Tim Gosling in Prague -

The European Commission recommended lifting the suspension of almost €500m in cohesion funds to Hungary on May 30 in recognition of Budapest's efforts to rein in its budget deficit. The move is the latest signal that the frosty relations between Brussels and Budapest are thawing.

However, the Commission also warned in its 2012 report on the country's convergence plan submitted in April that "Hungary continues to face serious challenges in the short to medium term," and that progress towards meeting the 2011 council recommendations has been "mixed".

Still, the commission's advice that the sanction on Hungary's development aid be dropped appears a significant victory for Hungarian Prime Minister Viktor Orban, who has demanded that the "unfair" penalty be lifted. The report cut its 2013 budget deficit projection for the second time since implementing the sanctions, cutting its forecast for the budget imbalance to just 2.7% of GDP.

The forint duly surged after Commission President Jose Manuel Barroso's comments at a news conference, reports Reuters. "We are... recommending that the suspension of the cohesion fund allocation for Hungary is lifted, as they have now taken the necessary action to correct its excessive deficit," Barroso said.

EU finance ministers will have the final say on the matter at a meeting in Brussels on June 22, but the Commission's recommendation is a strong indication the freeze will be lifted. "For Hungary, we consider that effective action has been taken," EU Economic and Monetary Affairs Commissioner Olli Rehn said of the progress made on Hungary's deficit.

EcoFin blocked the €495m in EU cohesion funds in March, demanding Hungary respond with deficit cutting measures by July. Ostensibly, the move was intended to push Hungary into making fiscal consolidation efforts to finally leave the EU's excessive deficit procedure for the first time since joining the bloc in 2004. However, it was clearly also a result of the increasingly bad blood between the pair in the first four months of the year.

A string of simmering disagreements over Hungary's economic policy - as well as moves concerning the judiciary and media - left Brussels refusing to agree to open three-way talks over an International Monetary Fund (IMF) loan programme. However, the Commission dropped its bad cop act in late April, and relations have since calmed.

However, that baton has been passed to the IMF, which has staunchly refused to open talks until it is satisfied that Budapest has withdrawn measures introduced in January that it says reduces the independence of the central bank (MNB).

The Hungarian parliament is set to finally vote through amendments to the central bank act on June 4, but it is suspected that not all recommendations are included in the bill. That worry was reiterated in Frankfurt in a May 30 convergence report from the ECB stating that Hungary - as well as six other CEE countries - fail to meet "all the requirements for central bank independence".

The continued lack of confirmation from either the IMF or EU that they are ready to open talks following that parliamentary vote has the markets wondering whether the international institutions will put the ball back in Hungary's court next month with further demands. "The government will have to address concern over executive control at the central bank moving to the MPC [the monetary policy council, which is now populated by government loyalists], which seems to have caused consternation at the IMF, EC and indeed ECB," Tim Ash at RBS writes in a note.

The forint lost some of the ground it had gained on the lifting of the EU funds sanction on the back of the ECB report, points out Bloomberg. The Frankfurt-based bank reiterated that the government's "strong commitment to engage in all policy issues relevant to macroeconomic stability" is a prerequisite for EU-IMF financial assistance. "Fiscal governance remains problematic in Hungary and is weakening investor confidence in the transparency, predictability and sustainability of Hungarian fiscal policies," it added.

Back in Brussels, despite the softer line on the cohesion funds, the European Commission expressed once more its strong concern over Hungary's economic and fiscal prospects. Worrying that the government faces a "pressing challenge" to stick to budget targets and adding that "wider reforms also remain necessary to promote the conditions for sustainable, investment-led growth," the commission forecasts a contraction of 0.3% in 2012, with recovery to a "modest growth rate of 1%" in 2013.

Ironically, it points its finger at the same fiscal measures that led it to lift the sanctions as being behind the deterioration. "Newly specified measures in Hungary's 2012 convergence programme will further depress domestic demand," the report reads. "In particular, in 2013 the financial transaction tax is the new measure that is expected to have the largest negative impact on the economy."

The taxes, which also include a new phone-call levy, will have a "substantial negative impact on private consumption expenditure," the report worries. "The new tax measures also imply that inflation is likely to remain well above the central bank's target rate over the forecast horizon," it added.