Prime Minister Viktor Orban abandoned plans on Friday to merge Hungary's central bank and markets regulator, the first concrete evidence that he is backing down in a dispute with the European Union that threatens to block a deal on financial aid.

Orban's conservative Fidesz party has been criticized by the international community for introducing a swathe of measures that threaten the independence of the media, the judiciary and the central bank since sweeping to power in 2010.

Hungary's financial markets have taken a hammering in recent weeks as a result, and while some analysts remain suspicious that Orban may try to hold out to impress his domestic political audience, they say the government now looks ready to give in.

Friday's move was the first specific commitment since Orban made a broad pledge to the European Parliament earlier this week to compromise.

He said he expected to secure a political agreement with European Commission President Jose Manuel Barroso on the disputed laws next week and said he was ready to modify nearly all contested legislation to meet the EU's demands.

If we take stock of the issues that have emerged, I do not see any particularly difficult issues, Orban told Hungarian Kossuth radio. Naturally, several laws may have to be modified, but the government cannot do it, this can be done only by parliament, and we will make proposals to this end.

The planed merger of the central bank and financial regulator had been a key point of contention. Orban later added that Budapest also no longer insisted on a government member being present at Monetary Council meetings as an observer.

Austrian Vice Chancellor Michael Spindelegger, who visited Budapest for talks on Friday, told a joint news conference with Orban that the prime minister planned a very clear timetable and very clear solutions regarding legal issues for next week's meeting with Barroso.

EU Economic and Monetary Affairs Commissioner Olli Rehn, who had a meeting on Friday with Tamas Fellegi, Hungary's minister in charge for aid negotiations, said the government would need to take concrete steps to ensure central bank independence as a condition for formal talks to start on a financing deal.

He reiterated that before we can start formal negotiations on this EU-IMF financing program, certain preconditions must be met, Rehn's spokesman Amadeu Altafaj said.

In particular, he stressed that Hungary must take concrete steps to ensure full independence of its central bank.

I don't have a crystal ball but once the negotiations started I don't see the reason not to move in a business-as-usual manner and timing, so I don't expect more difficult or even longer negotiations than normally, Fellegi told a separate news conference after meeting Rehn.

He reiterated that Hungary was seeking a precautionary stand-by loan from the EU and International Monetary Fund.

The forint currency rose around 1 percent and prices of Hungarian bonds surged on Wednesday and Thursday on hopes the government was finally ready to reach a compromise that would open the way to a deal with the IMF and EU.

But Orban's comments on Friday had a more muted effect, reflecting a dip in the euro and other riskier assets globally and residual scepticism among investors as to his intentions.

Orban, who first earned fame in 1989 with a speech in which he demanded that Soviet troops leave Hungary and is seen by many as a fighter, began to reverse his combative stance towards the lenders only when the forint plunged to record lows and bond yields hit a ruinous 11 percent early this month.

PARTY POWER

Fidesz has used its two-thirds parliamentary majority to rewrite Hungary's key laws, critics say, to erode democratic rights and cement the party's power in the long term.

The Commission, the EU's executive, says new laws on the central bank, the retirement age of judges and the country's data protection authority violate European Union rules, and has given Hungary one month to change them or face legal action.

Orban, who has promised to take Hungary on an independent course that would not bow to pressure from external parties like the IMF, said there was only one difficult issue over which there would be a debate with Brussels - the requirement that central bankers take an oath on the Hungarian constitution.

It would not be appropriate if we would backtrack on this issue a single step without a debate, on all other issues I think we can come to an agreement, he said.

Orban said he would also be cautious regarding limits imposed on central bankers' pay, which the EU has also criticized, but which he said applies to all public sector jobs.

But in general the prime minister said Hungary should have had a safety agreement with the Fund and the EU yesterday, even if the country had no plans to draw on any such funding.

This agreement is important for us, the faster we make this agreement the better, he told radio.

POLITICAL DAMAGE

Analysts say Hungary, whose economy faces recession this year, needs the financial backstop to restore investor confidence shaken by policies including a windfall tax on banks and the renationalization of private pension funds.

Its budget deficit for this year is targeted below the EU's limit of 3 percent of economic output, after a one-off surplus last year thanks to a $13 billion pension grab.

But Hungary's debt is rated in the junk category by all three main rating agencies.

In exchange for a financing deal, Fidesz will have to change course and Orban may even have to consider replacing his Economy Minister Gyorgy Matolcsy, chief architect of the ad hoc and unorthodox policies that eroded credibility among investors.

While Orban's climbdown could cost him politically among some Hungarians who believe the EU is meddling in the country's affairs, it is far less damaging politically than a potential sovereign default and another slide for the forint, which could erode even Fidesz' core middle-class voter base, analysts said.

The government has maneuvered itself into a dead-end. They don't really have any other option than to reverse and accept the EU's strict conditions, said Peter Kreko, a political analyst at think-tank Political Capital.

This would mean a significant loss of political face ... but this is the only way the government can have a chance to preserve its position and win elections in 2014.

Over half of its voters have turned away from Fidesz since the party gained power in May 2010 and growing discontent with the government's policies brought tens of thousands of protesters onto the streets of Budapest early this month.

But the political opposition is weak and fragmented. The Socialists have not recovered from a humiliating defeat in 2010 and the far-right Jobbik party is not in a position to have a say in decision making given Fidesz's crushing majority.

(Additional reporting by Gergely Szakacs and Marton Dunai; Writing by Krisztina Than; Editing by Catherine Evans)

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