Latvia in the euro zone: national economic outlook for 2014

By Petar Traykov | 15 February 2014

To quote this document: Petar Traykov, “Latvia in the euro zone: national economic outlook for 2014”, Nouvelle Europe [en ligne], Saturday 15 February 2014, http://www.nouvelle-europe.eu/node/1795, displayed on 21 November 2018

Recent forecasts about the state of the Latvian economy in 2014 are largely optimistic and predict that the Baltic country will maintain its position among the top-performing EU nations this year in terms of economic growth. Many commentators have highlighted the importance of Latvia’s recent accession to the euro zone for its continued post-crisis recovery in 2014. However, apart from facilitating progress towards the Baltic nations’ medium- and long-term economic goals, the euro zone also poses a number of important challenges to national and European policy-makers.

Latvia in 2014: generally positive economic prospects

The European Commission's 2014 GDP growth projection (European Commission, 2013) for Latvia is 4.1%, marking a marginal increase compared to the 2013 GDP growth rate of 4%. This effectively means that Latvia will remain the fastest-growing EU economy for a second consecutive year and will likely be one of only 8 EU member states whose national economic output will expand by over 2% in 2014.

Moreover, the Commission foresees a notable reduction in Latvia’s level of unemployment, from 13.7% in 2013 to 12.2% in 2014, indicating that this year’s unemployment rate in the country will be nearly identical to that of the Eurozone as a whole and slightly higher than the EU-28 aggregate (predicted at 11% in 2014).

In addition to these anticipated favourable developments, the Commission’s forecast points towards a slight improvement in the Baltic nation’s public finances, with Latvia’s headline budget deficit expected to drop by 0.3 points to 0.9% of GDP in 2014 and government debt predicted to decline to 40.1% of GDP.

Economic benefits derived from Latvia’s accession to the euro zone: growth of trade with the euro bloc

Positive economic trends in Latvia may, to some extent, be attributed to the country’s European Monetary Union (EMU) membership, among various other factors. The expected higher degree of economic and financial integration between Latvia and the other EMU economies and predicted decrease in the costs of trade between these economies are both likely positive consequences of Latvia’s adoption of the euro and the preceding process of convergence towards the Maastricht criteria. These two developments would in turn lead to a dramatic increase in Latvia’s trade with both the EMU and EU-28 countries.

Economic projections by the Bank of Latvia (Bitâns et al., 2004) indicate that the adoption of the euro would lead to a sustained increase in the volume of Latvian exports to the euro bloc – including all EU member states except Sweden and Britain; not to be confused with the euro zone. More specifically, these estimates predict that over the next decade the rate of growth of Latvian exports to the euro bloc would be 1.1 points higher in comparison with the alternative policy scenario where Latvia maintains its national currency and preserves its peg to the International Monetary Funds’ (IMF) Special Drawing Rights (SDR) basket of currencies.

Admittedly, the adoption of the euro may simultaneously induce a reduction in the volume of exports to former Soviet Republics, amounting to approximately 4%, compared to the alternative policy scenario. Nonetheless, given that the share of the euro bloc countries in Latvia’s total exports considerably exceeds that of the USD bloc economies and will continue to grow following the country’s EMU accession, the EMU appears to have a positive net effect on the country’s economy. The Bank of Latvia’s forecasts thus indicate that, ceteris paribus, post-EMU accession national GDP growth will be between 6 and 19% higher compared to the “no EMU membership” scenario (Bitâns et al., 2004).

Potential risks and policy challenges associated with Latvia’s EMU membership

Notwithstanding these benefits of Latvia’s participation in the EMU, 2014 will potentially prove a challenging year for policy-makers in Riga and Brussels, as the economic and political costs associated with the EU’s common currency area will become increasingly apparent. 

One noteworthy issue is of course related to the “one-size-fits-all” institutional and policy design of the EMU. Considering the fact that the European Central Bank’s policies are primarily directed at the EU as a whole, rather than at its individual constituent economies, it could be expected that EU monetary policy targets and instruments may occasionally be sub-optimal or even counter-productive for the Latvian economy.

At present, a major concern for Latvian policy-makers is that the EMU’s common interest rate may be set too low for Latvia’s already rapidly growing economy, and this sentiment has given rise to speculations that Latvia may face a much greater risk of high inflation as a Eurozone member than as an outsider. Conversely, assuming a future scenario where the Latvian economy lags considerably behind those of the other EMU member states due to structural factors or an external shock, the common EMU interest rate may in fact prove too high for Latvia relative to the optimum level needed to stimulate economic recovery (Austers, 2014).

Equally problematic is Latvia’s lack of control over its new currency’s foreign exchange rate.  In recent years, despite the economic crisis plaguing the euro zone, the euro’s exchange rate vis-à-vis major world currencies has appreciated significantly (The Economist, 2014). This has clearly been detrimental to the competitiveness of some European export industries, as seen in deteriorating international sales performance across a number of sectors. The appreciation trend is particularly troubling given the European Central Bank’s conservative approach to monetary expansion and its goal to maintain price stability (an inflation rate below, but close to 2%) in the euro zone. In view of this policy orientation, one could expect that the EU’s monetary authorities would be reluctant to go through with a depreciation of the euro, if this policy measure is believed to have future repercussions for aggregate price levels in the euro zone. Such a policy trade-off would in turn probably have negative ramifications for the future international competitiveness of EU exports, including those from Latvia and the Baltic region (Austers, 2014).

In view of the abovementioned challenges associated with Latvia’s joining the euro zone, it is essential that the Baltic state moves forward with further structural adjustment measures in 2014, in order to minimize economic risks arising from the mismatch between “one-size-fits-all” EU monetary policy and national economic idiosyncrasies. At the same time, 2014 is a year for Latvia to address other crucial policy areas, which are essential for the country’s post-crisis economic recovery and, to some degree, important for its smooth and stable transition to the euro. A brief list of relevant policy measures to be pursued by the Latvian government this year would include, inter alia: reforming the national tax system so as to lower taxation of low-income earners, improve tax compliance and combat the shadow economy; increasing the coverage and effectiveness of active labour market policies in order to reduce high youth unemployment; extending the coverage of social assistance with a view to tackling high poverty rates; modernizing and improving the performance of national education and research institutions; and, lastly, enhancing the security, efficiency and competitiveness of the energy sector (European Commission, 2013).

To go further

On Nouvelle Europe :

In books :

  • Austers, Aldis, “Latvia’s Stability within the Eurozone’s Instability”, in Andris Sprūds (ed.), Latvian Foreign Policy Yearbook (Latvian Institute of International Affairs, 2014)
  • Mârtiòð Bitâns et al., Impact of the Euro Adoption on the Economy of Latvia (Latvijas Banka, 2004)

On the internet :

  • European Commission, 5 November 2013, “Economies of the Member States; Latvia
  • European Commission, Recommendation for a Council Recommendation on Latvia’s 2013 national reform programme and delivering a Council opinion on Latvia’s convergence programme for 2012-2016, COM(2013) 364 final ,Brussels, 29.5.2013
  • The Economist, “European economy guide: Taking Europe’s pulse”, 1 January 2014

Source photo : Latvian euros on Flickr (January 2014)

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