Latvia: the Long Road to the Euro

The EU debt crisis has brought several vulnerabilities of the Eurozone to the surface, raising the issue of economic consistency of Brussels' monetary policy. Slower economic growth, strict budgetary discipline, rising unemployment and, consequently, social tensions are the prevailing economic trends in Europe. Nevertheless, the common European currency is still attractive for countries outside the Eurozone. On January 1, 2014, Latvia adopts the euro, but is it ready for this new political and economic environment?

The EU debt crisis has brought several vulnerabilities of the Eurozone to the surface, raising the issue of economic consistency of Brussels' monetary policy. Slower economic growth, strict budgetary discipline, rising unemployment and, consequently, social tensions are the prevailing economic trends in Europe. Nevertheless, the common European currency is still attractive for countries outside the Eurozone. On January 1, 2014, Latvia adopts the euro, but is it ready for this new political and economic environment?

The dire effects of the Eurozone debt crisis have not affected the popularity of the common European currency in countries whose elites aim to climb the pinnacle of Eurointegration. Of course, the Baltic States are at the forefront, since Baltic leaders are eager to gain protection by more affluent Germany and France and delegate anti-crisis measures to Brussels, thereby deferring responsibility for any possible consequences from a fresh package of utterly unpopular

Estonia was the first Baltic country to adopt the euro in 2011, Lithuania is to close the circuit in 2015, while Latvia is entering the top stage of European unity as soon as January 1, 2014. During the two weeks before and after this date, both euro and lats will circulate, after which the latter will be withdrawn.

However, the Latvian society is not yet sure about the practicality of this decision. Will joining the Eurozone bring forward the long-awaited new stage of national development, or will Riga's dream cause more losses for a Latvian economy already weakened by the crisis? According to European statistics, Latvia was among leaders in the fall in the GDP rate during the height of the crisis. It is not for nothing that the Czech Republic and Poland, more economically viable EU freshmen, are taking their time with deeper Eurointegration, although their economies have long been part of the common European economy, not to mention Great Britain, Sweden and Denmark.

Latvia Passes the Maastricht Test

Photo: www.consilium.europa.eu
Valdis Dombrovskis and Herman Van Rompuy

Formally, entry into the Eurozone should mean that Latvia has successfully met a package of fairly strict requirements set forth by the European Monetary Union. In fact, these pertain to the implementation of criteria envisaged by the 1992 Maastricht Treaty that obliges applicants to the European currency space to observe inflation and debt thresholds and budget deficit limits, and to maintain a fixed currency rate. And it is the latter provision that the Latvian government is taking credit for as a significant factor for praise from the EU Economic and Financial Affairs Council. The Czech government instead regards the country's economic success during the crisis period to its floating national currency relative to the dollar and the euro. Czech politicians believe that as result the country survived the 2008 disaster with relative ease and even displayed record growth rates among new members outside the Eurozone.

However, in order to fulfill the Maastricht criteria and receive the green light into the Eurozone, the Latvian economy had to undergo a number of grueling trials. It appears safe to say that since 2009, it is not just the Latvian economy that has been tested for strength but also the political competence of the government that was being assessed.

The issue of Latvia's accession to the Eurozone popped up in parallel to its EU application in 1995. But an increased level of Eurointegration became a reality only after 2009, when the coalition government of Valdis Dombrovskis – which succeeded the unpopular cabinet of Ivars Godmanis – took up radical stabilization measures to bail Latvia out of the deep economic crisis. This was the condition of the International Monetary Fund in order to provide Riga with an anti-crisis package and the Latvian economy with a slight repose, badly needed to appease the public and then launch the Eurozone drive. Even in those bad times, known both by the gravest crisis for Europe's emerging economies and considerable social tensions, the new government hoped for a quicker completion of the Eurointegration project and a transfer over to the single European currency in the aim of to obtaining economic security guarantees.

In a nutshell, the case of Latvia's accession proponents appears as follows:

• Increased foreign investment inflow and higher international ratings for Latvia as a collateral benefit.
• More jobs, primarily in the services sector, and the return of emigrants (according to Latvian official statistics, in 2013 emigration has by far exceeded immigration).
• Lower transaction costs for trading with Eurozone members.
• Influence on decisions made by Eurozone members.
• Further export growth launched by the government recovery measures in previous years.
• Presence in the same currency zone with Germany and Estonia, its main trading partners, which minimizes the impact of future crises on Latvia.

Photo: Long-Term migration

From Austerity to Social Safety Net

Latvia is entering the Eurozone against the backdrop of delicate domestic controversies. In November 2013, Mr. Dombrovskis resigned after the Maxima mall roof collapsed, which caused the deaths of 54 people.

Mr. Dombrovskis made history by holding the premiership for a record 4.5 years, a unique phenomenon for independent Latvia, mainly due to his ability to combine gentle governance with tough economic decisions. These actions saved several Latvian sectors (food processing, textiles, and ship-repairing), increased the country's investment attractiveness, and preserved social stability despite unpopular social reforms and sharp national differences during the crisis period.

Among other things, the investment climate has improved thanks to his residence visa program for investors in Latvian economy with the amendments to the 2010 Immigration Law. The amendments offer three options, each entitling EU nonresidents (first of all Russians) not just to a residence visa but also to its prolongation and permanent settlement provided certain requirements have been observed. The measure has stimulated the cash influx into the Latvian economy and alleviated the impact of budget cuts.

Apart from increasing investment attractiveness, the Latvian government also focused on improving the business climate, with the results of this strategy already at hand.

According to the Doing Business annual rating compiled by the World Bank in 2013 for the year ahead, Latvia is in 24th place, having improved its previous standing by one point. In the 2014 ratings, Latvia is behind every other Baltic republic. For comparison, in 2013, Latvia (25th position) was overtaken only by Estonia (21st). In the similar 2011 rating, Latvia was only 31st, which conclusively points to the efficiency of Mr. Dombrovskis' investment stimulation policy. As for the gap between Latvia and its Baltic neighbors, the reason seems to lie in Estonia's adoption of the euro, which inspired the World Bank economists to qualify the country as more comfortable for business.

In the medium term, the relative similarity of the Estonian and Latvian economies should also heat up the investors' interest in Latvia. And the very fact of successful convergence is also a sign of economic and financial maturity of the state, which should also attract potential investors.

Photo: Real GDP per capita, growth rate and
totals. Latvia vs EU

In order to make the Euro-dream come true, the Dombrovskis government had to apply tough austerity measures with many unsavory aspects, among them the optimization of the government sector through employment reductions, salary and pension cuts, weakening oversight structures, and rigid tax policies. For example, his opponents believe that it was the abolition of the State Construction Inspection in summer 2009 that caused the tragedy in the Riga shopping center.

The inspection's functions were spread over several institutions, from the Ministry of Internal Affairs to local government construction inspections. The closure of the State Construction Inspection was substantiated by the need to eliminate nonprofit enterprises which overburden the national budget – an unattainable luxury in the midst of a crisis.

In order to stabilize the economy after the belt-tightening was over, Mr. Dombrovskis launched his social safety net program that is still underway. This pacification package includes higher minimum unemployment allowance, more accessible healthcare, and assistance for low-wage families, although risks remain that the conversion of consumer process to the euro will overpower social bonuses.

Some Reject the European Currency

Consistently implementing the Convergence Program, the Latvian government has virtually neglected society, since the decision on accession to the Eurozone did not account for public opinion, while entry into the EU had been put on a nationwide referendum. This disregard for popular opinion comes, first, from the government's unflinching determination to join the Eurozone with overall and unconditional support of international rating agencies (Moody`s, S&P), and, secondly from the political bonuses Riga expects in return.

Opponents of conversion to the euro believe that the step will trigger an unreasonable price hike despite the government's promise to monitor traders. Surveys indicate that the government does not enjoy the overall support of its currency scenario (1, 2). At that, Latvian fears are fed by the experience of neighboring Estonia, where convergence to the euro has generated an average 1.5-percent price rise annually.

Photo: www.liaa.gov.lv
Investment Environment in Latvia

Latvia's Eurointegration should produce certain political adverse effects in relations with Russia, while Russian economic interests are not to be affected. Latvian business has long been deeply integrated in European trading.

Neglect of public opinion appears to indicate that the euro transition project is rather political than economic, since when outside the Eurozone, Latvia managed to overcome the crisis in a relatively short time, although with major social losses [1]. Latvians fear that inside the Eurozone, their country will completely lose its economic independence for adopting anti-crisis measures, while the transfer of powers to Brussels would hinge their wellbeing on Germany's consent to allocate stabilization packages as was the case with Greece.

What should the EU gain by engaging the Baltic into the European Monetary Union? There are reasons to believe that Latvia will become another instrument for pressuring Russia, similar to Lithuania chairing the 2013 Eastern Partnership summit, hapless due to declared high expectations and poor results. With the help of Vilnius, Brussels has attempted to play the Russian card by proclaiming the summit a turning point in the destiny of certain post-Soviet states, first of all Ukraine. A transition to the euro is something much more than replacement of national banknotes with the common European currency. It also means the consolidation of identity, ways of thinking, and selection of economic development priorities. In this context, Latvia seems to be the most contentious Baltic country, since its Russian-speaking minority is most active both socially and politically. The Harmony Center party, largely supported by Russian speakers, has 31 seats in the Latvian Saeima, while there are only five Russian speakers in the Lithuanian and eleven in the Estonian legislature.

Region-wide, the Russian-speaking minority is the largest in Latvia – 26.5 percent, followed by Estonia with 25.4 percent, and Lithuania with a mere 5.8 percent of Russian speakers.

In the recent years, the European Union has consistently worked to integrate Latvia into its political and economic projects, the most spectacular decisions being the appointment of Riga as Europe's cultural capital in 2014 and giving it the EU chairmanship in 2015. To this end, Brussels appears ready to close its eyes to the policies of the Latvian government toward the Russian-speaking minority and legitimate events aimed at the glorification of fascism. In addition, one more member in the weakening Eurozone should make it look more respectful and trustworthy.

The debt crisis of 2008 has shown that European leaders will not finance losers without major concessions on their part. The incorporation of the frail Latvian economy into the troubled Eurozone is sure to generate an additional burden on the budgets of the European locomotives, a fact which is crystal-clear for Brussels. At the same time, the EU is ready for tactical losses, since the strategic aim suggests a complete separation of Russia and Latvia, where Russian speakers participate in political decision making.

According to statistics, it is not only Russians but also Latvians who oppose the Eurozone entry. The economic problems caused by a transition to the euro will cause problems for the entire employable population irrespective of nationality. But the worst troubles are in stall for the non-citizens who have a limited role in the political and economic life, mainly due to the uneven calculation of pensions for different categories of residents in favor of citizens. Besides, pensions are taxed starting from the level of 165-lats, and after the transition to the euro this scheme could be easily amended.

Latvia's Eurointegration should produce certain political adverse effects in relations with Russia, while Russian economic interests are not to be affected. As a matter of fact, Latvian business has long been deeply integrated in European trading, as its turnover with the EU countries exceeds that of the CIS by several times. Latvia's accession to the Eurozone will simplify currency settlements with key European partners, suggesting that after 2014 Russia is to lose some of its attractiveness for Latvian businesses, while German investments in Latvia will grow.

Most likely, the expected consumer price rise in Latvia and overall Eurozone situation may affect Russian economic interests. Banking is to remain a vital element of Russian-Latvian relations. In the medium term, Russian deposits in Latvian banks are expected to grow due to the recently signed bilateral agreement on double taxation. But the Cypriot banking drama suggests that Russians should closely watch the relations between Latvian banks and the European Union.

1. Inter alia, this relates to the Latvian government's decision to reduce remittances to the second (accumulation) level of the pension system from two to one percent, gradual increase the old-pension age to 65 years, and enforce reductions at large industrial enterprises, for example at the Liepājas metalurgs, the country's largest steelworks found insolvent by a court in 2013.