Oct. 13 (Bloomberg) -- The Latvian Cabinet’s preliminary agreement to adhere to the fiscal terms of its bailout is “very good news,” European Commission Monetary Affairs Commissioner Joaquin Almunia said.

“The political commitment by the government shows the government is complying with the program,” Almunia told reporters in the capital Riga today. “I have received from the Latvian government that they are committed to the 500 million lati ($1.04 billion) consolidation.”

Almunia met with Prime Minister Valdis Dombrovskis today, a day after the ruling coalition said it will try to find 320 million lati ($668 million) in spending cuts and 180 million lati in tax increases in a bid to meet the demands the International Monetary Fund, the EU and Sweden attached to a 7.5 billion-euro ($11.1 billion) loan.

Yesterday’s Cabinet talks followed criticism from lenders that the Baltic state hasn’t shown enough commitment to its loan terms, which call for budget cuts of 500 million lati a year until 2012. Latvia tried to persuade donors to sign off on 325 million lati in budget cuts, prompting Swedish Premier Fredrik Reinfeldt to tell Latvia it “must correct” its deficit. The EU has called for better coordination in the country’s talks.

“We expect these comments and the budget accord to help relieve the recent market nervousness,” Yarkin Cebeci, an economist at JPMorgan Chase Bank in Istanbul, said in an e- mailed note.

‘Unsettled Markets’

Dombrovskis said the 500 million lati in budget cuts will leave the deficit at about 7.5 percent of gross domestic product next year, compared with the planned 8.5 percent target, citing finance ministry calculations.

“Since the start of the crisis last year, communication about Latvia has often unsettled the markets,” said Kenneth Orchard, a senior analyst at Moody’s Investors Service in London. “There has been a constant effort by the European Commission and the IMF to coordinate communication. It’s going to be an ongoing saga at least until after” general elections a year from now.

Latvia, which like neighboring Lithuania and Estonia pegs its currency to the euro as part of the exchange-rate mechanism 2, is suffering the EU’s second-deepest recession behind Lithuania after a lending boom spurred a property bubble that burst when the credit crisis descended on the region.

“As long as the economy remains weak, I can’t see this getting any easier,” Orchard said.

Output Slump

Gross domestic product contracted 18.7 percent in the second quarter, compared with a 20.2 percent slump in Lithuania and a 16.1 percent decline in Estonia.

Riga’s OMX Index fell 1.9 percent to 307.46 at 6 p.m. in Riga. The yield on Latvia’s 5.5 percent government bond due March 2018 rose 6 basis points today to 7.299 percent. The lats was little changed at 0.7093 per euro.

“Some good signals are starting to appear in the economic horizon in Latvia,” Almunia said. “If this budget of 2010 is adopted as has been agreed, this will create the conditions for positive growth again in Latvia before the end of 2010.”

Cabinet talks may drag on even after Almunia’s visit. The country’s biggest coalition party, the People’s Party, has said it may not support the Finance Ministry’s proposed cuts.

Dombrovskis and Finance Minister Einars Repse are members of the New Era Party. Repse must submit the proposed budget by Oct. 28. Lawmakers will vote on the budget a month later.

Almunia Not God

“Almunia is not the god, the lord,” Vents Krauklis, the party’s deputy faction leader said, according to the Leta newswire. The party last night said its chairman, Mareks Seglins will step down on Nov. 21, and may be replaced by Andris Skele, a three-time former premier. Skele said the party should support Dombrovskis’ government as long as it has the confidence of the president and the Parliament, according to the statement.

Danske Bank A/S said Skele’s previous support for a lats devaluation “could unnerve markets yet again,” in a client note today. Skele in August suggested widening the trading corridor of the lats band. He also called for a budget deficit of 3 percent of GDP in 2010, and to sell as soon as possible Parex Banka, the lender the state took over in November.

The region’s economic decline is hurting Swedish lenders as Stockholm-based Swedbank AB and SEB AB, the biggest banks in the Baltics, try to contain loan losses. Dombrovskis has struggled to limit the domestic fallout of the stipulated austerity measures, also needed to maintain the euro peg, and last week proposed capping mortgage holders’ liability.

Quell Speculation

That led to speculation, which the government has sought to quell, that the country may be preparing the ground for a lats devaluation by limiting the domestic losses such a move would incur.

Sweden’s krona slipped as much as 0.7 percent against the euro today to trade at 10.3663 at 5:10 p.m. in Stockholm. Swedbank lost 3 percent to 64.25 kronor and SEB AB was down 1.1 percent at 45.6 kronor.

Even as austerity measures exacerbate the nation’s recession, Latvia has no choice but to push through the IMF and EU-ordered budget cuts or risk spiraling debt levels that would undermine its chances of adopting the euro, Orchard said.

“If they start slipping, then the debt-to-GDP ratio could go to 80 percent or 90 percent and that may not be sustainable,” he said.

The country targets euro adoption, which requires member states to have budget deficits no wider than 3 percent of GDP and debt levels within 60 percent of GDP, in 2014.

The agreed budget cuts are “politically acceptable,” Dombrovskis said today after meeting with Almunia.

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

Last Updated: October 13, 2009 11:13 EDT