Thomas Escritt in Budapest -

How things change. Viktor Orban seemed almost invincible over his first 18 months in office: no chorus of international outrage, and no splutterings of anger from the country's divided and weak opposition seemed able to put the country's prime minister off his stride.

In economic policy, his government was able to defy the International Monetary Fund (IMF) when it demanded spending cuts in exchange for a new tranche of financial support, declaring a "struggle for economic independence" and sending the multilateral lender packing. Using his party's two-thirds parliamentary majority, he was able to ram through a new constitution, one filled with references to God and Hungary's historical mission that was more in tune with the beliefs of his populist conservative Fidesz party.

The past few months have been less kind to Orban, however, as a fresh wave of crisis from the Eurozone periphery has combined with growing pressure from both official circles abroad and a newly confident civil society at home, which culminated in a spectacular climb-down in December when Orban agreed to accept the IMF's and the EU's conditions for securing a new multilateral support package.

Hungary has been in permanent austerity mode since the then Socialist government precipitated its own demise in 2008 when, alarmed by the deteriorating macroeconomic environment, it enacted a dramatic U-turn on the generous spending promises it had made in the previous election. Now, Fidesz's attempts to break from the cycle of austerity have also been thwarted. And while across Europe economists are starting to question whether a focus on sound public finances is really what the continent needs as it faces its worst recession in many decades, the options available to a small, open economy dependent on market finances are very limited. But a head-strong government that is nervously eyeing its dwindling popularity in the polls may well decide in the end that the gamble of going it alone is a better bet than the austerity that could carry on for another four years.

Cry freedom

Even the government now expects the economy to grow by only 0.5% in 2012, as the modest recovery that opened 2011 runs out of steam, with most expecting it to shrink. The forint, which hit record lows against the euro in January, is the region's most volatile currency.

Given the signs that the government's struggle for "economic independence" has failed to live up to the promises that were made on its behalf, it is no surprise that criticism of Gyorgy Matolcsy, the national economy minister, has been growing. Matolcsy, a fervent opponent of austerity, hoped that a combination of a flat tax and targeted industrial policy would deliver the kind growth to get the economy out of the hole it finds itself in, in a way that the austerity demanded by the IMF would not.

Over the past few weeks, a series of economists closely associated with the ruling Fidesz party have been voicing their discontentment ever more loudly, demanding a change in course and insisting that it is a time for the government's economics team to be reshuffled.

The most recent criticisms have come from Peter Akos Bod, a former central bank governor whom Orban chose as Fidesz's candidate for prime minister in 2006. In a radio interview, Bod said: "At this point, you can say the government's [economic] policy has failed." Hungary needed to return to the IMF, he said, adding: "The prime minister talks about growth in every sentence, even when promising fiscal discipline... The honest thing to do is to state that there will be no growth."

While most expect Hungary to return to the IMF, the manoeuvre represents a painful climb-down. Orban split with the IMF shortly after returning to office, after the European Commission and the IMF refused to allow Hungary to run a 7% deficit, from which Orban had hoped to finance recession-busting counter-cyclical spending. The 18 months since have been dominated by a series of increasingly eye-catching revenue raising manoeuvres. First, multi-billion-euro crisis taxes were levied on banks and energy and telecommunications companies, and then some €10bn in private pension savings were nationalised.

But a return to the IMF became inevitable once investors lost confidence in the Orban government's ability to maintain fiscal stability. Over the past month, all three leading rating agencies have slashed Hungary's credit rating to junk status, while, until Orban indicated that he would be willing to make the compromises demanded of him by the EU and the IMF, Hungary's currency was plumbing an all-time low of HUF325 to the euro.

The combination of a weak forint and higher-than-anticipated spending means Hungary's budget deficit for 2011 is likely to be well over target. Meanwhile, government debt, at 83%, is at the highest level in Emerging Europe (though perhaps low by Eurozone standards).

This might all be manageable, were it not for investors' lack of confidence in the government's economic management, according to Neal Shearing of the consultancy Capital Economics. "The country is under pressure due to haphazard policymaking, including controversial measures such as the nationalisation of private pension funds, bank taxes and, most recently, a central bank law, viewed as trampling on its independence. These have all caused investors to take fright, leading to sell-offs in Hungarian assets."

But stability is what is least in evidence at the moment. Indeed, as Orban addressed the European Parliament in January in conciliatory terms, promising that the government was prepared to change a range of laws, including one that limits the independence of the central bank, in order to address the European Union's concerns and unlock IMF funding, his finance minister was responding to his party critics in increasingly irate terms.

When Zsigmond Jarai, another former central bank governor and a long-time adviser on economic matters to Orban, suggested that Matolcsy was looking "pretty worn out" and suggesting it was time for personnel changes at the top, Matolcsy responded with an official statement, published on his ministry's website, assuring his "former friend" Jarai that he was in "excellent physical and mental health."

The next day, Mihaly Kopits, a former head of the fiscal council who has been as relatively sympathetic to the government, called for changes at the top of the national economy ministry, saying that Matolcsy had "no credibility at home or abroad." Matolcsy responded with yet another official statement, entitled simply: "Who is Mihaly Kopits, and why?"

While Orban has not yet responded to the most recent round of criticism of Matolcsy, whom he has in the past called his "right-hand man", the strong-headed prime minister has in the past been reluctant to show weakness by dropping people when they are under attack. But change may be forced on him.

Playing for time

The announcement that the government was prepared to change a series of key laws affecting central bank independence and the independence of the judiciary had a positive effect on the forint, pushing it back below 300 to the euro by late January. Many speculate that the conciliatory tone was merely a bid to gain time until risk appetite returns to the financial markets.

If that was the plan, it has worked in the short term. On 24 January, the central bank's monetary policy council - now dominated by government appointees - felt comfortable enough about the strengthening forint to leave interest rates at 7%, despite voices cautioning that this was a risky move. "This move underlines that the autonomy of the monetary policy council is now limited. The forint did not fall falling the rate announcement because of the atmosphere of optimism surrounding the government's conciliatory rhetoric, but that could change if that optimism dissipates," says Eszter Gargyan, economist for Citigroup in Hungary.

However, given the current level of investor fright - Citigroup says risk aversion among buyers of sovereign debt has been sufficient to bring about currency depreciations in some countries, including Hungary, of more than those seen in the aftermath of the Lehman Brothers collapse in 2008 - few expect a return of risk appetite anytime soon.

Nonetheless, this has been the pattern over the past few months. When Hungary first confirmed it would resume talks with the IMF following sharp falls in the forint in December, it insisted that it would be seeking not a standby loan but what it termed an "insurance policy", without conditionality. It later emerged that the IMF was unaware of Hungary's intention to return to the negotiating table when the announcement was made, and that the only form of credit line available to Hungary would be a full standby loan, with strict conditionality attached.

As UBS points out in a note, the issue is one of confidence: "A Fund programme for Hungary would not really be an exercise in macro adjustment, but rather in institutional confidence-building - and, of course, in providing key funding buffers along the way."

The game of chicken could be bought to an end by a banking crisis. According to Capital Economics, Hungary has some €37bn of maturing external debt in 2012, mostly in the banking sector. In a risk-averse environment, Austrian and Italian parent banks, already stretched at home, could be reluctant or unable to roll this debt over, placing an enormous burden on the budget. Shearing suggests that this scenario could lead to even more dramatic falls in the forint, which could hit levels even lower than HUF325 against the euro, and force the central bank to push through substantial interest rate hikes. Under these circumstances, the government would have no choice but to bow to whatever demands were made of it by the EU and the IMF in order to get access to a credit line.

But even as it makes conciliatory noises abroad, there are signs at home that the government has lost none of its confrontational spirit, despite increasingly noisy protests both from party allies and an increasingly angry civil society.

On January 2, some 50,000 people gathered at a non-party demonstration in Budapest to protest at the coming into force of the new constitution. Further anti-government protests are planned for Hungary's March 15 national day. But when organisers attempted to lodge their request to hold a demonstration with police, they were told that the government had block-booked every single public space in central Budapest, leaving organisers with nowhere to hold their rally. This is not a government given to making compromises easily.