* Lavia not out of the woods despite austerity budget
* Political will seen tested in 2010 election year
* Lithuania may need IMF help, could raise devaluation talk
By Patrick Lannin
RIGA, Dec 3 (Reuters) - Latvia is not out of the woods yet despite the adoption of an IMF-mandated austerity budget. A prolonged recession could sap the political will to keep taking the harsh fiscal medicine and revive risks of a devaluation with domino effects around the Baltic region, analysts say.
Devaluation worries have receded since mid-year and further reassurance came on Tuesday when parliament passed a tough 2010 budget to meet the terms of a rescue package backed by the International Monetary Fund and European Union.
But the five-party coalition government endured sharp tensions in drawing up the required spending cuts and tax increases. With one in five Latvians out of work and many others having taken steep pay cuts, political pressure to ease the pain is bound to mount ahead of a general election late next year.
"If the recovery does not come soon then the political consensus will buckle," said Vyacheslav Dombrovsky, assistant professor at the Stockholm School of Economics in Riga, who advocates a devaluation as a way to boost the economy.
Neighbouring Lithuania's fiscal and political plight is also a source of concern as its budget deficit is likely to stay at 9 or 10 percent of gross domestic product (GDP) for the next two or three years, meaning further austerity budgets.
Estonia, long seen as more economically advanced, is the Baltic bright spot. Fiscal prudence during the boom years means its finances have withstood the downturn well and it has a good chance of becoming the next country to adopt the euro in 2011.
"Devaluation is ultimately a political decision. Devaluation will happen if the governments of Latvia and Lithuania fail to implement the necessary fiscal reforms and/or the IMF and EU withdraw support (from Latvia)," said Danske Bank chief analyst Lars Christensen.
"So the question still hangs in the air going into 2010."
FRAGILE
Latvia's political situation is the most fragile as a parliamentary election is due late 2010 and output is set to fall by 18 percent this year and a further 4 percent next year.
The central bank says the drop in activity from the height of the boom in late 2007 to the bottom of the bust will be an eye-watering 37 percent, taking the economy back to 2004 levels.
The government has already cut the wages of nurses, firemen, police and other state sector workers by between 20 and 40 percent and reduced old age pensions by 10 percent. In 2010, it plans rises in income tax, road tax and a capital gains tax.
Unemployment soared to 20.9 percent in October -- the highest rate in the EU -- and is set to rise further.
Support for the largest coalition party, the People's Party, is at low single digits in opinion polls. The party is widely blamed for the crisis that struck when a consumer and housing boom, fuelled by foreign currency borrowing, burst in 2008.
Its founder, former Prime Minister Andris Skele, has returned to active politics to revive his party's fortunes. He initially suggested the lat's trading range should be widened from the current 1 percent against the euro to the 15 percent permitted under the ERM-2.
He has since retreated from that stance, saying the process of internal devaluation has gone too far.
The central bank says it alone decides on the exchange rate. The bank also has plenty of reserves after earlier IMF and EU disbursements, but it remains possible that Skele or other politicians may run out of patience with current policies.
The authorities in all three Baltic states reject the idea that a devaluation would be of any help to recovery. It would also harm the many people who have borrowed in euros.
Swedbank chief economist Martins Kazaks said the internal devaluation was working, but that further productivity gains had to be obtained by making deeper structural reforms.
"We have to very clearly demonstrate that the budget and fiscal policy are going to be sustainable and that exports start to rise," he said, when asked how devaluation talk would end.
LITHUANIA NEXT?
Lithuania is in a similar position to Latvia, though it did not have to seek help from the IMF and EU.
It has also raised taxes, and cut spending and will reduce pensions next year. Nevertheless, its budget gap is set to hit 9 percent GDP this year and next.
Devaluation fears would surface if its fiscal problems mounted to the extent that it had to seek outside help.
"I don't see any reason why the situation with the budget deficit should improve in 2011," said Rimantas Rudzkis, senior analyst with DnB Nord bank in Vilnius, adding that this would make borrowing on international markets very expensive.
"I don't say its inevitable, but there is a huge risk that Lithuania will have to apply for the IMF's assistance," he said.
He also pointed to the need for strong political will.
"Speculations about currencies start when there is a lack of political will to carry out austerity policies, and populists step in to please their voters. If we are able to avoid that, then the speculation will die away," Rudzkis said. (Reporting by Patrick Lannin, editing by Paul Taylor) ((Riga newsroom, patrick.lannin@reuters.com, patrick.lannin.reuters.com@reuters.net, +371 29 269 191))