(Refiles to add dropped word "deficit" in 1st paragraph)
* Hungary deficit to rise to 3.9 pct of GDP in 2009
* Deficit to fall below 3 pct only in 2011
* Economy to shed 6.7 pct this year, 0.9 pct in 2010
* IMF, EU agree to disburse more funds from standby loan
(Updates with analyst comment, adds byline)
By Balazs Koranyi and Gergely Szakacs
BUDAPEST, May 18 (Reuters) - The International Monetary Fund and the European Commission allowed Hungary to raise its budget deficit this year and next, preventing the need for more austerity measures that could have stifled its ailing economy even further.
Hungary, the first European Union member to resort to international aid, secured a $25.1 billion IMF-lifeline in October. It now faces the worst downturn in about two decades as a collapse in demand in western Europe cuts jobs and incomes.
On Monday, Finance Minister Peter Oszko said the economy would contract by 6.7 percent this year, far below 0.9 percent projected when the programme was first drawn up. Oszko said the economy could shed a further 0.9 percent next year.
Under the agreement with the IMF and the EU, which on Monday praised the government's efforts to combat the crisis, Hungary will be allowed to let its budget deficit rise to 3.9 percent of GDP this year, up from 2.9 targeted before.
Even so, the finance minister said the economy would return to growth and the deficit fall below 3 percent only in 2011.
European Commission official Elena Flores said recent government measures kept the country on track to meet the conditions of its loan agreement with the EU and receive a third instalment of money later this year.
"We most welcome the structural measures the government has been taking ... and those measures that are of a structural nature are not only relevant for 2009 or 2010 but are very relevant for later to change the trend," Flores said.
VICIOUS CYCLE AVERTED
Analysts said news of the higher deficit was market neutral as most figures had already leaked out of the negotiations, however, it was a positive that the threat of an downward economic spiral had been averted.
"The essence is that the IMF has recognised that...if they (the IMF) require further restrictions (to meet the deficit) target, that would deepen the recession further and cause a vicious circle," analyst Gergely Suppan said at Takarekbank.
Hungary's new government, which took office in April, has already pledged budget cuts worth 1,300 billion forints ($6.12 billion) this year and next to prevent an excessive deficit.
The fiscal reforms will ease some of the economy's structural problems but the initial impact of the measures will be to deepen the recession. Hungary reported a 6.4 percent slide in GDP in the first quarter.
"The good news is that no further restrictions which would deepen the crisis further are needed," Suppan said.
The IMF said it had reached agreement to pay out a further $1.43 billion to Hungary and welcomed the government's measures to tackle the crisis.
"On the basis of these measures both on fiscal sustainability and financial stability, we expect that Hungary will have stronger government finances as a result and there will be greater assurances of financial stability," James Morsink, the head of the IMF delegation told a news conference.
"And therefore Hungary, we expect, will emerge from the crisis in a stronger position than it was before." (Reporting by Balazs Koranyi and Gergely Szakacs, Editing by Patrick Graham and Andy Bruce)