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Latvia’s Parliament Votes for the Euro

by | February 5th, 2013 | 09:00 am
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On January 31, the Latvian parliament gave final passage to a law applying for adoption of the euro. The vote was 52 to 40. The Latvian government will now submit an application to the European Union in February, and the European Commission will then prepare a report assessing whether Latvia is ready to join the euro area.

Latvia clearly qualifies by a wide margin as a result of its compliance with all the relevant economic criteria. According to fresh projections from the International Monetary Fund (IMF), its budget deficit last year was probably 1.8 percent of GDP, its gross public debt merely 37.6 percent of GDP, and its inflation was 2.2 percent. In fact, the budget deficit and inflation were probably even smaller than those levels. Latvia has an exchange rate that is already pegged to the euro, and it belongs to Exchange Rate Mechanism (ERMII) and thus is clearly ready to join the Economic and Monetary Union (EMU). The European Union is likely to render such a verdict in June, so that Latvia can adopt the euro on January 1, 2014 and become the 18th member of the euro area.

But why, you may wonder, would anybody want to join the crisis-ridden euro area—and why do it now? Well, Estonia joined the euro area in January 2011, and since then it has been one of the fastest-growing economies in Europe, so the risk—at least in the eyes of its neighbor to the south—is not  that great. The Latvian government and the Bank of Latvia have been adamant on their intention to adopt the euro all along. Their reasoning is easy and clear.

Latvia is a tiny country with only 2 million inhabitants. Many such small countries have pegged exchange rates, if they have a flexible, open, and diversified economy dominated by one currency. That is the case with Latvia. The country went through the global financial crisis without devaluation, showing that it has no interest in using exchange rate adjustment to solve its problems.

Latvia did lose 24 percent of its GDP in 2008–09, but the reason was a horrendous liquidity freeze—that is, a lack of access to the otherwise ample liquidity of the European Central Bank (ECB). Thus, if exchange rate policy has been ruled out as a tool to deal with its problems, it is better for Latvia to join the euro and gain access to funding in the case of crisis.

That leaves the question of when Latvia should join the euro area. There are three strong reasons for why Latvia should join the EMU as soon as it can. First, after an effective Greek default without an exit from the euro, it is clear that no single country will leave the EMU. An increasingly broad consensus embraces this view, which is shared by the Latvian government.

Second, some worry about the substantial bailout costs that have been inflicted on members of the EMU. But the EMU is a club, and it will certainly not be kinder to latecomers. Indeed it may be tougher on them. Latvia will have to accept the bailout costs of the EMU whenever it joins, so the argument for waiting is not pertinent. Moreover, the EMU is evolving fast. The sooner Latvia joins, the more it can influence the decisions taken.

As discussed above, Latvia is qualified to join the EMU by all criteria, but it is not obvious that it will be able to do so in the future. The government can control its fiscal policy, but not inflation, since the euro peg deprives it of independent monetary policy. Therefore, Latvia had better join the EMU now when it is clearly qualified. It would be most surprising, not to say strange, if the EMU would not accept such an eminently qualified candidate.

Ironically, however, the greatest obstacle to Latvia’s joining the euro area has been domestic public opinion. Euro adoption is no longer popular in Latvia. At present, nearly two-thirds of the population expresses negative sentiments in opinion polls. The euro crisis is the main explanation. Another popular concern is the risk of rising inflation. The government has tried to mitigate that fear by insisting on prices in both euros and lats before and after the transition to the euro. A specific worry is that Latvia will become the new Cyprus, a potentially unstable banking center for Russian money. Finally, many nationalists cherish the lat as a symbol of national sovereignty.

But the opposition does not offer any alternative. Devaluation or a floating exchange rate is no longer discussed, and Latvia committed itself to adopt the euro when it joined the European Union in 2004. The only issue is when to join the euro area. The parliamentary opposition could demand a referendum, but neither of the two opposition parties wants to do so. There is still a possibility that anti-euro activists will collect 30,000 signatures for a referendum, but the time is short.

Despite these problems, the Latvian government seems likely to succeed in its determined endeavor to have Latvia adopt the euro on January 1, 2014.