Is Latvia Really Mature for the Euro?
April 3, 2013
A couple of weeks ago, Latvia decided to apply for EMU/euro membership from 2014. This is an understandable step – but is it also a wise decision? I do have my doubts.
Sure, Estonia joined the euro in 2011. But all three Baltic States have their own characteristics; my own experience tells me that Estonia still should be regarded as the most flexible Baltic country. Latvia’s return to reasonable GDP growth at currently around 5 percent certainly has to be considered as a remarkable performance after the turmoil of 2008-2010 in a pure macroeconomic perspective (which many foreign analysts – unfortunately – tend to prefer). We should, however, not forget that pain was quite strong for major parts of the Latvian population as a result of the internal devaluation in the past years – and that Latvia could not come on the track of recovery without the support of the EU and the IMF.
My main arguments against Latvia’s joining of the euro already next year look as follows:
1) It is certainly no secret that Latvian public and political opposition to the lats’ euro entry is relatively strong. Such a constellation is no good starting point for a new exchange rate regime.
2) The Latvian economy was confronted with a severe economic crisis only 3-4 years ago. Thus, we do not know very much about the sustainability of the competitive progress that could be achieved by the internal devaluation.
3) A couple of years ago, the current account deficit of Latvia exceeded 20 percent of GDP – a horrible ratio! Currently, the situation looks better. But what will happen to the current account 5 to 10 years from now when the effects of the internal devaluation probably will have been wiped out (more or less)? I doubt whether Latvia in a couple of years will have achieved a structurally healthy current account balance. Of course, I hope this will be the case.
4) One of the main problems to come to a persistently favorable development of the current account is the very difficult process toward a new and modernized structure of Latvian exports with good qualitative and technological competitiveness on tough global markets. The way to such a fundamental change will be very, very bumpy – with a very uncertain outcome.
5) Right now, the Latvian government seems to have a feeling that the safety net for its currency, the huge bank lending in euro, and the banking system ought to regarded as more stable within the Eurozone than outside. Recent experience, however, tells us a different story. Small countries cannot be too small to fail! A little reminder: At present, the small EU/EMU country of Slovenia – having roughly the same population as Latvia – seems to give increasing reasons for concerns.
6) One of the worst disadvantages that could be watched already before the financial bubble burst in 2008, was the absence of an independent monetary policy because of Latvia’s membership in the ERM2 system, the final currency step of EMU preparation before joining the monetary union. If the instrument of an independent monetary policy still had been in place between 2006 and 2008, much misery could have been avoided in the following years (GDP loss more than 20 percent).
In other words: Only very competitive and fundamentally strong economies can afford the loss of national monetary policy decisions as a tool for adjusting or changing wrong developments at home.
Thus, the conclusion should be that Latvia should wait at least another business cycle – which could be 5-8 years – before the idea of joining the euro may be re-considered!
Hubert Fromlet
Professor of International Economics
Editorial board