June 5 (Bloomberg) -- Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden.

“These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

Latvia’s economy contracted 18 percent last quarter, more than any other European Union member, as the government struggles to slash budget spending to keep its bailout funds flowing. Sweden’s krona lost as much as 1.2 percent against the euro today on concern that Stockholm-based Swedbank AB and SEB AB, the biggest banks in the three Baltic states of Latvia, Lithuania and Estonia, face losses in the European Union’s worst performing economies.

It is “obvious” that the crisis in Latvia will affect the economic development in Sweden, the Nordic country’s Finance Minister Anders Borg told reporters in Stockholm today.

Latvia’s parliament last night agreed on a 9.2 percent budget deficit of gross domestic product in the first of two readings. The legislature will cut spending in the second reading and adopt amendments on June 17 to receive disbursement from the European Commission and the International Monetary Fund.

‘No New Demands’

“There are no new demands” from international lenders, Dombrovskis said. The government is “continuing to work on reducing expenditure.”

The economic situation is “challenging and there is a need for action,” said Caroline Atkinson, director of external relations for the IMF, yesterday. “We recognize that we have to respond flexibly to changes. Latvia was granted a 7.5 billion- euro ($10.7 billion) bailout from the IMF and the Commission in December.

European Central Bank President Jean-Claude Trichet said yesterday he had ‘‘full confidence’’ the Latvian government will take ‘‘appropriate decisions that are needed on a domestic basis without any change in the currency.’’

Latvia’s bailout plan initially called for a budget deficit of 5 percent, though the Baltic country said it would ask for a shortfall of 7 percent after projections for its economic contraction were revised down.

Devalue?

‘‘Latvia may have to devalue its currency even if it manages to implement deep enough budget cuts this week to put its agreement with the IMF and EU back on track,’’ a team of analysts led by Thomas Stolper, said in a Goldman Sachs International note. ‘‘A Latvian devaluation would, in turn, intensify the pressure on its neighbors’ pegged currencies and hit asset prices across the central and eastern European region.’’

An agreement between Latvia and the EU and IMF on a new deficit target ‘‘will be important for maintaining the currency’s exchange peg to the euro,’’ Fitch Ratings said in a statement yesterday.

The government has said it will cut expenditure before its final approval of a 9.2 percent deficit after it lowered the economic outlook further to 18 percent for the whole year. Neither the IMF nor the EU has officially commented on the changes to the deficit.

‘Prepared’

Michael Wolf, Chief Executive Officer of Swedbank AB, the biggest bank in the Baltic states, said in a statement yesterday that the lender could handle a drop in the value of the lats. Latvia accounts for 6 percent of Swedbank’s total lending, with total loans to the Baltic states making up less than 20 percent of the total portfolio.

‘‘We are prepared for a number of various scenarios and we feel comfortable about our action preparedness, regardless of which way the Latvian government chooses to go,’’ Wolf wrote in statement published on the bank’s Web site late yesterday.

The Swedish krona fell for a third time in four days against the euro today, dropping 1.2 percent as of 12:52 p.m. in Stockholm.

Latvia’s foreign currency reserves grew 1.9 percent on the month to $3.9 billion in May, the Latvian central bank said today. The reserves are down 35.7 percent from September.

Opinion

Former Swedish Central Bank governor Bengt Dennis, who’s advising the Latvian government, said on June 1 that the question of devaluation ‘‘should instead focus on how it will be carried out,” rather than whether it will happen. The remarks helped increase speculation that a change in the value was imminent.

Dombrovskis later said Dennis’s comments were his own “individual” opinion.

Latvia sold 2.75 million lati ($5.5 million) in Treasury bills in a tap auction yesterday after failing to sell any of the paper on June 3, when it offered 50 million lati.

Dombrovskis said rumors of devaluation “negatively affected” the sale of the bills.

“This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” he said.

“Yesterday’s failed auction was not surprising amid negative sentiment and the spike in money market rates,” Fitch said. “Latvia’s shallow financial markets and a lack of counterparties make it difficult for the market to launch a ‘speculative attack’ against the currency.”

To contact the reporter on this story: Aaron Eglitis in Riga at aeglitis@bloomberg.net

Last Updated: June 5, 2009 06:58 EDT