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FACTBOX-Key political risks to watch in the Baltic states

RIGA, May 26 (Reuters) - Of the three recession-hit Baltic states, the political situation in Latvia is the most fragile as it faces a parliamentary election in October, although Estonia and Lithuania are also working with minority governments.

The Baltic states suffered the largest drops in output in the European Union in 2009, led by Latvia’s 18 percent decline. They hope to gradually come out of recession this year. Estonia also has its eyes on adopting the euro in 2011. [ID:nLDE64413I]

Latvia’s need to fulfil the terms of its 7.5 billion euro bailout -- led by the International Monetary Fund and European Commission -- including harsh spending cuts and tax rises, led to the disintegration of its ruling coalition. The People’s Party, one of the three largest parties which is running low in opinion polls and seeking to distance itself from the measures, walked out. [ID:nLDE62G1OQ]

Prime Minister Valdis Dombrovskis intends to stay on as head of a minority government. Latvia needs to make further budget cuts, but that will be the job of the next government. [ID:nLDE63B1ZX][ID:nLDE64O0Z7]

In Lithuania, Prime Minister Andrius Kubilius saw his parliamentary majority whittled away due to an internal split in a coalition partner. He needs support from smaller opposition parties and still has to pass a tough budget for 2011. [ID:nADO555169]

Estonia also has a minority coalition, but there is wide support for euro adoption and the government passed austerity measures to cap the budget deficit.

Following are some factors to watch in the Baltic states.

LATVIA’S ELECTION

Latvians go to the polls on Oct. 2. The result will likely lead to another multi-party coalition government.

Polls show voters favour the opposition centre-left Harmony party, which has a broad base of support among Russian-speakers and, like the People’s Party, has 17 parliament seats out of 100. But the party also hopes to attract ethnic Latvians angered by the crisis.

The Unity bloc, which includes Dombrovskis, is also popular. The bloc currently musters 22 parliament seats.

Dombrovskis’s current coalition ally, the Union of Green and Farmers, also with 17 seats, has been standing in third place in the polls. However, the polls also show a large number of “don’t knows” ahead of the election, meaning the actual result could differ from the poll predictions.

Harmony was critical of the IMF/EU programme as too harsh, yet also helped Dombrovskis win a parliamentary vote in January to stay in the 7.5 billion euro bailout programme by abstaining.

Harmony wants to introduce a progressive income tax, which the IMF has also advocated, but its spending cut plans are vague. The IMF has said a mixture of spending cuts and tax rises will be necessary to meet future budget deficit cuts.

Dombrovskis, who hopes to become prime minister again after the election, has promised to keep Latvia within the bailout programme, but not revealed how he would meet the revenue rise and budget cut targets needed. [ID:nLDE63E1VM]

There is a question over whether the People’s Party and the Latvia’s First Party/Latvia’s Way group, with 10, will make it into the next parliament, though they are led by prominent businessmen who can finance a strong electoral campaign.

The two parties have been key players on the political scene for about a decade, but their popularity has plunged.

If they win seats in parliament, it is not clear who they would throw their weight behind in a coalition.

What to watch:

-- Will the Harmony bloc and Dombrovskis’s Unity agree to work together in government after the election? In theory, this could be difficult as Unity includes a strongly nationalist element that would be hostile to Harmony’s pro-Russian stance. But for the sake of achieving power could they bury their differences?

-- Will the new government lead to a softening of Latvia’s adherence to the IMF programme? This could again get financial markets nervous about the sustainability of the economy and the peg to the euro. [ID:nLDE6300ZG]

-- If Latvia stays in the bailout programme, its lat currency will stay stable within its pegged band and interest rates will stay low. If it drops out of the programme, then devaluation speculation will return and rates will rise, which could again cast a shadow over the other two Baltic states.

ESTONIAN EURO BID

Estonia got a green light from the European Commission on May 12 to say it can adopt the euro on Jan. 1, 2011. European Union finance ministers still need to give their formal approval, but this is expected in July. [ID:nLDE64B1VW][ID:nLDE6131JR]

Estonia achieved its goal because it set aside funds during the boom years, which have cushioned it from the downturn. Nevertheless, it also cut spending and raised taxes to keep its budget deficit within euro zone limits. [ID:nLDE63C0RP][ID:nLDE61N1RG]

What to watch:

-- Entry to the euro zone would likely give the ruling parties a huge boost in elections due in March 2011, particularly to the dominant partner in the coalition, the Reform Party. This would keep Estonia on a centre-right path.

-- However, some instability inside the ruling coalition is expected as the country nears the March elections, with the junior coalition partner, Pro Patria and Respublica Union, trying to stand out from the Reform Party’s shadow.

-- The new government will still need to keep the country on the path of fiscal austerity and some economists predict years of slow growth as the price of making sure the small nation remains competitive within the euro zone.

LITHUANIAN BUDGET MEASURES

Lithuania’s 2009 economic drop of 15 percent was second only in magnitude to Latvia’s. The coalition government of Prime Minister Andrius Kubilius had to take tough spending measures but has now lost its majority in parliament by one vote.

He says he can depend on the support of a small group of non-aligned lawmakers.

What to watch:

-- Possible further defections from the coalition: junior coalition party the Liberal and Centre Union has threatened to quit the government after failing to get support for direct elections of city mayors.

-- There have also been tensions with the National Resurrection Party, a new party for the 2008 election and which has already split into factions, one of which joined the opposition. The leader of the rump group that stayed in the government has had arguments over ministerial posts, but stayed in the government. If this rump group also leaves the coalition, that would spell deeper trouble for Kubilius.

-- A major test for the government will come in December, when parliament has to vote on a budget for 2011. It also has to approve a number of fiscal consolidation measures before that. [ID:nLDE63J1FB][ID:nLDE63F1RD][ID:nLDE6240SW]

-- If the government’s weak position leads to fiscal slippage and problems financing its budget deficit, then speculation against the currency could mount and local market interest rates rise. This could also spread worries, as in the case of problems in Latvia, to the other two Baltic states. (Reporting by Aija Braslina, Patrick Lannin, Nerijus Adomaitis and David Mardiste, editing by Peter Apps)

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