Fears over Latvia currency remain

Latvia is in recession after several years of boom

The Latvian government has said markets will stabilise once it has reached a deal with lenders, but fears remain it will have to devalue its currency.

The lat is under pressure after a bond auction failed. Latvia now hopes to raise money from the European Union and the International Monetary Fund.

Fears are growing that a crisis in Latvia, hit hard by recession, could trigger problems in the region.

A devaluation would hit European banks invested in Latvia.

It may also spark other devaluations in the region.

Market fears

The lat trades within a band against the euro. As currencies elsewhere have fallen, Latvia's fixed currency regime has made its exports uncompetitive.

In the past year, the government has spent almost one third of its reserves to support the currency, which has been at the weaker end of its trading band for the past two weeks.

We are just getting ourselves all worked up and creating emotion Valdis Dombrovskis

Asked about market nerves, Valdis Dombrovskis, the Latvian prime minister, said it was a situation "that will go over and when we have agreement with international lenders the market will also calm down".

"We have just to put this talk (about a devaluation) to one side," Mr Dombrovskis told Latvian television.

"We're just getting ourselves all worked up and creating emotion. The central bank and government have clearly said there will be no devaluation,"

The Latvian prime minister has tried to reassure investors

The country was granted a 7.5bn euro ($10.6bn; £6.5bn) IMF and EU bail-out last December, and hopes to secure a further 1.2bn euros from this pot in July.

However, to do so, the Latvian parliament first needs to agree on a revised 2009 budget.

A second reading of the budget, which will include more spending cuts, should be passed on 17 June, the prime minister said.

Any devaluation would have a disastrous impact on living standards in a country already badly knocked by the global recession. Latvia's economy contracted at an annual pace of 18% in the first three months of the year, a rate of decline that is expected to continue.

There has also been a sharp fall in consumer spending as unemployment has risen.

Regional fears

Governments elsewhere in the region are watching events in Latvia closely, amid fears that uncertainty there could weaken their currencies or hit banks heavily invested there.

A Polish central banker warned on Friday of the wider impact of the Latvian crisis.

"There is a threat that the situation in Latvia may spill over into the region," said Dariusz Filar, a member of the central bank's Monetary Policy Council.

"This situation is a challenge that requires a reaction on a broader scale than just Latvian, there is a need for more international assistance."

If Latvia is forced to abandon its currency board - a mechanism which requires it to retain a link with a foreign currency - other countries in the region, such as Estonia and Lithuania may be forced to abandon theirs.

"If one goes, the rest will have to go as they all have similar problems of overvalued exchange rates," said Neil Shearing, emerging Europe economist at Capital Economics.

The Latvian crisis could also hit banks in Sweden, amid fears that a devaluation of the lat could make it harder for borrowers to service debts. Swedbank, the biggest lender in the Baltic region, is seen as particularly vulnerable.

Given the illiquidity of the lat, some investors are using the krona to bet on the Latvian currency's devaluation.