Latvias Plan to Join the Embattled Eurozone October 16, 2013 | 1004 GMT Summary (ILMARS ZNOTINS/AFP/Getty Images) European Commission Vice President Olli Rehn (L), Latvian Prime Minister Valdis Dombrovskis (C) and Latvian Finance Minister Andris Vilks at an event unveiling Latvias euro currency on Sept. 12. Latvias search for economic stability and a way to counter Russian influence is at the root of Rigas decision to adopt the euro. Membership in the struggling currency union offers both economic opportunities and serious challenges for the Baltic country. Faced with a slowly recovering economy, a dependence on Russian energy imports and a banking sector that relies heavily on foreign deposits coming mostly from the former Soviet Union, Latvian leaders went against the wishes of their own constituents and finalized plans to join the eurozone at the beginning of 2014. Eurozone membership will boost Latvias economy, provide a safety net for its financial institutions, deepen integration with Europe and help counterbalance Russian influence, but it will also present the country with new responsibilities and financial burdens as a member of a club whose future is uncertain. Analysis As the European Union struggles to define its economic and political future, the eurozone is about to welcome its newest member. Latvia is set to become the eurozones 18th member in January 2014. While Latvias EU accession treaty stipulated that the country would become a member of the eurozone, many observers -- as well as a majority of Latvians -- doubted the wisdom of abandoning the lat for a currency whose future seems uncertain. Latvian Prime Minister Valdis Dombrovskis has pushed ahead with plans to adopt the euro despite the opposition of a majority of Latvians. Dombrovskis believes that eurozone membership will grant Latvia a much-needed financial safety net and deepen the countrys economic integration with Europe. Latvias Search for Economic Stability When the international financial crisis hit Latvia in 2009, it caused gross domestic product to fall by more than 17 percent. The impact of the crisis forced Latvias government to nationalize the countrys second-largest bank and request a $7.5 billion loan from the International Monetary Fund and the European Union. Latvia has since introduced a wide range of reforms and structural adjustments, helping resume growth. With unemployment hovering around 11 percent and government debt representing 40.7 percent of its GDP according to Eurostat, Latvia is doing better than many of its European counterparts. Real GDP grew by 5 percent in 2012 -- a modest increase when considering Latvias GDP fell by 17.7 percent during the 2009 crisis -- and steady growth rates over the past two and a half years point to a gradual recovery. Underneath the surface, however, Latvias leaders know the country is far from economically stable. With a banking sector that depends on foreign deposits for funding and a heavy reliance on Russian energy imports, Latvias recovering economy is vulnerable to outside pressures. Ratings agency Moodys reports that by the end of 2012, 49 percent of total deposits in Latvian banks belonged to non-residents. This makes Latvias financial system unique in the region: In neighboring Estonia, only 16 percent of deposits come from non-residents. An IMF study found that 80-90 percent of Latvias non-resident depositors come from the former Soviet Union. These depositors are drawn not only by Latvias relatively low tax rates, but also by the countrys geographic proximity, the presence of a significant local Russian-speaking population and the opportunity to park funds far out of the purview of Russian authorities. The recent crisis in Cyprus made Latvia an even more desirable financial destination. In 2012 non-resident deposits grew by 12 percent, mostly due to an influx of money relocated from Cyprus. Deposits from non-residents form the basis for the funding and survival of Latvias banks. International institutions ranging from the European Commission to the IMF have warned Latvia about the instability that these vast amounts of foreign deposits bring to Latvias banking sector. The Latvian government has sought to reassure its international partners that Riga takes this risk seriously by raising liquidity requirements for banks holding non-resident deposits. Even with these precautions, however, Latvias leaders are fully aware that their banks are highly dependent on funds arriving from Russia and other former Soviet states. The banking sector, however, is not the only segment of Latvias economy that is closely connected to the countrys powerful neighbor. Russia supplies practically all of Latvias natural gas and most of its oil. Unlike its neighbor Estonia, which can tap domestic shale oil resources, Latvia is extremely dependent on Russia for energy. On one hand, Latvia benefits from its close energy ties with Russia: Household electricity and natural gas prices in Latvia are among the lowest in the European Union. Russias role as the exclusive exporter of natural gas to Latvia, does, however, give Moscow a great deal of leverage in its relations with Latvias government. Despite plans for future diversification, in the near term Latvia has few alternatives. Riga relies on Soviet-era energy infrastructure and has yet to integrate into European energy networks. While Lithuania is continuing work on its new liquefied natural gas terminal and the European Union has pledged to help fund projects that could connect the Baltic states with European energy markets, it will be years before Latvians no longer have to import the vast majority of their energy supplies from Russia. Latvias relationship with Russia is further complicated by Latvias large population of ethnic Russians, who make up 27 percent of the total populace.Harmony Center, the countrys pro-Russian political party, now holds more seats in the parliament than any other one party. Although Harmony Center is currently in the opposition, its electoral strength does give Russia another indirect lever of influence in Latvian politics. In order to ensure continued economic stability and independence, Latvias leadership has decided to create closer ties with European institutions able to counterbalance Russia. For Latvia, eurozone membership brings a greater guarantee of EU intervention on the countrys behalf should Russia decide to use its considerable economic leverage to pressure Latvia in the future. Costs and Benefits of Eurozone Membership Latvia became a member of the European Union during the large 2004 expansion round and has pegged its currency to the euro for the past eight years. Its relationship with eurozone economies is thus close, and adopting the euro would deepen Latvias economic integration into Europe even further. Latvias government has argued that adopting the common currency would lower interest rates, reduce transaction costs and boost investment in the country. There are already signs this is the case: Ratings agency Fitch upgraded Latvias credit rating in mid-2013 after the European Commission announced the country was ready to adopt the euro. The experience of neighboring Estonia also points to the economic benefits of eurozone membership. Like Latvia, Estonias economy is highly integrated with the European Union and its currency has long been pegged to the euro. Estonia joined the eurozone in January 2011, at the height of the crisis. Nevertheless, the countrys real GDP grew by 9.6 percent in 2011, up from a more modest 2.6 percent growth rate in 2010. By 2012, 83.3 percent of foreign direct investment in Estonia came from EU countries. Moreover, Estonias exports grew by 37 percent in 2011. Latvias exports also performed well that year, increasing by 28.1 percent, while Lithuanias exports grew by 28.8 percent, but Estonias export boom in the months following euro adoption points to an added advantage Latvia will enjoy when it joins the currency area in 2014. Eurozone membership does come with serious costs and risks for Latvia. As we discussed in our 2013 annual forecast, the eurozone is likely to survive, but the tools European leaders have created in recent years to reduce the impact of the crisis do not address the fundamental issues of competitiveness, political fragmentation and social instability in the eurozone. The Latvian public is concerned about the future of the bloc and the potential costs of switching to the euro. In September this year, only 24 percent of Latvias population supported the adoption of the euro, while 52 percent opposed it and 22 percent had a neutral attitude toward the governments decision to pursue membership in the common currency. For a small country like Latvia, eurozone membership comes with a significant financial burden. When Estonia joined the eurozone, its debt nearly doubled in one year, partly due to its obligation to contribute about 2 billion euros (about $2.7 billion) to the European Stability Mechanism to help finance bailouts in Europes troubled periphery. As the newest member of the eurozone, Latvia is likely to face similar expenditures, which will stress its modest resources and risk further alienating a public that believes the common currency is not the right choice for the country. Although Latvias economy can be expected to benefit from eurozone membership, the real significance of eurozone accession rests not in its direct impact on Latvias economy, but in the institutional rights -- and demands -- that eurozone membership entails. The eurozones institutions and member countries will likely step in to protect Latvias financial system should the need arise, as they have in other eurozone countries experiencing economic troubles over the past few years. Furthermore, after adopting the euro, Latvia will have some influence and a seat at the table during discussions regarding the currencys future, and thus that of Europe. Latvia will play a role, along with the other eurozone countries, in crafting new processes and mechanisms for financial integration. At the same time, Latvia will have to comply with the complex rules and regulations that come with eurozone membership. Like Estonia, it will be called upon to contribute to European efforts to fix the eurozones problems. When it joins, Latvias GDP will be the lowest in the eurozone, and while it will enjoy more influence than it previously had in European institutions, Latvian voters are likely to become more disenchanted with the European Union if they are forced to help pay for bailouts in countries with a higher GDP per capita than Latvia, such as Greece. Moreover, because eurozone membership entails a loss of control over monetary policy, should Latvia undergo another economic crisis, it will not have the option of devaluing its currency and will be forced to introduce another round of austerity measures. With a relatively resurgent Russia at its borders, Latvia has spent the past few years working hard to become a full member of the European community. To ensure the countrys economic stability, Latvian leaders feel that they need the eurozone and its institutions to provide Latvia with a safety net. During a time when the rest of the continent is struggling with high unemployment rates, boosting trade with other European countries could help Latvias economic recovery. Prime Minister Dombrovskis is spending political capital and taking all the risks associated with adopting a currency whose future is being debated in cities across Europe, in the hope that Latvia will eventually be less vulnerable as a result.
Posted on: Thu, 17 Oct 2013 17:37:44 +0000
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