Baltic nation to join the euro on New Year’s Day against the wishes of its own people, five years after its economy crashed in flames
The tiny Baltic nation of Latvia is to join the euro on New Year’s Day against the wishes of its own people, becoming the eighteenth and poorest member of monetary union five years after its economy crashed in flames.
The country has endured a 1930s-style depression and a drastic experiment in EU shock therapy with stoicism, abiding strictly to the terms of an EU-IMF bail-out.
It has exported its way back to balance and defied critics by defending its euro-peg through thick and thin, yet the feat comes at a high social cost.
Euro accession has been greeted glumly by most of Latvia’s 2m people, worn down by lay-offs and 28pc pay cuts for teachers, nurses, and police. A mass exodus of youth has served as an escape valve, leaving an older society behind. Latvia’s population has shrunk by 7pc since 2007.
An SKDS poll in November found that just 20pc favour giving up the national currency, the Lats, brief symbol of sovereignty in the interwar years between interludes of Tsarist and Leninist occupation. The Lats was restored with great emotion in 1992 after Latvia broke free of Soviet control.
Few seem mollified by the familiar face of Milda — the braided ‘Latvian Maiden’ — on the new euro coins. Some 58pc are against joining the new currency, yet the government has chosen to press ahead regardless without a referendum.
Latvians are acquiescing quietly, if only because the euro helps to counter the strategic threat of Vladimir Putin’s Russia to the East. “Russia’s long shadow is the most important factor in Latvian politics,” said Professor Ivars ?jabs from Riga University.
Latvia’s leaders have sought to lock the country as deeply as possible into the western economic and security system, aiming to raise the bar high enough to discourage meddling from Moscow. Finance minister Andris Vilks says the euro is an insurance policy. “We can see what is happening in Ukraine. Russia isn’t going to change. We know our neighbour,” he told the Financial Times .
Latvia’s ordeal of boom, bust, and recovery has set off a heated debate among economists worldwide over the pros and cons of rigid austerity and fixed-exchange rates, a dispute unlikely to be settled by euro-entry.
Olivier Blanchard, the IMF’s chief economist, warned that Latvia’s saga should be treated with “great caution”, saying the country is sui generis and may not be a useful model for others. This has not stopped both sides digging in their heels.
European officials praise Latvia as the poster-child of “tough love” policies and a vindication of EMU “internal devaluation” strategy, proof that hard grind pays off better than a devaluation quick fix.
The economy grew by 5.5pc in 2011, and 5.6pc in 2012, and should grow by 4pc this year. Productivity levels have soared. The unemployment rate has dropped from a peak of 20.5pc to 11.9pc. Olli Rehn, the EU economics commissioner, says Latvia is a role model for EMU crisis states. “Tough decisions have allowed Latvia to emerge much stronger economically than before the crisis,” he said.
Critics are exasperated by such claims, countering that it was the euro-peg that incubated Latvia’s disaster in the first place, leading to interest rates that were far too low for a post-Soviet catch-up economy. The policy stoked an extreme credit bubble.
The country then lurched violently the other way, with GDP contraction of 25pc over eight quarters, and a 42pc fall in internal demand. Latvia’s leaders clung to an overvalued exchange rate against the advice of the IMF — largely for political reasons, but also to shield middle-class homeowners with euro and Swiss franc mortgages.
Real GDP remains 8pc below its peak even now. The unemployment rate has been flattered by emigration. Prof Mihails Hazans from Latvia University said the majority of those leaving are under age 35, often the best-educated. Just 20pc plan to return within five years. Latvian society has been gutted.
“The adulation of Latvia tells us more about what the European policy elite wants to believe than it does about the realities of Latvian experience,” said Nobel economist Paul Krugman, the most vocal of the critics. “What lesson does Latvia hold for other countries, and the euro in general? The answer, in brief, is none.”
A key question is not whether Latvia is growing again but whether it is close to fulfilling its potential as a post-Marxist Tiger economy with full access to the EU markets that should be enjoying Asian style growth rates. Poland has done much better over the last decade as a whole, deploying its currency to check the boom and then to cushion the shock after foreign credit dried up in 2008.
The IMF said Latvia’s recovery has been a success, but also questioned whether this can be replicated. The country has an open economy with exports equal to 60pc of GDP, double levels in southern Europe. It places 24th on the World Bank’s Ease of Doing Business index, comparable to Germany and above Holland, Austria, and France.
Latvia has a public debt near 40pc of GDP, far below levels in Greece, Cyprus, Ireland (Other OTC: IRLD – news) , Portugal, Italy, or Spain. This reduces the risk of a spiralling debt ratio caused by deflation policies, the so-called ‘denominator effect’.
Swedish and other Nordic (SES: MR7.SI – news) banks control 60pc of the Latvian banking system, reducing the need for the state to shore up the financial system — as in Ireland, or Spain.
The irony is that Latvia is now inventing a new business model for itself as a tax-haven and off-shore banking centre for Russian funds, luring deposits away from crippled Cyprus. It is a new Cyprus in the making, says Marco Giuli from the College of Europe. But that is a drama for another day, and another cycle.