* Latvia-IMF dispute could put spotlight on EU
* Baltic difficulties could spark wider regional crisis
* Bailing out Latvia comes with own problems
LONDON, July 23 (Reuters) - Latvia's dispute with the IMF could leave the European Union facing a dilemma -- whether to bail out troubled emerging European countries who won't make cuts or face the consequences of not doing so.
The International Monetary Fund (IMF) has withheld a payment of 200 million euros ($285 million) as part of a joint 7.5 billion euro package largely funded by the EU after Latvia refused to make further state pension cuts and tax increases.
Latvia, the European Union country worst hit by the financial crisis, has already made savage public sector pay and benefits cuts. Its economy is expected to contract 18 percent this year.
A string of other countries are also facing stark cuts, and analysts say in many -- like Latvia -- domestic politics could well intervene as elected politicians are unwilling to face the political consequences of cuts demanded by the IMF and wider financial markets.
"This could be a test case for Europe," said Lars Christensen, head of emerging markets research at Danske Bank in Copenhagen. "In Latvia, it's domestic politics that really become the driver. The question is what the EU would do if the IMF walks away."
Few are predicting that for now. Latvia's policymakers continue to say they hope they can resolve the disagreement and receive the next tranche of the IMF loan. But analysts say they are clearly looking at other potential options.
Latvia's current coalition government took over after its predecessor fell earlier this year, buffeted by riots and the impact of the financial crisis. Current coalition partners are reluctant to sign up to the cuts as they jostle for political advantage.
It recently signed a memorandum of understanding with the European commission to receive a 1.2 billion euros tranche which is part of the larger 7.5 billion euro IMF/EU package. It is up to Brussels to decide whether to go ahead or side with the IMF demands.
IMF, EU DIVIDED?
"Latvia can see there is a difference of opinion between the EU and IMF," said Joanna Gorska, the deputy head of the Eurasia desk at London-based risk consultancy Exclusive Analysis. "They may want to take advantage of that."
Without external support, analysts say Latvia would face dire economic consequences that would probably include the failure of its currency peg, deeper recession and a further rise in the number of defaults on foreign currency loans.
That would have dramatic ripple effects throughout the region, devastating Swedish banks who hold many of the loans as well as causing a spike in risk aversion across regional financial markets, hurting currencies like the Hungarian forint
and boosting credit default swaps premiums.
Sweden has already seen its currency
inch down on worries over the Baltics.
Regional currencies have broadly recovered from the beating they took last year and earlier this year, but at worst analysts say trouble in Latvia could push the entire region back into crisis, hurting the euro and possibly broader global markets.
That could leave both the EU and IMF picking up a costly bill. Analysts say bailing the region out if it suffers something akin to the 1997 Asian financial crisis could cost hundreds of billions of dollars.
On the other hand, effectively giving Latvia a blank cheque might lead to other countries also shrugging off austerity cuts and simply expecting the EU to bail them out even if the IMF will not.
OTHER COUNTRIES WATCHED
"Effectively, what you are doing then is putting everything on to mainly the German taxpayer," said Danske's Christensen. "And with German elections coming up later this year no one wants that to become a political issue there."
Whilst Latvia remains the most troubled EU country, a string of others are in a similar but marginally better condition, including Bulgaria, Romania, Hungary and Croatia, making cuts and relying on multilateral lenders.
Those countries with upcoming elections or fragile coalitions are likely to be those which find pushing through austerity measures hardest. Hungary is due to vote in early 2010, with the opposition well ahead in opinion polls and government popularity further hit by the crisis and cuts.
Just beyond the borders of the EU, Ukraine is also gearing up for elections -- and interparty squabbling has left little space for budget cuts, prompting one tranche of its IMF package to be delayed already with another seen possibly postponed later this year.
Countries such as Bulgaria which have recently had a change in government are seen better placed, as policymakers can blame their predecessors for the measures they have to take. However, if they see neighbouring countries getting away without cuts, they may follow suit.
Latvia might have the option of turning to other countries for bilateral funding even if the IMF walks away. Swedish policymakers might rather intervene in Latvia than see their own banks suffer, or it could turn to giant neighbour Russia.
Facing their own crises, both Ukraine and Iceland approached Moscow for loans -- although both ended up dependent on the IMF anyway taking little or nothing from Russia.
Then, it would remain to be seen what political and other concessions Russia would want from Latvia, one of only three former Soviet republics now to be members of NATO.
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