Market Analysis

Latvia Likes the Euro (Lats)

This summer, Latvia hopes to cash in its lats for euros. But after all of the euro’s bad press lately, couldn’t this currency conversion end badly for the Baltics?

For the last few years, there’s been a lot of talk about eurozone membership—specifically, struggling peripheral economies abandoning it. But on March 5, Latvia applied to become the 18th eurozone member in 2014. Isn’t that timing a little strange? Reading the news these days, you’d think no country wants to be part of the eurozone, never mind a country with a relatively healthy economy.

But we rather think Latvia’s bid illustrates just how hyperbolic and mistaken such discussions of the eurozone and its supposedly tenuous future are. Latvia’s seen economic boom, bust and bailout, returned to growth and yet wants to join the currency which, according to common-currency critics, is bound to fail. However, looking at Latvia’s history, we see a different tale of somewhat austere economic reform (featuring less government spending) putting a country on track for growth.

For the majority of its recent history, Latvia was either occupied or governed by the Soviet Union—not exactly known for its economic (or personal) freedoms. In fact (other than its tumultuous, war-filled early years), Latvia’s own economic history largely began in 1991 after declaring independence from the Soviet Union. A few relatively stagnant years later and Latvia’s economy was growing rapidly—becoming one of the fastest-growing European economies for almost a decade. But in 2008, while the global economy recessed, Latvia crashed hard, experiencing more than a 25% economic decline.

As a result, Latvia received a €7.5bn bailout from the European Commission and IMF in 2008. And in return, the country rather quickly downsized its government, severely cut public spending, restructured its unhealthy banking system and quickly and decisively increased capital buffers in return—lessons some current eurozone countries should take to heart, as those reforms helped Latvia return to growth in 2010.

And it’s continued to do well. In Q4 2012, Latvia’s GDP grew at a relatively gangbusters 5.1% y/y and at a still strong 3.1% y/y in Q1 2013—which, if that was the country’s weakest quarter of growth since 2010, good for Latvia. Plus, a core part of its reform package was diversifying its economy to rely on exports more—something it’s accomplished fairly well for being such a small country emerging from years of a planned economy. So though the country hasn’t yet reached new peak levels of GDP, Latvia already meets necessary conditions for joining the euro with its low inflation, budget deficit of 1.2% of GDP and government debt ratio of ~40% of GDP—criteria only a few current eurozone members meet. But if it’s doing so well, why join the eurozone, which seems to currently be experiencing troubles Latvia recently left behind?

The reality is a single currency can carry economic benefits, which many eurozone countries initially experienced, but may be lost on the commentariat amid recent troubles. In Latvia’s case, officials hope for increased ease of doing business and financial credentials. Joining a currency with more economic ties (even if you only count the 17 countries currently with the euro) means more economic opportunities, and likely more global influence—a positive for everyone. Particularly key, should Latvia hope to continue its export diversification, is full, smooth entry into the currency union.

Additionally, while we’re sure there are some euro-skeptics in the Baltics, Latvian officials apparently are less worried about contagion from economic weakness in other countries than they are optimistic regarding the gains. Perhaps they understand weakness in one country with its own, specific troubles (like Greece, Ireland or any of the other periphery countries) won’t necessarily spread into a healthier economy with different fundamentals—like Latvia. Effectively, maybe they see their country has control through choices it makes—just as Greece had control in the run up to their present woes to slash cronyism, longstanding socialism and a host of other woes.

Therefore, Latvia likely receives approval to join the euro in January 2014—to its overall benefit. And potentially to the eurozone’s benefit. While Latvia’s €20 billion economy is a drop in the bucket, it may act as powerful symbolism suggesting the currency’s imminent demise is not at hand. (And fully offset Cypriot output plus a smidge.) Latvia’s joining sends a much needed, more realistic message. And rumors weaker countries, like Greece and Cyprus—who realistically need eurozone support to keep on their feet—may leave the euro will likely hold much less credibility when a stronger, successfully economically-reformed country wants to join it.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.