* Govt must be ready to take steps to manage budget risks
* Hungary's medium-term potential GDP growth seen lower
* IMF sees gradual, cautious rate cuts continue
(Adds more detail, background)
By Krisztina Than
BUDAPEST, Oct 20 (Reuters) - Hungary must be ready to take more steps if needed to meet its budget deficit targets in 2009 and 2010 as there are risks to them in both years, the International Monetary Fund (IMF) said on Tuesday.
The government must also take further adjustment measures in order to lower the deficit under 3 percent of GDP in 2011, the IMF said in a report on the third review of Hungary's performance completed last month.
The prod from the Fund illustrates both the more lenient approach by the IMF during this economic crisis than in last decade's Asian turmoil but also its steady pressure on bailout recipients.
Other EU states Latvia and Romania have dragged their heels in meeting commitments to reforms under similar rescue deals but they have also faced constant pressure to meet terms.
"The government should be prepared to take additional measures, if necessary, to underline its commitment to fiscal sustainability," the IMF said in its report on Hungary.
Hungary has to keep the budget deficit at 3.9 percent of gross domestic product this year and reduce it to 3.8 percent next year under its financing deal with the IMF and EU which saved the country from financial collapse last year.
The IMF said Hungary's programme was on track, and its plan to manage the risks to the 2009 target was appropriate but a potential big negative shock to revenues or slippages in expenditure "would require a quick and forceful response".
The Fund said Hungary continued fiscal consolidation and stable external financing conditions should allow for further cautious interest rate cuts.
However, risks to medium-term economic growth remained tilted to the downside with potential GDP growth in this timeframe now put at 2.5 percent versus 3.0 percent during the second review earlier this year.
Last month Hungary agreed with the IMF to extend access to its loan facility by six months until October 2010, to have it as a safety buffer, while it also signalled its plan to come off external aid and finance itself from the market again.
The IMF said the proposed rephasing of the remainder of the package would allow the central bank to maintain reserves at about 90 percent of short-term external debt at remaining maturity.
RISKS IN 2010 BUDGET
As for 2010, the IMF said strict spending controls and a cautious use of budget reserves will be key to manage risks in a year when the country faces parliamentary elections in April or May which the main opposition party Fidesz looks likely to win.
"The budget is premised on reasonable assumptions and includes larger contingency reserves than in the past. However, risks remain and, if combined, could rapidly exhaust planned buffers," the Fund said.
Hungary, which previously ran excessive budget deficits due to heavy overspending, has cut the gap sharply in the past years and must keep fiscal policy disciplined this year and next despite suffering the deepest recession in almost two decades.
The economy is expected to contract by 6.7 percent this year and return to growth only in 2011. The Fund said it forecast Hungary's real GDP to grow by 3.2 percent in 2011 as the economy is expected to rebound in line with a global recovery.
Hungary's external debt, seen peaking at 132.3 percent of GDP at the end of this year, is seen gradually declining from 2011 to about 115 percent by 2014, on an improvement in the trade balance, a pick-up in growth and a return of non-debt creating capital inflows.
Returning its debt level to a downward path is key for the long-term sustainability of Hungary's finances.
For highlights of IMF report pls click on [ID:nLK420065] (Editing by Stephen Nisbet)