By Kuba Jaworowski and Marcin Goettig
WARSAW, June 24 (Reuters) - The IMF said it hopes Latvia's budget cuts will reassure investors it will not have to devalue its currency but if it is forced to abandon the lat's peg other countries in the region would come under pressure too.
International Monetary Fund (IMF) representative for Central Europe, Mark Allen, also told Reuters in an interview late on Tuesday it was not yet clear whether the harsh cuts Riga had introduced would be enough to stem the crisis.
"What Latvia is trying to achieve is quite heroic," Allen said. "We certainly hope that this budget action would reduce speculation on the imminent exchange rate change."
Latvia, which is trying to hold the lat's peg to the euro while battling an almost 20 percent slump in GDP, has made euro zone entry part of its plan to fight the crisis. Allen said the IMF supported the strategy.
"That is what the whole policy is designed to achieve, to maintain the peg and to get into the euro zone as soon as possible... That's the policy of the Latvian government, that's the policy we're supporting," he said.
Allen warned, however, that should Latvia devalue the lat this could cause a chain reaction in the region, hurting other countries with a currency peg.
"There is no doubt you always get this effect. As soon as one goes, the market, like a pack of wolves, goes after the next weakest. It's a most unseemly spectacle," he said.
"It's obvious the Lithuanians, the Estonians and the Bulgarians would probably come under quite a lot of pressure. There could even be spillovers to other nations. Maybe Croatia too because of its exchange rate regime."
"They would be forced into a position a bit like Latvia. They have to go through tough adjustments anyway as it is. It's possible they could turn to the European Union for financing."
Although Bulgaria says it is shielded by years of running budget surpluses, it still plans spending cuts. Both the Lithuanian and Estonian economies are expected to contract by double digits this year, forcing their governments to implement even more painful spending cuts.
NEXT TRANCHE
Asked whether he was optimistic about measures endorsed by Latvia's parliament last week, which include slashing public sector wages by a further 20 percent and pensions by 10 percent on top of earlier cuts, Allen said:
"Yes, I mean it's pretty impressive what they've done. Is it enough? We'll have to see. It's being evaluated at the moment."
He added that an IMF mission on the ground is looking into the matter but declined to comment when a decision on the next tranche of Latvia's 7.5 billion euro package would be made. The tranche is worth 1.2 billion euros.
Turning to Poland, Allen said the centre-right government's decision on Tuesday to raise its budget deficit target by almost 50 percent was "sensible", given the economic slowdown.
He added that the government's plan to take the EU's largest ex-communist economy into the euro zone in 2012 was no longer feasible and that 2013 was now the earliest date when Poles could swap zlotys for euros.
The zloty currency, which shed some 30 percent against the euro since its all-time highs last July, may be "slightly undervalued", Allen said, adding that the disparity was "well within the range of error".
Allen said a key concern for Poland and the region remained the condition of western European banks, which are heavily exposed in central Europe, adding that stress tests currently under way should help deal with the problem.
"The idea is to come up with an estimate of what capital really needs to be put into those institutions... But until that's done there is a risk that something can go wrong. And I think that's what we have to worry about," he said.
"If it turns out that there are extra problems there, then we will have to think again about things here. But at the moment that particular vulnerability seems to be under control." (Writing by Kuba Jaworowski; Editing by Victoria Main/Toby Chopra)