By Patrick Lannin and Aija Braslina

RIGA, March 15 (Reuters) - The IMF on Monday praised Latvia for progress in meeting the terms of its 7.5 billion euro bailout, but warned of sizeable risks ahead and urged the government not to cut taxes or increase spending.

The ruling five-party coalition, however, said it had approved cutting value-added tax for hotels, at the urging of the largest ruling party, even though the IMF warned that tax revenues would be eroded as wages and prices are likely to keep falling for at least two more years.

'The sharp economic downturn is starting to bottom out, but recovery has not yet begun and sizable risks remain,' the IMF said in a second review of its bail-out agreement with Latvia, whose economy shrank 18 percent in 2009.

'Risks to the program, although still considerable, have diminished,' the report added.

The IMF raised its forecast for Latvian economic growth in 2011 to 2.75 percent, from 1.5 percent previously. For this year, it said it was cautious but said the Latvian authorities had held out hope that GDP would be stronger than a 4 percent contraction estimated under the bailout.

The International Monetary Fund, which spearheaded a bail-out for Latvia with the European Union and Sweden at the end of 2008, also warned of potential political problems ahead of a parliamentary election due in October including a possible backlash to fiscal reform.

'Falling output and rising unemployment have increased social strains, raising the risk of a populist backlash to fiscal adjustment and an inability to plan new structural reforms ahead of the fall 2010 parliamentary election,' it said.

The easiest fiscal measures had already been taken and further steps would be increasingly difficult, it said, and urged the government to avoid tax cuts or increasing spending.



GOVERNMENT BACKS VAT CUT

However, after several weeks of argument, the five-party coalition backed a reduction in VAT for hotels, a move proposed by the largest coalition party in the face of warnings from Prime Minister Valdis Dombrovskis that Latvia risked losing its fragile stability and turning into another Ukraine.

'The coalition has backed this issue (the VAT cut). At the same time it stressed that we cannot create a so-called snow ball effect (of tax cuts),' Dombrovskis told reporters.

'If these kind of proposals now start to come more and more, we will have very serious problems with international lenders.'

Latvia has rejected any idea it should devalue its lat currency, which is pegged to the euro in the ERM-2 pre-euro entry grid. Instead, it is depressing wages and prices to regain its competitiveness.

'Successful adjustment will likely entail falling wages and prices for at least two more years, which will erode tax revenues and undermine loan quality,' the IMF said.

It said stability in the banking sector depended on the continued involvement of top foreign banks, Swedbank, SEB, Nordea and DnB NORD.

'These banks have signalled their willingness to make bilateral commitments (to maintain exposure to Latvia) in the next stage of the process. However, these commitments will be difficult to enforce, especially in an environment of global deleveraging,' the IMF said.

(Reporting by Patrick Lannin; Editing by Toby Chopra/Susan Fenton) Keywords: LATVIA IMF/ (Riga newsroom, patrick.lannin@reuters.com, patrick.lannin.reuters.com@reuters.net, +371 29 269 191) COPYRIGHT Copyright Thomson Reuters 2010. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.