Latvia has been urged to tighten its public finances as fears escalate that the recession-hit Eastern European country is facing a huge currency devaluation.

The failure of a government bond auction this morning heightened fears that the tiny Baltic state will have to devalue its currency, the lat, which could have a huge impact on the rest of the region and other EU states.

On Thursday the Latvian central bank urged the Government to watch what it said about the national currency as jitters spread about a possible devaluation.

If the lat, which is pegged to the euro, is devalued, Estonia and Lithuania’s currencies are likely to follow suit.

Sweden would also be affected because large Swedish banks, such as Swedbank and SEB, control 50 per cent of Latvia’s lending market.

Some economists believe that the panic caused by a devaluation in the Baltic States could spread to other weaker members of the EU, such as Romania and Hungary, and even older members such, as the Irish Republic, Greece and Portugal.

This could mean that the stronger economies in the eurozone, such as Germany, would have to bail out their fellow EU countries or risk the break up of the single currency.

Latvia, a recent addition to the EU, was bailed out by the Union and the International Monetary Fund (IMF) in December after its economy was pummelled by the financial crisis.

It has followed a monetary policy of “fixing” its exchange rate and encouraging its citizens to borrow in euros and Swiss francs, which is one of the reasons it is now in so much debt.

This morning a gilt auction aimed at decreasing the budget deficit failed, apparently because of a severe lack of liquidity in the country's money market.

The Government now has to appeal to the EU to release the second part of a €7.5 billion (£6.6 billion) aid package.

However, the EU is trying to impose more stringent terms on the country’s financial plans before it grants the money.

It wants the Government to raise taxes and cut the amount the state spends before it awards more aid.

However, there are fears that this could lead to more civil unrest in Latvia, where the previous Government was forced to resign in February as rioting erupted in Riga over unemployment and poverty.

Joaquín Almunia, EU Monetary Affairs Commissioner, said: “The supplementary budget presented this week is a first step.

“The Commission wants to support Government’s efforts. I am looking forward to seeing additional steps adopted during the second reading of the budget, as announced by the Government."

Valdis Dombrovskis, the Latvian Prime Minister, denied that the country would need to devalue the lat and said that such a move would unfairly hit savers and increase the cost of the country's imports.

Last month he warned that the Latvian economy could shrink by 18 per cent this year, making the country the worst-hit economy in the EU.

Explore Economics

• Pre-Budget Report 2009

• Budget 2009

• World Economic Forum

• The Times MPC

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive