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Final green light for Latvia to adopt the euro in 2014Sustainable low inflation a challenge. Small short-term effects from accession

FRIDAY

JULY 5, 2013

At the Ecofin Council meeting in Brussels onJuly 9, European Union finance ministers areexpected to formally approve Latviastransition to the euro from January 1, 2014.

This is Latvias last step toward becoming the18

thmember of the euro zone.

In practice, Latvia has already received the green light.The final hurdle was cleared after a discussion in theEuropean Council on June 27-28 when the Councilcongratulated Latvia for fulfilling the convergencecriteria of the Maastricht Treaty, based on soundeconomic, fiscal and financial policies. Earlier lastmonth, on June 21, the euro zone member statesadopted a recommendation in favour of Latvianaccession and said they agreed with the EuropeanCommissions assessment that Latvia has achieved a

high degree of sustainable convergence. Early in June,the Commission and the European Central Bank bothpublished positive convergence reports on Latvia.

Ever since 2009, when Valdis Dombrovskis took office asprime minister amidst deep economic crisis, the Latviangovernment has been clearly determined to adopt theeuro. Over the past two years, the government has stuckto 2014 as its target date.

Since 2012, our assessment has been that Latviawould also get an OK for euro membership after theEC and ECB convergence reports. In the March 2013

issue of our semi-annual report Eastern EuropeanOutlook, we highlighted several reasons for coming tothis conclusion:

1.All Maastricht criteria are fulfilled by a wide margin.

2. It is difficult to accuse Latvia of using quick-fixeconomic policies to force down inflation and budgetdeficits; the downwardtrend of recent years appearslasting, looking ahead a year or two.

3.Convergence toward future euro zone accessionwas one key objective of Latvias EU/IMF-ledinternational loan package in 2008-2011 (i.e. Latvianeuro adoption has also been in the interest of the EU).

Fulfilment of the Maastricht criteria*

ECB Convergence Report, June 2013

Criterion Reference value Latvia

Inflation 2.7% 1.3%Gov. budget (2012) -3.0% -1.2%

Gov. debt (2012) 60% 40.7%

Interest rate 5.5% 3.8%

Exchange rate Stable 2 y in ERM II OK

*Inflation at the time of evaluation may not be higher than1.5 percentage points above the yearly average for the

three EU countries with the lowest inflation (Sweden 0.8per cent, Latvia 1.3 per cent, Ireland 1.6 per cent). The

general government budget deficitmay not exceed 3 percent of GDP. Government debtmay not exceed 60 per cent

of GDP or must be moving down towards this level at asatisfactory pace. Long-term government bond yields maynot exceed 2 percentage points above those of the three

EU countries with the lowest inflation. The exchange ratemust have been stable for two years, with ERM IImembership and no devaluation. Furthermore, the central

bankmust be politically independent. Worth noting is thatwhen the ECB and the EC evaluate whether a country

meets the Maastricht criteria, they also assess whetherthere has been a sustainable deceleration in its inflationrate and budget deficit.

Source: ECB, SEB

4.The EU probably wants to show that the europrocess is alive, despite the current economic crisis invarious member countries.

Criteria are fulfilled but challenges ahead

As mentioned, the EC as well as the ECB gave the go-ahead for Latvia to convert to the euro in January 2014,as the country meets all the required Maastricht criteria.

Olli Rehn, Vice President of the European Commission,also praised Latvia at a press conference announcing theconvergence report on June 5: I am glad to announce

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Economic Insights

that we have concluded that Latvia is ready to adopt theeuro on January 1, 2014, having achieved a high degreeof sustainable economic convergence with the euro

area.

Furthermore Olli Rehn said: Latvias experience showsthat a country can successfully overcomemacroeconomic imbalances, however severe, andemerge stronger out of the crisis with a solid recovery.

However, at the Ecofin meeting on July 9 one shouldnot expect only praise for Latvia in the councilscomments/statement on its final YES decision. In their

convergence reports, both the EC and the ECBlaying

the foundation for the Ecofin decisionexpressedconcerns over the longer-term sustainability of the

countrys economic convergence. In this respect theECB was more expressive compared to the EC, whichfocused more on recipes for handling challenges.

Catch-up process an inflation risk

To start with inflation, the ECB noted that in the past tenyears, consumer price inflation in Latvia has been veryvolatile, ranging between annual averages of -1.2 percent and 15.3 per cent our graph shows also a higherdegree of volatility in inflation compared to Estonia (aeuro zone member since 2011) and Lithuania (targetingmembership in 2015 but in our view it may be tricky tobring down inflation sufficiently for this). This reflectsLatvias past boom-bust cycles and high macroeconomicvolatility, admitted the ECB. But maintaining low inflationwill be challenging in the medium term: the catch-upprocess is likely to drive up the inflationdifferentlyin Latvia and the overall euro area, according to ECB.

The EC was less sceptical on the inflation issue in itsreport and said that risks to price stability from catch-uprelated price adjustments are limited by the recentlydemonstrated flexibility of Latvias labour market and

wage-setting mechanisms, which should ensure thatlabour costs are aligned with productivity. But the ECpointed to the necessity of addressing bottlenecks in the

labour market: a shortage of well-qualified labour in themedium term could drive up wages relative toproductivity. The productivity growth required to ensure

a smooth catch-up in the price level will largely dependon improvements in the business environment andprogress in attracting new investment, the EC wrote.

Regarding longer-term economic sustainability ingeneral, both the EC and ECB stressed theimportance of continued economic policy discipline.The EC noted that policy discipline increased during andafter the crisis but has not always been strong in thepast. The ECB argued that it is necessary for Latvia tocontinue along a path of comprehensive fiscalconsolidation in line with the requirements of theStability and Growth Pact and to lock in the

competitiveness gains achieved in recent years bykeeping labour cost growth in check. The ECB also saidthat it is crucial that a comprehensive policy toolkit isavailable to deal with risks to financial stability, includingthose stemming from the reliance of a significant part ofthe banking sector on non-resident deposits as a sourceof funding.

Minor short- term effects expected

Anticipating a green light on July 9 for Latvian euro zonemembership, we foresee no dramatic economicconsequences in the short term. The main reason is

that Latvia became euroised de facto on January 1,2005) when the lats was re-pegged from the SDR to theeuro. That same year (on May 2, 2005), the lats enteredthe exchange rate mechanism ERM II, with a standardfluctuation band of +/-15 per cent. Upon ERM II entry,the authorities unilaterally committed to maintaining atighter fluctuation margin of +/- 1 per cent around thecentral rate. Over the two-year reference period at thetime of ECB and EC evaluation in May 2013 the lats alsoremained close to its central rate. Thus, in practice,Latvia lost its ability to conduct an independentmonetary policy in 2005.

We see the following short-term economic effectsahead of, and in connection with, euro adoption onJanuary 1, 2014:

The LVL will probably be converted intoeuro at the ERM II central parity. The realeffective exchange rate (REER) is also in linewith fair value after the necessary internaldevaluation (lowering of wages and costs) in2009-2010, which corrected severe internalimbalances after earlier overheating in theLatvian economy. During that period, averagemonthly wages and salaries were lowered by atotal of 19 per cent in Latvia and the REERdepreciated by about 11 per cent.

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