May 15 (Bloomberg) -- Latvia’s leaders and the international lenders they turned to for help have bet the Baltic state’s economy and social stability on joining the euro.

The price so far: an 18 percent economic contraction in the first quarter, the sharpest in Europe, as well as wage cuts and spiraling unemployment. Street protests and rioting were later followed by the ouster of the previous government on Feb. 20.

Across Eastern Europe, recessions are deepening as export- led economies are hurt by the evaporation of credit in their most important western markets. The IMF has stepped in with emergency loans to Latvia, Hungary and Romania within the European Union, and Ukraine, Serbia and Belarus outside the bloc. Conditions are harsher in Latvia because of its pledge to peg its currency, the lats, to the euro.

“We are seeing one of the strongest contractions on record,” said Marco Annunziata, chief economist at UniCredit Group in London. “It’s really quite frightening.” Still, the strategy is “probably the right one, given that the end game is the euro zone.”

Domestic demand in the economy that had the fastest growth in the European Union in 2006 has collapsed. Latvia’s current account deficit, which reached 27 percent of gross domestic product in the fourth quarter of 2006, turned to surplus in the first two months of 2009. Retail sales fell 25 percent in the first quarter.

Never Before

“They are trying to do something that has never been done before” by cutting wages and prices during a contraction to restore a loss of competitiveness, said Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen.

The central bank cut its refinance rate to 4 percent on May 13, the second reduction this year, in an attempt to boost borrowing amid a liquidity squeeze and tighter lending standards. The bank also has bought about 1.1 billion lati since September 2008 to defend the currency.

The interventions have reduced Latvia’s foreign currency reserves by 36.7 percent to $3.8 billion compared with September last year, according to April data. By removing lati from circulation, interest rates on the Rigibor, the interbank lending market, have risen 42 percent since Feb. 3 to 13.7 percent on May 14, for six-month loans.

More Funding?

“The adjustment that Latvia is undertaking is almost without historic precedent, and because of that, the program will need additional funding” from the EU and the IMF, said Aidan Manktelow, a London-based analyst at the Economist Intelligence Unit.

Latvia plans to adopt the euro in 2012 to boost investment and make life easier for its citizens and companies who’ve taken about 90 percent of their loans in euros. As part of the process, the country entered the Exchange Rate Mechanism, the waiting room for euro adoption, and unilaterally fixed its currency to the common currency. Estonia and Lithuania joined the mechanism at the same time.

Latvia’s 7.5 billion-euro ($10.1 billion) rescue, from a group led by the European Commission, the IMF and the Nordic countries, is worth about 34 percent of 2007 GDP, about twice the ratio of Hungary’s 20 billion-euro bailout.

Swedbank AB and SEB AB, two of Sweden’s largest banks, are the biggest lenders in the Baltic region. Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market.

Spending Spree

The bailout comes after a boom following EU accession in 2004 as cheap loans helped create a real-estate bubble and public sector pay increases sparked a consumer spending spree. GDP grew an average of 10 percent a year between 2005 and 2007.

“Most of the central and eastern European region experienced a credit boom, asset price bubble, expansionary fiscal policies and large increases in external debt over the last six years,” said Kenneth Orchard, Moody’s Investors Service’s London-based vice president and senior analyst for the Baltic region. “The only difference in Latvia was that the boom was much bigger, causing imbalances to become more extreme.”

The central bank expects GDP will decline 16.5 percent this year and Prime Minister Valdis Dombrovskis is calling for a wider budget deficit than the 5 percent originally agreed in the bailout. Measures to trim state spending will include closing some hospitals and schools. They may be passed by parliament in June.

On April 2, thousands of teachers gathered outside government offices in Riga, the capital, to rally against pay cuts. The protest followed a Feb. 3 demonstration by farmers, who drove tractors into the city center, and the country’s worst civil violence on Jan. 13, when a few hundred youths rioted in the old city after a peaceful protest dispersed, smashing shops and clashing with police.

“The Baltics have proven that they are flexible enough to carry out these reforms and wage cuts,” said Neil Shearing, an emerging market economist at Capital Economics Ltd., in London. “The only danger is that public pressure could grow due to the rounds of budget cuts.”

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

Last Updated: May 14, 2009 21:40 EDT