March 11, 2010, 8:55 AM EST

(Adds GDP forecast in penultimate paragraph.)

March 11 (Bloomberg) — Latvia’s central bank cut its benchmark refinancing rate for the first time this year after rates in the interbank lending market dropped to record lows.

the bank cut the rate to 3.5 percent from 4 percent, Governor Ilmars Rimsevics told reporters in Riga today. the bank lowered the rate by 2 percentage points in 2009. the central bank also lowered the overnight deposit rate by half a percentage point to 0.5 percent and introduced a new seven-day deposit facility with a 1 percent interest rate.

Latvia is stuck in the European Union’s deepest recession after a credit-fueled housing boom collapsed, credit markets froze and the country’s second-biggest bank needed a state bailout. the government turned to a group led by the European Commission and the International Monetary Fund for a 7.5 billion-euro ($10.3 billion) loan to shore up the economy.

Today’s rate changes “will further push the interbank lending rates down for overnight and one-day lending,” said Kaspars Jansons, head of treasury at Parex Banka AS. “Banks have a lot of lati and they need to place them somewhere, and this will likely be another push on the lending side.”

Latvian lenders may move their money from overnight deposits at the central bank to the new seven-day facility at after today’s cuts, Jansons said.

Rigibor

Asking rates on the three-month Rigibor, the interbank lending rate, fell to 2.33 percent yesterday, the lowest since the central bank began calculating the index 12 years ago. the three-month rate climbed to a high of 29.8 percent on June 26 when speculation mounted that the country would have to devalue its currency.

“Low lending activity currently is not due to the interest rates but is still explained by the bank’s cautious lending policy in these complicated economic conditions, also the low demand for credit from households and from business,” Rimsevics said today.

Banks are holding between 250 million lati ($483 million) and 300 million lati on deposit at the central bank, he said.

on Feb. 24, Latvia’s Treasury sold 8 million lati ($15.4 million) in two-year Treasury bills at auction, the first sale of such a maturity since may 2007, with an interest rate of about 6.07 percent. Yesterday the Treasury sold 12 million lati of 2-year paper with an average yield of 5.6 percent.

Contraction

the government should begin work on the 2011 budget now, or risk taking last minute budgetary decisions only after October parliamentary elections, Rimsevics said. the economy is showing signs of stabilization as interbank lending rates drop, exports have begun to improve and productivity is increasing, he said.

Foreign investors are showing a renewed interest in Latvia, especially in the country’s domestic Treasury bill market, Romsevics said.

the economy contracted 16.9 percent in the fourth quarter after shrinking 19 percent in the third, the central statistics office said today. the central bank kept its forecasts for a 2.5 percent contraction this year and 3.8 percent deflation at the press conference.

the economy may grow 0.2 percent on an annual basis in the fourth quarter, according to a chart Rimsevics showed today. the economy may contract an annual 5 percent in each of the first two quarters and 0.8 percent in the third quarter.

the refinancing rate affects the minimum interest rate on central bank swaps and repurchase agreements, worth about 75 million lati a week. the bank runs a quasi-currency board system, where lati in circulation are backed by foreign currency.

–Editors: Tasneem Brogger, Chris Kirkham.

To contact the reporter on this story: Aaron Eglitis in Riga at aeglitis@bloomberg.net

To contact the editor for this story: Chris Kirkham at ckirkham@bloomberg.net

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