Latvia now Euro Zone’s 18th member state: Not just cause for celebration

Kiel Focus

Kiel Focus

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Viewed against the backdrop of a series of escalating crises in the euro zone, it is remarkable that Latvia, now the 18th EU member state, finally adopted the euro as its common currency on January 1, 2014. Having followed in the footsteps of Estonia, which entered the euro zone in 2011, Latvia constitutes the second Baltic state to have met the requisite criteria for adopting the euro as its common currency. The experiences drawn from the so-called “euro crisis” bring two questions to the fore: Can the Latvian economy handle the euro? Is there cause for concern that Latvia’s entry will impose an additional strain on the euro group?

Viewed against the backdrop of a series of escalating crises in the euro zone, it is remarkable that Latvia, now the 18th EU member state, finally adopted the euro as its common currency on January 1, 2014. Having followed in the footsteps of Estonia, which entered the euro zone in 2011, Latvia constitutes the second Baltic state to have met the requisite criteria for adopting the euro as its common currency. The experiences drawn from the so-called “euro crisis” bring two questions to the fore: Can the Latvian economy handle the euro? Is there cause for concern that Latvia’s entry will impose an additional strain on the euro group?

In the wake of Latvia’s independence from the Soviet Union in the fall of 1991, the country gradually developed into an operational market economy and fully diverted its attention to the prospect of EU integration. Despite constantly changing governments and amid temporary turbulence in its reform policies, Latvia has remained on track. Latvia’s trajectory toward Europe had been reached once it obtained full membership to the EU on May 1, 2004. This new beginning was also reflected in a simultaneous boost to its real economic development. Latvia seemed to excel in the 2000s with double-digit growth rates that effectively reduced the prosperity gap with the more affluent EU nations. Until the outbreak of the economic and financial crisis in 2008, Latvia even proudly wore the epithet of a “Baltic tiger state.”

But Latvia’s economic fall during the 2009 crisis virtually heralded the end of the growth miracle, when the Latvian economy, hitherto growing stronger than any other EU economy, had shrunk by almost 18 percent. In reality, growth rates attained in the 2000s as a result of a boom in demand could not again be matched. By 2011, however, Latvia has again succeeded in returning to a growth trajectory in the 5 percent range, which is appropriate for a catching-up economy. As the forecasts for 2014 clearly show, Latvia will remain in this growth corridor and gradually regain lost territory. Even if a “tiger growth” can no longer be predicted, Latvia has already succeeded in overcoming its short-term growth crisis.

Latvia’s robust economic growth in the years following its EU accession led to a favorable employment trend. During the course of the crisis, the Latvian rate of unemployment rapidly sped to a level hitherto unknown, at almost 20 percent. The recovery that began in 2011, however, has resulted in a declining rate of unemployment, being at the 10 percent level. Thus Latvia is spared the fate of an employment crisis that has hit the southern European countries.

Before the global financial and economic crisis, Latvia could boast a comparatively small national budget deficit and, analogously, a small debt ratio relative to the GDP. Yet, the financial stability that Latvia had experienced until then temporarily ended in the aftermath of the crisis. Having reached a debt level of 44 percent in 2010, Latvia was still far removed from the benchmark set in Maastricht, by 15 percent points, which Germany, e.g., has clearly surpassed. The situation in Latvia has not deteriorated since then; rather it has slightly improved. The general government deficit in the coming years will remain well below the 2 percent level; the debt level probably will linger in the 40 percent range. Latvia has thereby reached a debt level that is sustainable and will, in fact, be able to maintain its deficit level in the coming years.

Against that backdrop, Latvia in no way represents a “problem country” for the euro zone. The Latvian economy has survived the crisis without sustaining greater damages, if thanks only to the strict austerity politics that imposed severe cutbacks on people and in part brought about reversals in social development. Certainly, this could also be attributed to the fixed exchange-rate (currency board) system that until recently pegged the Latvian lats to the euro, which in turn prevented a devaluation of the lats. Instead, devaluations occurred “internally” through drastic cuts to income levels. Latvia thus still is one of the poorest EU economies.

But what about Latvia’s economic development potential? Latvia still does not offer a range of high quality products that allow it to make its mark on the stage of the world economy. The dominant production lines still are labor, raw material and capital intensive, and service industries predominantly offer a rather modest income potential. “High-tech made in Latvia” is still a rarity and qualified young people too often seek greener pastures outside the country. Latvia has obviously not attracted vast private investments in premium international value-added chains.

On what can Latvia pin its hopes to help it achieve the required growth thrust? Riga, a bank sanctuary that provides the international platform for financing and closing the east-west trade, still represents an old Latvian dream. That produces both opportunities and risks. This business model of Latvia had already suffered a harsh reversal during the banking crisis of 2008, which in the short-term at least impacted the macroeconomic stability of the country. And with its entry to the euro zone, rumors continue to circulate that Latvia could replace Cyprus as the “safe haven” for foreign capital investments from different sources. It would thus be in Latvia’s interest to rely on an influential supervisory authority to prevent banking excesses as those in Cyprus. The country can profit from the EU even in this regard as the latter prepares to set up a European financial supervisory authority.

Latvia must be welcomed into the euro zone as an economy geared toward stability. But doubts still remain as to whether its membership in the hard currency union will be able to optimally support the catching-up process of a country that is still poor. Latvia must definitely resist the temptations that have unsettled Cyprus after its entry to the euro zone.