RIGA, June 5, 2009 (AFP) - Recession-hit Latvia looks prepared to make the tough decisions needed to stem the economic crisis, the IMF said Friday, as Riga continued to deny rumours of currency devaluation and faced suggestions its woes could spill beyond its borders.

"The budget adoption this week is a first step in the right direction," the IMF's Mark Griffiths told reporters after meeting with Latvian Prime Minister Valdis Dombrovskis.

"More work needs to be done. It's quite challenging, but we think the government is ready to do that," he said.

In power since March, the Dombrovskis government has been striving to slash spending to meet the terms of a 7.5-billion-euro (10.5-billion-dollar) bailout agreed in December by the International Monetary Fund, the European Union and top regional investors including Sweden.

There are growing fears that the deepening Latvian crisis could spill over into Estonia and Lithuania -- which are already struggling -- as well as Sweden, whose lenders Swedbank and SEB are heavily exposed in the region.

EU Economic Affairs Commissioner Joaquin Almunia said Riga's actions would be crucial in lowering the risk.

"I recognise the difficult situation in Latvia," he told reporters during a conference in Poland.

"But I am confident that if -- and it's very important if -- the Latvian government and parliament adopt adequate measures, the reforms that they need, and we know what they are, they will succeed, and this will avoid contagion of negative spillovers to the neighbours of Latvia or to other economies," he said.

Latvia, a former Soviet-ruled republic of 2.3 million people, joined the EU in 2004. It enjoyed sustained economic growth before rampant inflation and a burst credit bubble dragged it into recession last year.

Latvia’s economy contracted 18 percent year-on-year in the first quarter, more than any other EU member. It is expected to shrink by the same proportion across 2009.

For Latvia to get the next 1.2-billion-euro chunk of the bailout, it has to continue its ongoing round of belt-tightening to curb a gaping budget deficit -- the shortfall between government revenue and spending.

On Thursday, parliament approved a draft revised budget in the first reading with a projected public deficit of 9.2 percent of gross domestic product. Riga had originally agreed a 5.0-percent deficit with lenders.

Dombrovskis has said he will continue preparing budget cuts over the coming two weeks, until the budget goes to lawmakers for the final vote.

"What Latvia has already showed is a step in a right direction, but more steps are needed and maybe additional funds," said Marek Belka, head of the IMF's European department, at the conference in Warsaw.

Besides trying to rein in spending, Dombrovskis has also been forced to devote time to fighting rumours that Latvia may have to devalue its currency, the lat, which is pegged to the euro.

On Friday, he hammered the message home in a Latvian television interview, saying it was "time to stop all the rumours and speculation."

Talks with international lenders did not cover devaluation, Latvian central bank head Ilmars Rimsevics told reporters Friday. Finance Minister Einars Repse echoed his comments, saying: "It's not on the agenda."

Speculation had intensified Monday after an adviser to Dombrovskis, former Swedish central bank chief Bengt Dennis, said devaluation was looming.

Raising the stakes, the Latvian treasury failed this week to sell its debt at a public auction.

Some analysts, however, have predicted that Riga will end up biting the bullet.

"We continue to think that devaluation in Latvia is eventually almost inevitable," said Oliver Weeks of Morgan Stanley Research.

But Stockholm-based SEB said that its "main scenario is that the fixed exchange rate will again survive this time around, but that uncertainty will linger."

Latvia pegged the lat to the euro in 2005 as part of a bid to switch to the European single currency, which it hopes to adopt in 2013. The economic crisis has forced the Latvian central bank to intervene to protect the peg, under which the lat-euro exchange rate can only fluctuate by 1.0 percent.