Latvia: The country that fell for the euro

The single currency is supposedly doomed, weighed down by the parlous state of the Greek economy and infighting between member states. So why on Earth would a Baltic state with a strong economy want to board this stricken ship?

A woman pays for her shopping in euros at a supermarket in Rujiena, near the border with Estonia. On 1 January Latvia became the 18th country to adopt the Euro (AFP/Getty Images)

The Latvian government has been accused of dragging the Baltic nation into the eurozone “by force” this week, as it became the 18th member of the single currency.

“Latvians have been forced to adopt the euro and haven’t been allowed their say,” said Andris Orols, the chairman of the Anti-Globalist Association. “The majority of the population is opposed to the move”. An opinion poll conducted last month showed 50 per cent of Latvians were against joining, with only a fifth in favour of their country swapping the old currency – the lat – for the euro.

There is also widespread concerns that retailers will use the currency transition as an excuse to push up prices. In the same poll 83 per cent expressed concerns that the euro would trigger unwarranted price increases.

However, earlier this week the Prime Minister, Valdis Dombrovskis, insisted that, despite the eurozone’s turmoil of recent years, accession to the currency union was unequivocally the right economic course for Latvia. “It’s a big opportunity for Latvia’s economic development” Mr Dombrovskis said, speaking at a ceremony on New Year’s eve in Riga, at which he symbolically pulled a euro note out of a cash machine.

Mr Dombrovskis added a note of caution, warning Latvians that euro membership was “not an excuse not to pursue a responsible fiscal and macroeconomic policy”. That warning was very much in keeping with the country’s austere economic policy of recent years.

Latvia suffered the most extreme economic bust of any country in the world during the global financial crisis of five years ago. In 2008 and 2009 it lost a full quarter of its economic output – a shock equivalent to America’s Great Depression.

A decade-long boom fuelled by a vast surge of capital inflows from abroad (which accelerated when the former Soviet state entered the European Union in 2003) ended in a banking crash in 2008 and Latvia’s application for a €7.5bn bailout from the International Monetary Fund and the European Union.

Many countries experiencing a crash on that scale devalue their currencies in order to boost exports and maintain unemployment – and indeed that was what the IMF recommended. But the administration of Mr Dombrovskis refused to sacrifice the country’s long-standing currency peg with the euro. Instead, it opted to regain its international competitiveness and restore balance to the country’s books by imposing massive fiscal austerity. In 2010 the government pushed through a staggeringly large consolidation, equivalent to 4 per cent of GDP.

This ascetic policy approach thrust Latvia into the international limelight. The European Commission sang its praises for embracing austerity and eschewing devaluation – a policy combination it was demanding of the likes of Greece and Portugal.

Attention intensified when the medicine seemed to work. The Latvian economy bounced back quicker than anyone expected, growing by about 5.5 per cent in both 2011 and 2012. The country is projected by the IMF to have expanded by a further 4 per cent last year, faster than any other country in the European Union and taking Latvia back to its 2007 GDP peak. The current account swung from a 22 per cent deficit to virtual balance. The unemployment rate, having hit 19 per cent in 2010, has since receded to 11.7 per cent, below the eurozone’s 12.2 per cent average and well below the excruciating 27 per cent rates in Greece and Spain.

However, some say the story of Latvia as a poster child for the merits of austerity is overblown. They claim that its impressive return to growth (despite its severe fiscal squeeze) is more attributable to its latent catch-up potential and developmental momentum rather than the benefits of massive state budget cuts. They reject comparisons with Greece, Spain, Portugal or Italy, pointing out that the Baltic state has a considerably lower income per head and a much larger export sector relative to GDP.

Critics also point out that an exodus of many young Latvians to find work abroad has flattered the unemployment figure. Between 2008 and last year the total population is estimated to have fallen by about 8.5 per cent.

The IMF’s chief economist, Olivier Blanchard, says he has been pleasantly surprised by Latvia’s performance, but maintains that he is not convinced the government’s front-loaded fiscal squeeze was either necessary or helpful to the economy.

Nevertheless, it is striking that Latvia’s growth rate in 2014 is forecast to be four times higher than of the rest of the eurozone which it joins this week. Latvia’s accession has shown that one of Europe’s most dynamic economies still regards the eurozone as a club worth joining.