Poorest Euro Entrant Gets Nod as Crisis Quells Latvia Prices

Five years after Latvia posted the European Union’s fastest inflation this century, the Baltic country where wages are less than a quarter of Germany’s has got the green light to become the euro region’s 18th member.

The nation of 2.1 million yesterday won the European Commission’s endorsement to switch to the euro in 2014, with a final decision by European finance ministers due on July 9. Real gross domestic product per capita of 6,800 euros ($8,900) makes it the poorest newcomer to the currency area.

As euro membership boosts trade and investment, that wealth gap makes Latvia more prone to inflation and a repeat of the 2008-2009 crash that erased a quarter of GDP and prompted an international bailout, according to ING Groep NV. Having met EU inflation limits in the wake of its recession and with help from tax tweaks, keeping prices in check will be a challenge, the European Central Bank said yesterday.

“These tiny countries suffer from bigger boom-bust cycles than larger ones,” Carsten Brzeski, senior economist at ING in Brussels, said May 31 by phone. “Given the significant differences in wealth levels, they can hardly be avoided.”

Yields on Latvia’s 2018 euro debt have plunged more than 900 basis points since peaking at 11.358 percent in 2009, when the government collapsed. They rose 7 points to 1.90 percent at 11:30 a.m. in Riga, the capital.

Purchasing Power

The cost to insure Latvian government debt against non-payment for five years using credit-default swaps reached almost 1,200 basis points in March 2009. The swaps declined 3 points to 118 today, compared with 29 basis points for Germany.

While Latvia met targets for inflation, deficit, debt, long-term interest rates and currency stability, it had 54 percent of the euro area’s average purchasing power in 2011, according to Eurostat, the EU’s statistical arm.

That makes the Baltic nation, whose monthly wages are equivalent to 692 euros compared with 3,391 euros in Germany, poorer than Estonia, Slovakia, Cyprus, Malta, Slovenia and Greece when they adopted the euro, the data show.

“Typically, poor countries have higher rates of inflation than richer ones,” William Jackson, a London-based economist at Capital Economics Ltd., said May 31 by e-mail. “High inflation within a currency union can quickly erode a country’s competitiveness, creating the need for a painful adjustment via internal devaluation further down the line.”

Eastern Wave

Latvian inflation peaked at 17.9 percent in May 2008 as the wave of eastern nations joining the EU four years earlier drove an unprecedented boom in the region. In the run-up to the Baltic country’s crash, foreign banks boosted mortgages almost tenfold, fueling a property bubble, while real wages doubled and foreign loans widened the current-account gap to 27 percent of GDP.

In bringing consumer-price growth within EU boundaries, Latvia relied in part on a sluggish economy in the wake of its recession and a 2012 reduction of 1 percentage point in the value-added tax rate. Prices fell 0.4 percent from a year earlier in April, the first decline since August 2010.

“There are concerns regarding the sustainability of inflation convergence,” the ECB said yesterday. “Maintaining low inflation rates in Latvia will be challenging in the medium term, given monetary policy’s limited room for maneuver.”

Lithuania became the first nation to be rejected for euro adoption after it breached the inflation threshold amid the boom in 2006. Estonia complied with the rules as its recession ushered in 10 months of deflation. Price growth reached 5.7 percent in December 2010, the month before its currency switch.

Changing Fortunes

Much has changed since Latvia’s recession, the world’s worst at the time. Austerity equal to 16 percent of economic output helped the government narrow last year’s budget gap to 1.2 percent of GDP from 9.8 percent in 2009. The 7.5 billion-euro bailout was repaid almost three years early.

Following Estonia into the euro region will provide access to ECB liquidity, helping shield Latvia from aiding banks in the event of a crisis, Fitch Ratings said May 31 in a statement. The government took over Parex Banka AS, the nation’s second-biggest lender, in 2008 after a run on deposits.

Latvia must heed ECB advice to maintain competitiveness by ensuring salary growth doesn’t outstrip productivity gains and keep inflation under control by limiting lending, Prime Minister Valdis Dombrovskis said yesterday in an interview.

“The budget is of course an important element but it’s not the only element,” he said by phone. “It’s also a question of credit development, also a question of wage development, of several other factors.”

‘Well Integrated’

Latvia’s economy grew 5.6 percent last year, the EU’s fastest clip, and will probably pace the bloc again in 2013 and 2014 on higher exports of machinery, food and forestry products, the European Commission predicted May 3. In making its endorsement yesterday, the commission said the nation is “well integrated” into the regional economy.

The open nature of Latvia’s economy, where net exports accounted for 61 percent of GDP last year, means the nation must keep wage growth in check in order to prosper, according to Shekhar Aiyar, the IMF’s mission chief to the country. The best way to cope with the wealth differential is to have rapid productivity growth, he said.

“That enables a poorer country to join a richer union and still prosper in it without becoming uncompetitive because of inflation,” he said in a May 13 interview.

Before it's here, it's on the Bloomberg Terminal.