June 4 (Bloomberg) -- Latvia currency traders expect the lats to drop to half its value against the euro within a year as the Baltic nation struggles to cope with the effects of the global financial crisis, said Bank of America Corp.-Merrill Lynch & Co.

Forward contracts price the lats 53 percent weaker than its current spot rate of 0.7073, Benoit Anne, the London-based chief strategist for Emerging Europe, Middle East and Africa, said in a phone interview today. Forward contracts are agreements in which assets are bought and sold at current prices for future delivery.

Speculation that Latvia may be forced to scrap its currency peg to the euro has intensified as the central bank stepped up its defense of the lats in the past two weeks and the government failed to sell any bills at auction yesterday. Latvia defends a 1 percent band around a target rate to the euro in a quasi- currency board system preceding adoption of the single currency. The system is backed by foreign-exchange reserves held at the central bank.

“A look at the macro picture suggests that the peg is not sustainable, mainly owing to the substantial external-sector vulnerabilities,” Anne said. “Investors are already betting on it and we estimate that if the move happened, it would presumably be large, in the order of 20 to 25 percent.”

Latvia’s central bank will maintain the lats’ peg to the euro until the country adopts the single currency, the Riga- based lender said in a statement today.

Devaluation Consensus

“There seems to be a reasonable market consensus that Latvia will devalue,” said Paul McNamara, who helps manage $1.6 billion of emerging-market debt at Augustus Asset Managers Ltd., in London. “It’ll take a couple of months. In the current risk- loving environment it shouldn’t have a bigger impact on other east European currencies, but if it coincided with renewed stress in the markets and especially the banking sector it could be quite nasty.”

The economy of the ex-Soviet republic shrank an annual 18 percent last quarter, the biggest slump in the European Union. Latvia and its neighbors Lithuania and Estonia have led the EU’s economic slowdown after their economies, fueled by property and spending booms, expanded at the fastest rates in the bloc in 2006.

Latvia needs to do more to limit the increase in its budget deficit, the EU said today in a statement. The International Monetary Fund is also planning to make a statement today.

Budget Agreement

The country must agree on a revised budget with the IMF and the EU’s executive branch to keep receiving money from a 7.5 billion-euro ($10.6 billion) international loan. The fund delayed a 200 million-euro transfer in March after the government failed to make budget cuts.

“Investors remain nervous about this issue, but an imminent devaluation looks unlikely,” said Paolo Batori, a strategist at UBS AG in London.

Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on the economic crisis, said on June 1 that the Baltic country will need to devalue its currency, adding that “the timeframe is always uncertain.” Justice Minister Mareks Seglins said a day earlier the government should debate a devaluation of the lats, the Baltic News Service reported.

Contracts tied to Latvia’s debt jumped 54 basis points to 729, according to CMA DataVision, while default swaps on Lithuania climbed 32.5 to 482.5 and Estonia rose 16 to 368.5.

A basis point on a credit-default swap contract protecting 10 million euros ($14 million) of debt from default for five years is equivalent to 1,000 euros a year.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company or country fail to adhere to its debt agreements. A decline signals an improvement in the perception of credit quality; an increase, the opposite.

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To contact the reporter on this story: Ewa Krukowska in Brussels at ekrukowska@bloomberg.net

Last Updated: June 4, 2009 08:01 EDT