* IMF says significant level of stabilisation in Latvia
* Fund more optimistic on currency peg than 6 months ago
* Says big challenges persist, but govt taking right steps
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By Michael Winfrey
VIENNA, Jan 19 (Reuters) - Latvia, one of the countries worst-hit by the financial crisis in Europe, has stabilised significantly and progress on its plan to keep its currency peg is much more encouraging than six months ago, the International Monetary Fund said on Tuesday.
Saved by an IMF-led, 7.5 billion euro aid deal this year, the tiny Baltic state has drawn criticism for clinging to the peg to the euro, which some economists say is exacerbating an already drastic recession.
Anne-Marie Gulde, senior adviser in the IMF's European department, said challenges remained enormous, including rising unemployment and a Constitutional Court decision to row back on pension cuts. But she said the picture was improving.
"We have seen a significant level of stabilisation in Latvia, in contrast to some of the scenarios that had been painted," she told Reuters on the sidelines of an economic conference in Vienna.
"I'm much more optimistic now than I would have been half a year ago (about the currency peg), because we have seen some of the critical steps being taken, and I think that also creates momentum."
Having suffered an estimated contraction of almost 20 percent in 2009, Riga has cut pensions and state wages and slashed other budget spending in pursuit of a "internal devaluation".
The process involves forcing down wages, and in turn prices, to stay competitive without really changing the nominal level of the lat against the euro.
PRESSURE
Some commentators have called for Riga to let the lat peg slide by a fifth or more, and an opinion poll last year showed that 60 percent of the population thought that could happen, even if most Latvians are against devaluation.
Last week, the Finance Ministry ruled out any move to devalue after debate over the issue has flared in recent weeks, with prominent global economists, including Nobel Prize Laureate Paul Krugmann, predicting the peg would end.
Supporters of the peg staying at its current levels say devaluation would wallop Latvians who took out euro-denominated loans with the eventual hope of joining the single currency and could deeply wound the mainly Swedish banks who made them.
Gulde said Latvia's deep fiscal consolidation had been undermined by a verdict by the Constitutional Court in December ruling that cuts to old age pensions were unconstitutional.
But she added the IMF stood by Riga's strategy and it was "inspiring ... that the government understands what's involved and is taking steps in the right direction".
Some of the most painful measures include huge cuts to public wages, including a 50 percent drop in teachers' earnings, slashing of pensions and double-digit cuts in other spending.
"We're engaged in that strategy, and if we would have insurmountable doubts about it, we wouldn't be there," she said.
"The government understands what is involved and is making the right kind of effort and the right steps that are needed. This is a difficult process, but the alternative would be difficult also." (Editing by Charles Dick)