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Latvia Is Approved by the European Union for Euro Adoption

by | June 5th, 2013 | 04:04 pm
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On June 5, the European Commission and the European Central Bank (ECB) issued their convergence reports on Latvia, declaring that it is ready to adopt the euro starting on January 1, 2014. The announcement marked the decisive turning point by the European Union, even if several formal steps remain for the next month. Latvia will become the 18th member to adopt the euro. The last country to do so was Estonia in January 2011. As Olli Rehn, the EU commissioner for economic and monetary affairs, put it: “Latvia’s desire to adopt the euro is a sign of confidence in our common currency.”

The convergence reports offer glowing support for Latvia’s euro adoption based on the fact that the country has fulfilled all criteria by a wide margin. First, average inflation in the preceding year must not exceed by more than 1.5 percent that of the three best performing EU member states (Sweden, Latvia itself, and Ireland). The reference value was 2.7 percent, while Latvia’s inflation from May 2012 until April 2013 was 1.3 percent. Second, the budget deficit has to be a maximum of 3 percent of GDP, but Latvia’s deficit was only 1.2 percent of GDP last year, and it is forecast to be the same in 2013. Third, the public debt must be below 60 percent of GDP, and Latvia’s debt was only 40.7 percent of GDP at the end of 2012. Fourth, the exchange rate must have been stable for two years, and since Latvia has had a pegged exchange rate since the early 1990s it easily fulfilled that criterion. Fifth, the long-term interest rates need to be less than a reference value of 5.5 percent in April 2013, and Latvia’s average long-term interest rate over the year to April 2013 was 3.8 percent. Sixth, monetary legislation has to be compatible with EU requirements on the independence of the central bank, etc., with which Latvia also complied. Finally, other factors may be considered. The ECB warns that Latvia has to make sure that its competitiveness gains and fiscal consolidation are being maintained, but no real concerns were raised.

The Latvian government and the Bank of Latvia are to be congratulated on this verdict, for which they have worked so hard. Many wonder why the Latvian authorities have been so anxious to join the euro. Why run into a burning house? The fundamental reason is that Latvia’s massive output fall of 24 percent in 2008–09 was caused by a liquidity freeze, which in turn was caused by the complete absence of ECB credits. Like Estonia and Lithuania, the Latvian leaders say never again. Moreover, this small country of 2 million souls has a very open, diversified economy that is dominated by trade in euros. Indeed, most of its banking is euroized. With a fixed exchange rate, Latvia cannot pursue an independent monetary policy in any case. The small Baltic states have only been independent since 1991, a longer period than their last time of independence in the interwar period, 1918–40. For them, a central seat in the European Union is vital for their national security.

The only question has been when to join. Like other European leaders, the Latvian leaders are convinced that the euro will survive. The Economic and Monetary Union (EMU) is a club, and a club determines the cost of entry, so the price of bailouts is not likely to fall over time. Finally, Latvia is fully qualified now and nobody has opposed its entry for political reasons. The Latvian leaders thought they had every reason to go ahead as soon as possible.

Not surprisingly, the euro has lost popularity in Latvia during the protracted euro crisis, as it has elsewhere in Europe. Since the crisis has abated, however, the popularity of the euro has recovered somewhat to about one-third, while another third opposes it, and the final third is hesitant. The main opposition, however, rests with the Russian-speaking electorate, which amounts to about one-third, and this opposition is unlikely to expand. The government has skillfully maneuvered to avoid a referendum, which is otherwise a common practice in Latvia, and it has managed to do so because the opposition is disorganized. Given that the fixed exchange rate continues to enjoy strong support, it does not make much sense not to adopt the euro, although Denmark actually maintains such a policy.

After the Cyprus banking crisis, parallels have been drawn between Latvia and Cyprus. Half of the Latvian bank deposits come from nonresidents, predominantly Russians. However, this comparison is not valid for three reasons. First and most important, Latvia’s banking assets are far smaller than those in Cyprus. At the end of 2012, they amounted to only 122 percent of its GDP, while those of Cyprus were about 700 percent of GDP. Second, Latvia has much stricter bank regulation than Cyprus, where Russian and Ukrainian officials held large accounts. Third, Cyprus is a center for Russian and Ukrainian transactions, which Latvia is not, since only Cyprus has a highly beneficial double-taxation treaty with Russia and Ukraine. Yet, the Latvian authorities are well aware of the potential dangers and have reinforced bank regulation and inspection.

In the next month, the final EU decisions on Latvia’s euro adoption will be made. On June 20–21, the EU finance ministers will consider it. On June 27–28, the EU Council of the heads of governments will pass their judgment. During its plenary session July 1–4, the European Parliament is expected to approve a resolution on Latvia’s euro adoption. On July 9, the EU finance ministers will make the final decision. Latvia has already promulgated legislation on how the euro adoption will take place, drawing on the wealth of experience of other EMU countries. A critical issue is to maintain pricing in two currencies for a prolonged period so that the currency conversion does not lead to an inadvertent price hike.