UPDATE 3-Czechs drop 2010 euro target, no new time frame set

(Releads with quotes from official proposal for government)

By Marek Petrus

PRAGUE, Oct 25 (Reuters) - A yawning fiscal deficit forced the Czech Republic on Wednesday to drop its aim of adopting the euro in 2010, reinforcing the market's view that euro zone entry was a distant prospect for larger central European economies.

A euro convergence analysis prepared by the finance ministry and the central bank (CNB) recommended the government should not try to peg the crown to the euro within the European Union's ERM-2 mechanism in 2007.

"This decision means a shift in potential entry of the Czech Republic to the euro zone beyond the (earlier) considered horizon of 2009 and 2010," said the analysis for the government, which Reuters obtained from a finance ministry source.

Cabinet meets at 7:30 p.m. (1730 GMT), with a news conference scheduled for 9:30 p.m. (1930 GMT).

Czechs have wanted to avoid spending more than the required two years with the crown locked within the ERM-2's bands, as it could create confusion by giving the CNB another target to add to its existing inflation goal.

The country will be left with no time frame for euro adoption, as the finance ministry and the central bank said the deficit-riden budget and the inflexible labour market must be reformed before any decision can be made on a target date.

Currency and debt markets shrugged off the news. A euro entry delay matched expectations that a deepening budget deficit will prevent Czechs from meeting the entry criteria until at least 2012-2013, despite economic growth of 6 percent annually.

"Fundamentals have been good. But political -- and consequently fiscal -- dynamics for early euro adoption have deteriorated recently," said Radoslaw Bodys, central Europe economist at Merrill Lynch in London.

LOWER CPI TARGET

Fading political will to slash budget gaps below the euro entry limit of 3 percent of gross domestic product (GDP) has also cast doubt on the euro entry timetables of central European peers, Poland and Hungary.

Burgeoning welfare spending is forecast to boost the Czech fiscal gap to 4.2 percent of GDP in 2007, but the protracted parliamentary deadlock following a June election has put any fiscal reforms off the political agenda.

Meanwhile, the analysis said the CNB might cut its inflation target to avoid the risk of breaking euro zone entry rules, which require inflation to be at most 1.5 percent above the three best performing EU members on price stability.

The CNB aims for annual inflation of 3 percent, allowing for deviations of plus or minus one percentage point -- a set-up that permits price growth above the threshold, which was 2.77 percent based on September data.

Central bank watchers, and some policymakers, have suggested earlier the CNB could cut the target's midpoint to 2.5 percent.

"That would also be negative for the bond market -- a downward revision to the CNB inflation target ... may require tighter monetary policy," said Bodys at Merrill.

Czech 5-year/5-year forward rates <BNPPCZK> -- a key gauge of a country's euro adoption prospects -- have hovered a touch below the euro zone benchmarks, indicating investors have been betting on full debt yield convergence by 2011. ((Editing by Gerrard Raven; Reuters Messaging: rm://marek.petrus.reuters.com@reuters.net; e-mail: prague.newsroom@reuters.com or marek.petrus@reuters.com; Tel: +420 224 190 477))

Keywords: ECONOMY CZECH EURO