective action," he said.
Diplomats said Germany and Austria, a country whose banks play a large part in Hungary's financial system, had proposed a compromise for a conditional delay, while other backers worried any freeze could complicate the start of EU/IMF talks.
In a compromise, EU finance ministers will revisit the issue on June 22 and will lift the suspension if Hungary assures them it has done enough to address its excessive budget shortfall.
Under the European Commission's original proposal, Hungary needed to show by September that it could bring its fiscal deficit to below the EU threshold of 3 percent of gross domestic product in 2013 in a sustainable way in order to be let off the hook.
Although 23 of the EU's 27 states have exceeded the bloc's deficit ceiling of 3 percent of GDP in the past, Hungary is the first to face the freezing of funds aimed at helping it to catch up with richer EU members.
The Commission has struggled to impose the limit since 2003, when Germany and France both missed budget deficit targets and rejected being disciplined.
But analysts say the EU has been harsher with Budapest to make it an example after Orban ignored warnings from Brussels and used his two-thirds majority in parliament to pass Europe's highest banking tax, a new central bank law, and other policies criticized as ineffective and potentially undemocratic.
EU officials say Hungary's deficit could hit 3.6 percent of GDP in 2013 if Budapest does not take new measures, from a target of 2.5 percent of GDP this year.
Orban's government has given mixed signals about its intentions on its legal disputes with the EU, saying both that it is willing to come to terms with Brussels but also it could take some matters to EU courts to protect Hungary's interests.
"Obviously turning to the European Court is a last resort," Deputy Prime Minister Tibor Navracsics told Reuters in an interview. "That would mean we were unable to find a solution. I would be very happy if we did find one."
HEADING INTO RECESSION
The Organisation for Economic Cooperation and Development agreed more fiscal consolidation was needed, particularly in cutting the government spending that makes up 50 percent of output. It painted a grim picture for Hungary's economy.
"Overall, the economy is projected to be in recession in early 2012, with a weak recovery starting in the second half of the year as confidence improves somewhat and global financial and economic conditions improve," it said.
The grouping of more than 30 industrialized countries predicted a contraction of 0.6 percent this year and growth of 1.1 percent in 2013. Budapest sees 0.5 percent growth in 2012.
The OECD said the only way to return to growth would be through structural reforms and to reduce a high level of foreign currency debt burdening its households, among other moves.
It also urged Orban to close a funding deal with the EU and the International Monetary Fund as soon as possible.
The government has said it could clinch a funding deal in the second quarter, but Budapest is still contesting some conditions the EU's executive has set for talks to start.
Ratings agency Moody's said the possible suspension of cohesion funds and Budapest's delay in securing an IMF deal were pressuring the country's credit rating, which is rated the "junk" level of Ba1.
It said it could stabilize its ratings outlook if Hungary were to embark on sustainable budget reforms.
The delay in the EU/IMF funding talks has hammered the forint, which has fallen 22 percent since mid-2008 to 294 per euro on Tuesday, although it briefly rebounded on signals that the decision to suspend of EU funds might have been postponed.
The forint's travails have caused a spike in loan payments for households which borrowed in the lower interest rates of the euro and Swiss franc before the crisis.
The OECD said an end-2011 drop in the forint had rendered useless an effective nationalization of $14 billion in private pension assets last year. Orban used the funds to pay back debt, but the weaker forint pushed the debt's value back up.
The report said a recently approved flat tax hit poorer earners, and the reduction of taxes for rich Hungarians should be cancelled. It also highlighted an extraordinary tax on banks — the highest in Europe — which it said had restricted credit to the economy, and taxes on utilities and retailers.
"The 'crisis taxes,' in particular the bank tax, are highly distortive," it said. "They should be removed no later than 2012 or 2013 (bank tax), as planned," the report said.
The OECD described as marking a "clear departure from best practices" changes to a central bank law that raised the number of board members, removed the governor's right to name his deputies and gave it to the prime minister, and allowed for the merger of the central bank and financial regulatory authority.
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