By Ashish Advani Latvia’s currency is called the Lat (LVL) and in case you haven’t heard, the currency, and indeed the entire country are facing significant pressures these days.

With its external debt rising to 128% of GDP, Latvia’s problem was they drank a bit too much of the ‘cheap credit’ Kool-aid major countries were passing around the last few years.

While the current account has “turned around,” they are feeling the price of the adjustment not only in the real economy but in public finances. The budget deficit has thus spiraled out of control as budget revenues have collapsed.

The original IMF program had targeted a budget deficit of 4.9% of GDP. But to date, the budget performance is seriously lagging that estimate. That’s why officials originally requested that the IMF adjust this up to 7% of GDP. Now it appears the government is now targeting a deficit of over 9% of GDP.

Meanwhile forecasts warn of a deficit in excess of 11% of GDP.

This Could All Actually Be a Boon for the Country…

Latvia had adopted a fixed peg for its currency. This worked well when the going was good in the world economy. It was obvious to most that it was only a matter of time before the peg would come under pressure.

The real question now is whether the economy can grow under the current fixed exchange rate regime. The government had the support of the opposition for the currency peg. But now that a former prime minister is calling for a currency regime change and supporting the merits of devaluation, it is only a matter of time before the peg falls.

This is particularly important for the Swedish Banking system and the Swedish Krone. Sweden and its banking system has the largest exposure to Latvia and will feel the pain and embarrassment when Latvia devalues.

For Sweden, developments in the Baltics could prove embarrassing if the line is pushed and the Latvian real economy is in effect being sacrificed in the best interests of Sweden’s banks.

After all, a currency devaluation in Latvia, would see non-performing loans (NPLs) rise. But here’s the interesting thing: It would be Swedish banks, and not the Latvian government, which would be expected to pick up the tab on recapitalizing of local subsidiaries. That means Sweden will suffer.

Latvia’s entry into the Eurozone in 2012 is still on track. With the devaluation of the currency, it may actually prove to be a boon rather than the bane of Latvia.

Watch for the consequences of a Latvia Lat devaluation on the Swedish Krone.

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