Monday, June 24, 2013

Latvia Readies to Adopt the Euro

Recent 2013 convergence reports by the European Commission and the European Central Bank on Latvia point strongly to the country's being ready to adopt the euro to replace the lat as the national currency by January 2014.

Overall, for a small country, Latvia seems to have recovered very quickly from the impact of the global financial crisis and its own housing market bubble in 2008-2009.  A reason cited is a rapid pace of "fiscal consolidation," code word for austerity.  Inflation, measured by the EU's Harmonised Index of Consumer Prices (HICP), hit 15.3% during 2008, and the latest twelve month average reading is around 1.3%, well below the reference target of 2.7%.

In the near term, the inflation pressure in Latvia will be to the upside, as deregulation in markets like retail electricity will provide one-time shocks to the twelve-month average inflation rates.  As the labour market has tightened and if export prospects improve, then wage pressures will probably increase too.  Politically, these inflationary pressures are being laid at the doorstep of choosing to adopt the euro, but really they are part of the normal economic adjustments caused by austerity and then a rebound when market prospects improve.

On many other measures, including gross government debt to GDP, Latvia's ratios are all favorably aligned to the convergence target values required by the EC, EMU, and ECB.  The government is strongly behind adopting the euro, but many of the reasons are philosophical in nature. The desire to put behind it the country's history with Russia is openly cited as a positive for the euro.  From the EMU side, they are very happy to see new countries eager to join the EMU and adopt the euro.  From the EMU side, they cite the reduced exposure to systemic risks which they say comes for the euro.

The improvement in legal, regulatory, business environment and fiscal management has led to improvements in Latvia's international credit rating,with a positive outlook going forward.  Since the lat and contracts are pegged to the euro anyway, the incremental benefits from adopting the euro will be convenience-related for business, tourism and trade.

The Latvian government has done an excellent job, according to the numbers in the reports.  The question is now what is being given up and what will be gained from adopting the euro?  According to the ECB report,
"All in all, although Latvia is within the reference values of the convergence criteria, the longer-term sustainability of Latvia’s economic convergence is of concern. Indeed, in the past, Latvia has experienced major boom-bust episodes and high macroeconomic volatility, which were also visible inter alia in domestic prices and long-term interest rates. More recently, Latvia has introduced a number of policy measures to enhance the domestic framework for counter-cyclical policies. Joining a currency union entails foregoing monetary and exchange rate instruments and implies an increased importance of internal flexibility and resilience. Economic sustainability is thus conditional on a permanent willingness, on the part of both the authorities and the public at large, to adjust and to introduce the necessary reforms and policy measures to safeguard macroeconomic stability and the competitiveness of the economy."
There are lots of Eurocratic code words in the text, but loss of flexibility and the exposure to the political whims of Brussels will be the price to be paid.  To counteract the examples of Greece and Cyprus, the EU needs Latvia's adoption of the euro to be a long-term success.

Only about one-third of Latvia's population is said to support joining the euro, but the die is cast and let's hope that the government and the Latvian people benefit from this process.

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