June 4 (Bloomberg) -- Latvia’s central bank pledged to defend its currency’s peg to the euro after some investors shunned assets linked to the Baltic nation on concern its economic collapse will precipitate a devaluation.

The bank “has explained and clearly said that it will maintain the stability of the lats until the lats is replaced by the euro,” it said in a statement on its Web site today. “It’s clear that such a mechanism as a fixed currency exchange rate allows the Bank of Latvia to achieve this policy.”

The Baltic country, which is suffering the severest recession in the European Union, is struggling to rein in its budget gap in order to secure the continued payment of an international bailout. Latvia’s economic collapse is threatening the prospect of recovery in Sweden, known for its textbook handling of its 1990s banking crisis, because the largest Nordic nation’s banks are the biggest in the Baltic region.

The situation in Latvia is “markedly worrisome,” Swedish Finance Minister Anders Borg said in a statement on the government’s Web site today. The economy shrank an annual 18 percent in the first quarter.

Credit-default swaps linked to Baltic government debt rose for a second day today. Contracts on Latvia soared 60 basis points to 735, the highest since April 28, according to CMA DataVision prices at 12:20 p.m. in London. Default swaps linked to Lithuania climbed 35 basis points to 485 and Estonia rose 12.5 to 365.

Credit Default Swaps

The cost of protecting Swedish government and bank debt also increased. Contracts linked to the country rose 2.5 basis points to 60, CMA prices show. Default swaps on Stockholm-based SEB AB, the second-largest lender to Baltic borrowers, jumped 47 basis points to 195, and Svenska Handelsbanken AB rose 7.5 to 102.5, CMA prices show.

Investors fled assets linked to the Latvian economy yesterday after a lack of lati on the market lifted interbank rates. Latvia’s Treasury yesterday failed to sell bills at an auction at which 50 million lati were offered. At a tap auction today, the Treasury sold 2.75 million lats ($5.5 million).

The failed auction yesterday sparked a 16 percent decline in shares of Stockholm-based Swedbank AB, the biggest bank in the Baltic states.

SEB Shares

SEB AB, the second biggest lender in the region, dropped 11 percent, while Nordea AB decreased 5.2 percent. Those declines contributed to a 3.1 percent slump in Sweden’s benchmark index. The index was down 0.5 percent as of 2:41 p.m. in Stockholm today.

“There is just a shortage of lati in the system overall,” said Kristaps Strazds, head of trading at SEB AB’s Latvian unit. “It’s not a question of price, it’s a question of liquidity.” The Treasury sold about 100 million lati in treasury bills in May, he said.

Latvian interbank lending rates rose to the highest on record today because of a lack of liquidity after the central bank removed lati from the market. The six-month Rigibor rate rose to 16.2 percent today. The three-month rate rose to 16.02 percent and the overnight rate rose to 16.8 percent, both also record highs.

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.

‘Responsible’

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

Latvia’s central bank buys and sells foreign-currency reserves to prevent the lats fluctuating more than 1 percent either side of 0.702804 per euro and is “responsible” for keeping the current exchange rate until the lats is replaced by the euro, the bank reiterated today.

Latvia, as well as Baltic neighbors Estonia and Lithuania, have kept fixed pegs to the euro throughout the global financial crisis, even as their economies suffer the deepest recessions in the EU. For Latvia, the peg is a condition attached to a 7.5 billion-euro ($10.2 billion) bailout from the International Monetary Fund loan.

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

‘Challenging’ Situation

The economic situation is “challenging and there is a need for action,” said Caroline Atkinson, the director of external relations for the IMF, in comments made today. “We recognize that we have to respond flexibly to changes,” she said at a press conference in Washington that was rebroadcast on the IMF’s Web site.

“I think the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg,” she said.

Latvia may yet be forced to devalue its currency, according to Oliver Weeks, an emerging market strategist at Morgan Stanley in London.

“We think that devaluation is inevitable and obviously getting closer,” Weeks said. Still, a devaluation “may not be quite as imminent as the market seems now to expect.”

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

‘Unlikely’ Devaluation

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

The lats strengthened 0.3 percent today as of 12:34 p.m. in Riga after the Treasury and other market participants bought the currency, said Strazds.

“During the past week, several Latvian politicians and economists have made public announcements about the exchange rate of the lats,” which have raised the usual “rumors” and “anxiety” in society, the financial markets and businesses, the central bank said.

Latvia’s recession has eroded tax revenue while the global financial crisis has pushed up the cost of credit, making it difficult for the government to keep its budget deficit under control.

Spending Cuts

The government has proposed spending changes in a supplementary 2009 budget, which is “a step in the right direction,” EU Monetary Affairs Commissioner Joaquin Almunia said in an e-mailed statement. He urged the Cabinet to do more to control the deficit and said that he received assurances that the country wants to keep the exchange rate peg.

“Sadly, the economic recession is proving more severe than expected in Latvia,” Almunia said. “I take note that the authorities want to control government debt and maintain their exchange rate peg. The supplementary budget presented this week is a first step. I am looking forward to seeing additional steps adopted.”

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

Last Updated: June 4, 2009 11:13 EDT