Hungary's battered currency strengthened yesterday after the IMF announced that it had reached broad agreement with the Government on a rescue package to stabilise the economy. The forint has lost almost 20 per cent in the past month against the euro and the dollar.

The IMF package is likely to stave off growing fears that Hungary could be the next Iceland, with potentially catastrophic consequences across the region if an EU member state's economy was allowed to collapse. Yesterday's downgrading of Romania's debt rating to junk status did little to help.

The IMF did not disclose figures but analysts believe the rescue will involve more than $10 billion (£6.4 billion).

Dominique Strauss-Kahn, managing director of the fund, said: “The policies Hungary envisages justify an exceptional level of access to resources.”

The rescue is expected to be conditional on the minority Socialist Government cutting spending, which is among the highest in Europe as a proportion of GDP, by about 300 billion forints (£863 million) next year. Public sector wages and pensions may be reduced. Eszter Gargyan, an economist at Citigroup, said: “It is positive that it will not be just a financial package but also a policy package, which suggests further cuts in public expenditure and measures to provide growth.”

The speed and scale of Hungary's economic problems took many by surprise but its economy has been riddled with structural problems for years. Central Europe's former wunderkind is now its walking wounded. Before 1990, Hungary's Communist leaders ran the most relaxed regime in the region, allowing limited private enterprise and sening emissaries to the IMF and Western capitals to lure foreign investment. The strategy worked: when the one-party system collapsed, investors flocked to Hungary, which soon enjoyed an economic boom.

But Hungary has long since been overtaken by its neighbours. Foreign investment is lagging and capital was leaving long before the credit crunch, often for Slovakia and Romania, which have introduced flat taxes of 19 per cent and 16 per cent.

Hungary has one of the highest tax rates in the region, with 20 per cent of the labour force paying 80 per cent income tax. Employers pay more than 30 per cent social security contributions and the tax regulations keep changing, adding to uncertainty.

The Government has attempted to bring more taxpayers into the system but the grey economy still accounts for about 18 per cent of GDP. Numerous companies pay their employees the minimum wage of 69,000 forints (£200) a month and then boost it by refunding VAT receipts for goods bought by employees in the company's name. Last year Hungary had the lowest rate of economic growth in the European Union, at 1.1 per cent, while unemployment is at 7.5 per cent. Inflation in September was 5.7 per cent.

Ferenc Gyurcsany, the Prime Minister, who is a former Communist youth leader turned multi-millionaire, has never recovered from the political damage inflicted by his speech two years ago when he admitted that the Government had lied about the economy.

Despite Mr Gyurcsany being hailed as a reformer, his critics say that he proved woefully inadequate in the task of modernising Hungary.

Social polarisation is growing. Many of Hungary's new rich have their roots in the former Communist nomenklatura and used their connections to make fortunes in the early 1990s. But at the same time poverty is widespread and one third of the population lives on or below the poverty line.

Hungary is also burdened with a political class whose primary interest appears to be self-enrichment, while the concept of public service for its own sake remains a novelty. The country fell eight places from last year on Transparency International's perceptions of corruption index, to 47.

Corruption cases are often allowed to fade away. As one political insider said: “The Government and opposition have so much dirt on each other that nobody is ever guilty of anything.”

Keeping Iceland afloat

Iceland is seeking $4 billion (£2.56 billion) in loans in addition to the $2billion it has sought from the International Monetary Fund, its Prime Minister said. Geir Haarde expected that gross domestic product could fall by as much as 10 per cent next year, with the budget deficit set to soar. Fredrik Reinfeldt, the Swedish Prime Minister, said that the Nordic countries were ready to help Iceland and would set up a working group to look at the issue.

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