June 17 (Bloomberg) -- Sweden’s economy, enmeshed in the steepest recession in at least 15 years, will suffer a further blow from its banks’ decade-long expansion in the Baltic states.

Writedowns for Swedish banks in eastern Europe, especially the Baltics, may cost 5 percent of Swedish gross domestic product, Fitch Ratings Ltd. estimates, even after Latvian lawmakers last night approved deep cuts in public spending to unlock the next part of a bailout loan and avert a devaluation.

Swedbank AB and SEB AB, the largest banks in the Baltics, have loaned more than 366 billion kronor ($48 billion) there, respectively 17 percent and 13 percent of total loans. That means the banks will be hurt whether Latvia devalues the lats or not, depriving the Nordic region’s biggest economy of a much- needed stimulus, says Roger Josefsson, chief economist at Danske Bank A/S in Stockholm.

“If Swedish banks suffer from large loan losses in the Baltic states they will be forced to shrink their balance sheets, not just in the Baltic states but in Sweden too,” Josefsson said. “Since Swedbank and SEB account for a large part of the lending in Sweden -- Swedbank to households and SEB to companies -- it will obviously have an effect on Sweden.”

Latvia is avoiding bankruptcy by complying with the terms of the bailout, Prime Minister Valdis Dombrovskis has said. Even so, the budget cuts assumed under the terms of loan from the European Commission and International Monetary Fund-led group threaten to exacerbate the European Union’s worst recession. That may hurt Sweden’s banks just as much as a lats devaluation.

‘Similar Level’

“Banks will see a major rise in bad loans across the Baltic states as real wages fall and unemployment rises, whether currency devaluation is avoided or not,” said Aidan Manktelow, an analyst at the Economist Intelligence Unit. “The effects would be more concentrated in the event of currency devaluation, but the course of ‘internal devaluation’ ultimately implies a similar level of loan losses. Either way, there will still be a high chance that the Swedish banks will need to inject additional capital into their Baltic subsidiaries.”

The banks will have to write down 170 billion kronor this year and next, Sweden’s central bank estimates in its main scenario, with the Baltic accounting for almost 40 percent of that. In a worst case scenario, loan losses could reach 300 billion kronor, the bank said.

“The Swedish economy is going to get hit, sending the krona lower,” said Ian Stannard, a currency strategist in London at BNP Paribas SA. “Either we get all the bad news now with a Latvian devaluation, or we get it drip fed over the next few months.”

‘Obvious Effect’

Sweden’s krona is the worst-performer against the euro this month of the 16 major currencies tracked by Bloomberg, having lost 3.1 percent. Swedbank and SEB are among the worst performers in Sweden’s benchmark index of stocks this year.

It is “obvious” Latvia’s crisis will affect Sweden, Finance Minister Anders Borg said on June 5.

The economy of Latvia, which pegs the lats to the euro, contracted 18 percent in the first quarter. The government yesterday passed into law spending cuts of 500 million lati ($1 billion) to unlock a 1.7 billion euro tranche of its 7.5 billion-euro ($10.4 billion) IMF and European Commission loan.

In statements last night, the organizations welcomed the parliamentary approval and said they would assess the move and decide on disbursement “without delay.”

The budget includes pay cuts as deep as 20 percent and 10 percent pension reductions, undermining households’ and businesses’ ability to service debt.

‘Conservative’ Outlook

Sweden’s crisis has been export-led, leading to an economic contraction of 6.5 percent in the first quarter. As global markets show signs of recovery, the outlook is improving. After contracting 4.5 percent this year, the economy will grow 1.3 percent in 2010, the central bank estimates.

Still, Fitch’s estimated cost of 5 percent of GDP to cover bank losses linked to the Baltics is “conservative,” said Eral Yilmaz, associate director at Fitch Ratings Sovereign Group in London.

“Loan losses in the Baltic states hurt Swedish banks’ profitability, reducing the income credits on the current account,” Yilmaz said. “It will increase the government’s borrowing requirements at a time of increased competition for international financing.”

Sweden’s Riksbank on May 27 said it would bolster reserves by 100 billion kronor ($13 billion). It said on June 10 it will borrow 3 billion euros from the European Central Bank to safeguard financial stability.

The government injected 50 billion kronor in capital to support its lenders and loaned 10 billion kronor to Latvia, to be paid in 2010. That, plus the economic stimulus, account for 30 percent of Sweden’s estimated 200 billion-krona deficit in 2009 and 2010.

“Swedish banks, like all other banks operating in the region, will face big loan losses in the Baltics even if there is no devaluation,” said Maris Lauri, Swedbank’s chief economist for Estonia in Tallinn.

To contact the reporters on this story: Niklas Magnusson in Stockholm at nmagnusson1@bloomberg.net Aaron Eglitis in Riga at aeglitis@bloomberg.net

Last Updated: June 16, 2009 18:00 EDT