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Latvia, with the worst contraction in the 27-nation EU in the fourth quarter, was cut to Baa3 from Baa1. Lithuania's foreign and local currency ratings were cut to A3 from A2 by Moody's Investors Service. It also confirmed Estonia's A1 rating. All three countries have a negative outlook.

"The depth and pace of the economic adjustment is much more severe than previously anticipated" for Latvia, said Kenneth Orchard, a vice president and senior Analyst in Moody's Sovereign Risk Group.

The Baltic region, which had the best-performing economies in the EU in 2006, has slumped after ratings companies warned that surging real-estate and consumer prices and soaring credit would create a "hard landing" in their economies. Latvia's rating is now on par with Armenia, Bulgaria and Romania, while Lithuania has the same rating as Tunisia.

Latvian stocks extended losses on the downgrade, with the OMX Riga dropping 1.8%. The country's credit default swaps were up a quarter of a percentage point. Lithuania's OMX Vilnius index was down 0.05%. The Latvian government sees gross domestic product shrinking 12% to 13% this year, according to Orchard, while Lithuania's economy may contract 10% for 2009.

The declines are also causing headaches for the governments as the recession slices into tax revenue and widens budgets, making the prospect of euro adoption even more remote. The three countries, which dropped out of the euro race once already, want to complete adoption to help them weather the downturn. Estonian President Toomas Hendrik Ilves yesterday said his country may have to make "large" budget spending cuts and raise taxes to meet European Union requirements for euro adoption in 2011. In Latvia, Orchard said the contraction has "had negative repercussions for government revenues and the budget deficit, causing the budget-related conditions in the IMF stand-by arrangement to be missed." The government had to take a 7.5 billion-euro (9.8 billion US dollars) International Monetary Fund-led bailout to keep its banking system afloat. To meet conditions attached to the IMF bailout, Latvia is cutting wages, raising some taxes and slashing spending. It must keep the currency peg to the euro in accordance with the Washington-based lender's recommendations, forcing companies to slash pay to stay competitive. The economy may contract 12% this year, the Finance Ministry said on Feb. 18. Orchard said similar problems face neighboring Lithuania, the largest of the three Baltic nations.

"At the same time, the government's ability to borrow on the public capital markets is constrained," he said of Lithuania.

The economic collapse has already led to political unrest in the two countries. The government of Latvian Prime Minister Ivars Godmanis fell on Feb. 20, interrupting talks on additional budget cuts to keep the deficit below 5% of gross domestic product, one of the IMF program's requirements.

Valdis Dombrovskis, who was named prime minister-designate on Feb. 26, warned that the country is on the brink of bankruptcy and must cut spending by 700 million lats (1.3 billion US dollars) or risk not getting the next tranche of the IMF loan.

"As long as nothing is being done with the budget amendments and wage cuts are not implemented, the next tranche of money will not be transferred," Dombrovskis said in a Feb. 27 interview.

Standard & Poor's cut Latvia's rating to junk on Feb. 24, prompting the central bank to buy 28.4 million lats to defend the currency. The downgrade had weakened the lats to its limit, forcing policy makers to defend the currency, the first such intervention since the country singed its loan agreement with the IMF in December.