Two-thirds of all Latvians are not convinced that the economic crisis is over, according to a survey published last week in the largest daily newspaper, Diena. Yet the country has been breaking records for GDP growth. The figure last year was 5.6 percent, the highest in the European Union.
It’s as if a look at reality in the third poorest EU country and a look at the macroeconomic data generate two different pictures of the world – although we’re talking about a country that European politicians and economists cite as an example of successful crisis management. The reward should then be membership in the euro zone, which Latvia officially requested in February and which the European Union and the European Central Bank will rule upon in June.
The Latvian economy fulfills the criteria for euro zone entry, with sufficiently low public debt (45 percent of GDP) and a budget deficit of 1.9 percent, comfortably below the 3 percent limit.
Inflation is around 1 percent, but after Estonia’s experience upon adoption of the euro, that figure is expected to increase for Latvia. In any case, Latvian firms and households are already counting things in euros. Eighty percent of all loans are denominated in the common European currency.
Latvians themselves are cautious. In surveys, only a third of those questioned favor entry into the euro zone. They are concerned mainly by price increases after the introduction of the euro at a time when two-thirds say they carefully plan their spending each month and must restrict purchases of consumer durables, as well as shoes and clothing. In the EU, Latvia is poorer than only Bulgaria and Romania, and unemployment – though down from the 22 percent of 2009, the worst year of the crisis – is still high at 10.9 percent.
Foreign investors and entrepreneurs have a different view. A recent survey from the German-Baltic Chamber of Commerce showed that 91 percent of the German companies operating in the Baltics support both the introduction of the euro in Latvia from 1 January 2014 and the planned entry of Lithuania into the euro zone one year later. In particular, German firms expect a reduction in their exchange rate risk, a simplification in accounting procedures, and lower transaction costs. Although Latvia fares the worst in the eyes of German investors among the three Baltic countries, the proportion of those who expect a downturn has dropped by a third over the past year.
What then is the most fundamental argument in favor of Latvian entry into the euro zone? For all three Baltic states, it is more geopolitical than economic.
Until now, it's been the French who voiced the most significant concern over Latvia's entry into the euro zone, afraid that Latvia could become a second Cyprus because its banks are popular among wealthy clients from the former Soviet Union. Latvia is simply some kind of eastern Switzerland.
Accordingly, Prime Minister Valdis Dombrovskis recently had to spend considerable time in Paris explaining the rules of the Latvian banking supervisory authority and assuaging such fears. All Latvian government officials do that these days. In a speech in Washington, the governor of the National Bank of Latvia, Ilmars Rimsevics, said only a quarter of the deposits in Latvian banks are owned by “non-residents,” that is, people and companies from abroad. Rimsevics also said only roughly 100 million euros ($130 million) flowed from Cyprus to Latvia in the first quarter of 2013, just a fraction of the 3 billion euros that left Cypriot banks.
In 2005, in the run-up to joining the euro zone, the Latvians introduced a fixed exchange rate for the Latvian lat to the euro. It amounted to an internal devaluation, and that was how Dombrovskis and Rimsevics explained extensive austerity measures. Eventually, even the International Monetary Fund reproached Riga for its toughness (the IMF oversaw the Latvian reforms because the country had taken a 7 million euro rescue loan in 2008, which was paid back early last fall).
Most Latvians understood the tough measures – such as reducing salaries in the public sector by 30 percent, closing schools, and shuttering hospitals – and accepted them for one simple reason: that the ultimate goal would be geopolitical disengagement from Russia, which since Latvia’s declaration of independence in 1918 has been everything possible for Latvians, just not a friendly neighbor. The dual German-Russian occupation and World War II wiped out one-third of the population, who either fled or were killed. In contrast, the Soviet regime settled thousands of immigrants in Latvia, so that ethnic Russians now make up about one-third of the country's population, concentrated mainly in the capital.
Of course, Russia is also Latvia's main trading partner. But the assumption that Moscow (or anyone else) will negotiate nevertheless somewhat differently with a member of the euro zone is, from the view of a small state with an open economy, legitimate. In addition, Latvia’s drive to the West won’t end with entry into the euro zone. Next year, the country could become a member of the Organization for Economic Cooperation and Development, an organization grouping together the world's most advanced economies.