Latvia to join euro zone

Updated: 24 June, 2014 seen 755

Despite years of speculation about which country will quit first, the 17-nation euro zone will become one country bigger when Latvia joins on January, 1.

The eastern European nation with a population of just two million has been a member of the European Union (EU) free market since 2004, but finally got the green light to join the single currency zone last June. It follows in the footsteps of two other former Soviet satellite sates, Estonia and Slovakia.

As of Wednesday, Latvians will be able to exchange lats for euros free of charge at a fixed rate of 0.7 to 1 euro. There will be a two-week period during which both currencies will be in circulation, before the lat ceases to be legal tender on January 15.

Latvia and Europe

Latvia's ascension to the euro zone will consolidate its integration with the rest of Europe and the Western world, which started when Latvia became first a member of NATO and the UN (United Nations) and then the EU after the collapse of the Soviet Union.

The country remains poor compared to those in Western Europe — its GDP per capita of $21,905 was only two-thirds of the EU average in 2012, while Germany's was $41,245 — but is posting far healthier growth than most; the Latvian economy is seen expanding 4 percent this year. In comparison, the euro zone economy is forecast to contract by a further 0.6 percent.

Furthermore, Latvia is viewed by many on the continent as an exemplar of how austerity and growth can be combined. After being hit hard by the global financial crisis of 2008, the country received a 7.5 billion euro ($10.3 billion) loan from the EU, International Monetary Fund and neighboring Nordic countries and implemented the most savage austerity program seen on the continent, trimming the size of its deficit by nearly 17 percent. Measures included slashing public sector wages by an average of 25 percent, widespread job cuts, reductions in state benefits and hikes to indirect taxes.

To qualify for joining the euro, Latvia had to meet five economic "convergence criteria", which include price and exchange rate stability and low levels of government debt and deficit.

Why Latvia wants to join

Given its success in fending for itself, Latvia's decision to join the euro zone — which is slowly beginning to recover from a crippling four-year government and banking debt crisis — has left many scratching their heads.

However, membership will come with several benefits, including reduced transaction and exchange rate costs when exporting to the euro zone, to which Latvia exports 30 per cent of its goods. Membership will also reduce the economic risk from the country's large external financing requirements and high level of foreign exchange debt.

In addition, Latvia will likely become more attractive for foreign direct investment once it joins. This is partly because the cost of doing business with other euro zone countries will fall, making it more appealing for companies looking for a European base. But it is also because participation in a wider bloc may reassure investors the economy would be supported were it to flounder.

From a PR perspective, joining the euro zone also helps Latvia emphasize its post-2009 recovery. "Latvia still seems to be being penalized for the fact that it was at the center of the crisis in the region in the immediate aftermath of the 2008/09 crisis, but this fails to give it due credit for the massive adjustment it has undertaken since then," said Standard Bank in a research note this month.

The downside for Latvia

The loss of control over monetary policy will reduce Latvia's ability to respond to economic shocks. This is a particularly important for Latvia given its small, open economy. However, the country does have a strong record on economic adaptation, given the success of the severe fiscal measures, internal devaluation and structural reforms it imposed following the crisis.

Nonetheless, membership is controversial among the Latvian public, who doubt the benefits of harnessing the country to a zone mired in political and economic difficulties. Other concerns include price rises, inconvenience and loss of national sovereignty and identity.

When membership was announced in June, public support for joining stood at only 38 percent..

Will other countries follow Latvia?

Lithuania is the only other country seen joining the euro zone in the short-term, and is expected to join at the start of 2015. Other potential members like Poland, Bulgaria and Romania are yet to join the Exchange Rate Mechanism (ERM) — a means of pegging national currencies to the euro — which is one of the "convergence criteria" for joining.

However, if Latvia's ascension goes smoothly, other eastern European nations may warm to the idea of the single currency. An EU survey in April this year found that 54 percent of respondents across the region thought joining the euro would be negative for their country. Only 39 percent thought it would be positive — a proportion that has remained consistent since 2012.

Also worth watching in Latvia

The country is without a government or leader following the resignation of Prime Minister Valdis Dombrovskis, who accepted responsibility for a supermarket collapse which killed 54 people in November. While negotiations to appointment a new prime minister and cabinet continue, Dombrovskis will preside during Latvia's ceremonial ascension to the euro, which takes place at 12:20 a.m. local time on Wednesday.