UPDATE 4-Hungary's PM puts ally at top of central bank in place of critic

* Matolcsy as c.bank head is "least risky decision" -Orban

* PM Orban says Mihaly Varga to be new economy minister

* C.bank head with government experience will bring stability-PM

By Krisztina Than and Marton Dunai

BUDAPEST, March 1 (Reuters) - Prime Minister Viktor Orban tightened his grip over Hungary's economy on Friday, putting a close ally in charge of the central bank in place of a critic of his go-it-alone economic policies, which have unnerved investors.

Orban's naming of Economy Minister Gyorgy Matolcsy to head the central bank follows an overhaul of the constitution and other moves that gave his ruling Fidesz party firmer control over the bank, media and courts, raising fears among some EU leaders that Hungary is sliding out of the European mainstream.

The architect of Orban's pro-growth policies, Matolcsy has imposed Europe's highest bank tax and nationalised billions of dollars in private pension assets, contributing to the collapse of loan talks with the IMF and EU last year.

He replaces Andras Simor, whom Orban's government tried to force out after it took power in 2010 by slashing his pay by 75 percent. Matolcsy's six-year term means he will control the National Bank of Hungary even beyond elections next year.

"Matolcsy is something of a bull in a china shop as far as markets are concerned," said Nicholas Spiro, head of London-based Spiro Sovereign Strategy.

"Make no mistake about it, his appointment ranks as one of, if not the most, controversial in the world of central banking."

The prospect of Matolcsy taking over the central bank has weakened the forint slightly in recent weeks, due to speculation that he would take aggressive action to pump more cash into a recession-stricken economy.

The bank had already been slashing interest rates in recent months despite the objections of Simor, who was outvoted by officials named by the Fidesz-controlled parliament.

A 57-year-old economist, Matolcsy has lashed out at banks and foreign companies for criticising the government and betting against the "junk"-rated assets of central Europe's most indebted country.

On Friday, he said he supported "conservative, responsible" monetary policy and the bank would stay independent. But he added it must aim for a "strategic partnership" with the cabinet as long as it did not threaten price stability.

"I am a supporter of a central bank that regards the relationship between government and central bank as an open, partner-like relationship," he told a news conference.

The forint currency initially eased after Friday's announcement but quickly recouped all of its losses.


The appointment comes as Fidesz tries to rebuild its popular support, which has dropped by almost half to around 25 percent in opinion polls since the 2010 election.

Orban needs to show crisis-weary Hungarians that the economy is finally moving out of the doldrums after a recession last year and has planned a string of measures to boost growth.

Matolcsy's approach has been in lock-step with that of Orban, who has eschewed traditional austerity in a bid to pull Hungary out of economic stagnation and campaigns about the need for country of 10 million to regain its "economic sovereignty".

"If ... our central bank does perform better, then the Hungarian economy can perform well," Matolcsy said. "Economic policy can stand on two feet: the cooperation of government and monetary policy."

Ignoring the reservations of its outgoing governor Simor, the bank made its seventh quarter-point cut in its base rate on Tuesday, bringing rates to 5.25 percent and matching the record low hit in April 2010 when Orban swept to power.

So far, the rate cuts have not forced investor flight, with the historically low interest rates in developed countries keeping up appetite for higher-yielding assets. Budapest also issued a successful dollar bond earlier this month.

But with high debt of around 80 percent of GDP, Hungary is the region's most exposed economy to sudden shifts in sentiment.

Analysts expect rate cuts to continue in coming months and said Matolcsy was unlikely to start his term with drastic steps.

But comments from foreign observers also reflected a wariness over taking comments from Fidesz officials at face value, particularly after the government's abandonment of talks with the EU and IMF after months of saying it wanted a deal.

"It is difficult to conceive of a less market-friendly candidate than Dr. Matolcsy to take over," Neil Shearing, an economist at London-based Capital Economics, said in a report.

"This is likely to erode the central bank's independence and the credibility of policymaking, and thus increase the risk premia on Hungarian assets."


In late January, Matolcsy said the central bank could support growth like those in developed economies such as European Central Bank, the Federal Reserve or the Bank of England are doing, but it must be cautious and conservative.

Outgoing bank chief Simor had been under mounting pressure from Fidesz to do more. Orban criticised his personal investments, calling him "an offshore knight", while Brussels accused the prime minister of interfering with the bank's independence.

Appointed by a Socialist government in 2007, Simor had opposed Orban's desire for looser monetary policy to spur recovery ahead of elections in 2014. One of Simor's deputies, Ferenc Karvalits, will also leave the bank at the end of March.

To replace Matolcsy as economy minister, Orban tapped former finance minister Mihaly Varga, who told a hearing the government would not change course.

He added that there was no way it could boost spending ahead of a 2014 election.

Deputy state secretary in charge of taxation, Adam Balog was picked as a third deputy central bank governor. Now parliament must name an additional member to the board and expand it to the maximum allowed nine, all but one Fidesz appointees.