The Baltic states are once again in the eye of the storm after leaked reports that Sweden is bracing for a full-blown economic and political "breakdown" in Latvia.

By Ambrose Evans-Pritchard, International Business Editor

LONDON, England - October 5, 2009 - The Svenska Dagbladet newspaper said Sweden's finance minister, Anders Borg, had told banks secretly that Latvia's political order was unravelling, advising them to prepare for the collapse of Latvia's rescue talks.

Latvia has failed to deliver draconian spending cuts agreed to secure the next tranche of its €7.5bn (£6.85bn) bailout from the EU, the International Monetary Fund, and Sweden, balking at 20% cuts in pensions and a further 15% cut in public wages.

The People's Party, the largest group in the coalition, voted against austerity measures last month, raising concerns that the country is ungovernable.

Mr. Borg said the world's patience is running out. "It will be very hard to continue with these international programs if they don't fulfill the spirit and the content in the agreements they have signed."

Latvia's economy contracted by 18.2% in the twelve months to June, trumped only by Lithuania at 20.4%. "Latvia's currency peg is back on the agenda," said Hans Redeker from BNP Paribas. "The government has to relax policy for social reasons. The hardship this winter is going to be unbelievable."

Youth unemployment in Latvia is already 31%, and concentrated among ethnic Russians. Premier Valdis Dombrovskis said his chief task is to "preserve social peace".

Neil Shearing from Capital Economics said the appetite for austerity has been exhausted. Latvia is "more likely than not" to devalue, toppling pegs in Estonia and Lithuania. "Financial markets elsewhere in the region are likely to be hit by contagion, with Hungary, Romania, and Ukraine most vulnerable."