The government and foreign-owned banks must stimulate the Latvian economy to prevent a prolonged recession, according to Ilmars Rimsevics, governor of the central bank.

“We try to encourage the banks which have made a pause … so that they can resume lending,” Mr Rimsevics told journalists after meeting with Swedish banks that dominate Latvia’s banking sector. “I hope that in March we will see some lending increasing.”

Governments in central and eastern Europe fear that foreign banks that made big profits during the region’s boom after European Union accession will now cut lending and repatriate capital because of the global financial crisis.

This threatens to deepen recession in the region, with Latvia facing the worst economic outlook in the EU after being forced to seek a €7.5bn ($9.7bn) IMF-led stabilisation package at the end of last year to defend its currency peg to the euro.

Swedish banks committed themselves to maintain lending during talks on the IMF package. In his meetings in Stockholm the governor discussed ways in which Latvia could make it easier for the banks to lend.

Mr Rimsevics said Swedish banks – which are led by Swedbank and SEB – were continuing to lend but he expected that the total volume of loans would be flat or even fall this year. “Lending will fall – there is no doubt about that,” he said. “The question is can we stop this fall?”

Mr Rimsevics said the Bank of Latvia now expected the economy to contract by between 7 per cent and 8 per cent this year, compared to its previous forecast of a 5 per cent decline. “It could be lower if there is an efficient and timely stimulus package,” he said. “It could also be on the higher side.”

The government is expected to launch a stimulus package to help struggling companies within the next few weeks. “It is very important for the government to put together a stimulus package so the economy can boom again,” said Mr Rimsevics.

However, Mr Rimsevics said the worsening economic picture would also necessitate further austerity measures next month to keep the budget deficit below 5 per cent of GDP this year.

He said keeping the deficit below 3 per cent was now the main obstacle to adopting the euro in 2012, which was vital for the future stability of the Latvian financial sector.

As a condition of the IMF loan agreement the government already passed an austerity package of spending cuts and tax hikes at the end of last year amounting to 7 per cent of gross domestic product.

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