-- Paul Taylor is a Reuters columnist. The opinions expressed are his own --
By Paul Taylor
PARIS, June 15 (Reuters) - Latvia needs more support from the European Union if it is to preserve its currency peg to the euro and avert a chain reaction of devaluations and bankruptcies around the Baltic and beyond.
The Latvian government and central bank are taking extreme measures to maintain a currency board linking the lat with the single European currency, hoping to steer the former Soviet republic into the safe haven of the euro zone in 2012.
But the price in wage and pension cuts for ordinary Latvians has risen to normally intolerable levels, and the prospect of entering the promised land of monetary stability looks ever more remote as the EU sticks to its strict rules on euro entry.
Furthermore, Latvia's prospects of economic recovery after a staggering 20 percent forecast contraction of output this year look poor with an overvalued currency. The boom years of consumer spending based on cheap euro credit are well and truly over.
To secure the disbursement of 1.2 billion euros in emergency International Monetary Fund and EU loans, parliament in Riga is expected to approve a revised budget on Tuesday cutting pensions by 10 percent and public sector wages by a further 20 percent on top of the 20 percent reduction already implemented.
Devaluing the lat, as emerging market economists recommend, would trigger a wave of bankruptcies because 80 percent of private borrowing is in euros. Euro zone entry would recede since the country would have to restart from scratch in the EU's Exchange Rate Mechanism (ERM) with higher inflation and a bigger budget deficit. A new currency peg might prove hard to defend, while a floating lat would likely overshoot on the downside.
More seriously for the EU, a Latvian devaluation would cause big losses at Swedish banks, heavily exposed to the Baltic states, and put immediate pressure on the currency pegs of neighbours Estonia and Lithuania, and perhaps of Bulgaria. It could also make the main central European economies such as Poland and the Czech Republic more wary of entering the ERM.
There is some suspicion that Germany, the EU's central economy, may want to slow down euro zone enlargement to preserve stability for existing members and perpetuate its orthodox influence over European Central Bank decision-making. But the EU has a strategic interest in holding the line in Latvia against currency turmoil.
To achieve this, it needs to give Riga both more generous financial assistance and a clearer perspective for euro zone membership. Yet so far the European Commission and the ECB have seemed semi-detached, at the risk of sending Latvians the message that Europe doesn't care too much. The Commission has left the loan negotiations to the IMF. The ECB has lent Sweden 3 billion euros to guard against its banks' Baltic exposure. ECB President Jean-Claude Trichet disclosed in an aside on June 4 that the ECB had a repurchase agreement with the Latvian central bank, but he did not say if or when it had been used and whether the European institution accepted assets in lats as collateral.
The EU is a community of law. Treaty rules for joining the single currency cannot simply be torn up in a crisis to admit countries in distress. But once the Latvian parliament adopts the drastic budget cuts, the EU should use this week's summit to send a political signal to markets that it will do what it takes to keep the Baltic states on track for the euro zone.
To underpin this commitment to avert contagion, the ECB should flesh out its intention to support Latvia with liquidity, accepting assets denominated in lats as collateral. The Commission should propose to member states using more of the EU's emergency balance of payments facility to support Latvia.
Both moves might set risky precedents if other, bigger economies get into trouble. But if the EU wants to prevent a currency meltdown with wider consequences, that is the political price. (Editing by David Evans)