Euro Endorsement Key to Igniting Delayed Latvian Debt Rally

Latvia Counts on Euro-Endorsement Spark to Ignite Delayed Rally
Latvia is eager to trim loan rates and boost trade with the currency area’s 17 existing members even as Europe’s debt crisis curbs the zeal of eastern European countries such as Poland to adopt the euro. Photographer: Ilmars Znotins/Bloomberg

Latvia is banking on a green light for its euro-adoption bid awakening investors who’ve so far failed to drive an asset rally similar to the one neighboring Estonia experienced before it switched currencies in 2011.

Prime Minister Valdis Dombrovskis says joining the euro region will trim borrowing costs. Still, the yield spread between Latvian government euro bonds due 2018 and the equivalent German debt is little changed this year, data compiled by Bloomberg show. The cost to insure Latvian debt against default for five years has declined less than 10 basis points this year, while Estonia’s fell by half in the six months before its euro bid was approved in 2010.

Latvia is eager to trim loan rates and boost trade with the currency area’s 17 existing members even as Europe’s debt crisis curbs the zeal of the continent’s east to adopt the euro. Approval this week would cement the success of a 2008 bailout and lower the risk of repeating a banking crisis that erased a quarter of economic output, SEB AB and Commerzbank AG say.

“We see further spread tightening and a good chance that Latvia outperforms its peers,” said Margarete Strasser, who helps manage the equivalent of about $770 million in central and eastern European debt, including Latvian bonds, at Pioneer Investments Austria.

Yield Falls

As comments from the U.S Federal Reserve on a possible reduction in monetary stimulus crimp financial-market gains, the extra yield on Latvia’s 2018 euro notes over German equivalents declined nine basis points to 137 at 2:40 p.m. in Riga, after reaching a five-week high of 146 basis points on May 30.

The yield on dollar bonds due 2020 declined 6 basis points from a four-month high to 3.34 percent. Latvian credit-default swaps fell four basis points from a five-week high to 116.

Latvia wants to adopt the euro on Jan. 1, 2014, crowning a recovery from the world’s deepest recession in 2008-2009 to the EU’s fastest growth last year. The European Commission, the bloc’s executive arm, and the European Central Bank will give their recommendations on Latvia’s application tomorrow.

Latvia’s government has received “mostly positive signals” from both institutions during the preparation of the convergence report assessing its eligibility to join the euro bloc, Dombrovskis told reporters in the capital Riga yesterday.

Euro Recommendation?

The European Commission plans to recommend tomorrow that Latvia join euro area next year, Germany’s Handelsblatt newspaper reported today, citing copy of a commission report. It echoed a similar report by Latvijas Radio yesterday, which didn’t say where it got the information.

“We would expect lower interest rates” after joining, Dombrovskis told Bloomberg Television in a May 13 interview. “We would also expect reduced currency conversion costs as we do around 70 percent of our foreign trade in euros. We also hope it would help us attract foreign investment in a similar way as it happened after Estonia joined the euro zone in 2011.”

To meet the euro-area requirements and the terms of a 7.5 billion-euro ($9.8 billion) bailout from the European Commission and the International Monetary Fund, the nation of 2.1 million transformed its public finances with austerity equal to 16 percent of gross domestic product, winning praise from officials including EU President Herman Van Rompuy.

Early Repayment

Latvia repaid its IMF loan at the start of 2013, almost three years ahead of schedule, even drawing criticism from the fund for taking socially focused spending cuts too far.

The government narrowed the budget shortfall to 1.2 percent of GDP last year from as much as 9.8 percent in 2009 and state debt is 40.7 percent of gross domestic product, Eurostat data show. Among the existing 17 euro-area members, only Finland, Estonia and Luxembourg stayed within the EU’s 3 percent and 60 percent budget and debt limits last year.

“Latvia comfortably meets the Maastricht criteria,” which also include thresholds for long-term bond yields, inflation and exchange-rate stability, Fitch Ratings said May 31 in a statement. “No country that has met the quantitative criteria has had its euro application rejected.”

Euro-area finance ministers meet July 8 and EU finance ministers meet on July 9 to make a final decision. Admitting Latvia to the euro would “likely” trigger an upgrade in Latvia’s BBB credit rating, the second-lowest investment grade and on par with Russia and Iceland, Fitch said.

‘Event Risks’

Moody’s Investors Service, which in March upgraded Latvia’s rating to Baa2, the second-lowest investment grade, said euro entry “would reduce Latvia’s susceptibility to event risks, particularly exchange-rate risk and support the positive outlook on the rating,” according to an e-mailed comment today.

Latvia’s economy grew 5.6 percent last year, the EU’s fastest pace, and will probably outpace the bloc again in 2013 and 2014 as exports of machinery, food and forest products jump, the European Commission predicted May 3. The recession five years ago, worsened by the terms of the EU and IMF-led bailout as its biggest lender collapsed, erased about a quarter of GDP, which remained 12 percent lower than its 2007 peak at the end of last year.

Euro adoption was a key plank in the Washington-based fund’s aid package and the European authorities will be keen to show the currency remains attractive even after the region’s recession extended into a sixth quarter, according to Sweden’s SEB AB, the second-biggest lender in the Baltic countries.

“The EU probably wants to show that the euro process is alive, despite the crisis in various euro-zone countries,” it said last month.

Neighbor Wins

Estonia has benefited from adopting the euro in 2011 because interest rates and currency-conversion costs have fallen, President Toomas Ilves told reporters May 27 in the Lithuanian capital, Vilnius. Public support for the currency in Estonia has risen since membership, he said. A Faktum ja Ariko poll of 500 people put it at a record-high 63 percent at the end of 2012. It didn’t give a margin of error.

Backing for the switch in Latvia grew to 36 percent in April, with opposition at 62 percent, according to an April 3-23 TNS survey of 1,016, people that gave no margin of error.

Estonian CDS declined by more than half to 105 basis points in the six months to May 12, 2010, when the European Commission issued its report recommending the first expansion of the euro area to a former Soviet republic.

Other countries in Europe’s east have grown skeptical of the common currency.

Regional Caution

Poland in February delayed setting a date for euro adoption until after a general election in 2015, when Prime Minister Donald Tusk said all requirements to switch currencies will have been met. The Czech Republic probably won’t adopt the euro before 2019, central bank Governor Miroslav Singer said last week. Hungary isn’t planning accession during the next decade, central bank President Gyorgy Matolcsy said May 31.

Polish dollar bonds due 2021 have outperformed equivalent Latvian debt over the last month, with the extra yield investors demand to hold the Baltic nation’s paper increasing to 43 basis points from 37.

“The introduction of the single euro currency is not a guarantee of well-being and economic growth any more, as the recent crisis in the euro zone has demonstrated,” Artem Birykov, a Moscow-based economist with HSBC, said in an e-mail. “Latvia’s knock on the euro zone’s door is more a political move rather than an economic one.”

Still, euro adoption will reduce the risks of another banking crisis in Latvia with the ECB becoming the back-stop for its banks, which don’t have a lender of last resort under the existing currency board system, Barbara Nestor, a strategist at Commerzbank AG in London, said May 10 by e-mail. The benefits are underscored by the size of Latvia’s banking industry relative to GDP, the second-biggest in eastern Europe behind Slovenia at 129 percent last year, she said.

“There can be some additional spread tightening,” Nestor said. “It is not certain at the moment how much emphasis the EC/ECB place on factors of sustainability, hence a few basis points of uncertainty about Latvia’s entry.”

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