Joining the euro • IR.lv

Joining the euro

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Latvian inflation rates, 2004 – present. Source: Central Statistical Bureau of Latvia
Morten Hansen

A very small window of opportunity

In the ‘fat years' it was the high rate of inflation that precluded Latvia from joining the eurozone. Today it is the budget deficit (still far above 3% of GDP), long-term interest rates (still too high; the Maastricht criterion stipulates that it should be less than the average of the three lowest (currently Germany, Denmark and the Netherlands) plus two percentage points. At 7.55% for Latvia this still exceeds a criterion of around 5% (1/3*(2.91 + 3.01 + 3.16) + 2 = 5.03%) and, technically, the exchange rate criterion due to the support from international lenders. Only the debt-to-GDP criterion (max. 60% of government debt to GDP) has never been broken.

The IMF-EU package envisages the budget criterion to be fulfilled by 2012. If so, Latvia should have gained credibility from financial markets thereby lowering borrowing costs and thus also fulfilling the interest rate criterion and the road to the eurozone lies open.

Or perhaps not?

Although inflation was reduced dramatically (inflation was 17.9% in May 2008; by February 2010 it was minus 4.2%) following the financial crisis and the dramatic rise in unemployment it is picking up again – and will rise further due e.g. to the increase in VAT.

The graph below shows in red the ‘familiar' inflation rate – price increases measured year-on-year and this one is already into positive territory after what I consider a too short period of deflation.

In blue we have HICP (Harmonized Index of Consumer Prices, Eurostat's way) inflation measured as one full year over the preceding full year, which makes the curve much smoother. The development of CPI inflation, the shorter measure, can be seen as what will happen to HICP, the longer measure, in the future. HICP is still negative but will soon turn positive due to perky CPI.

The Maastricht inflation criterion speaks of a Latvian HICP inflation rate that has to be lower than the average of the three lowest non-negative EU inflation rates plus 1.5 percentage points. For 2009 this demanded a very low inflation rate: Portugal and Ireland had negative inflation rates so they didn't count but in Belgium, Luxembourg and France inflation was 0.0%, 0.0% and 0.1%, respectively, setting a criterion of just about 1.5%.

OK, as the EU economies will rebound inflation rates will increase somewhat but due to a still lingering crisis the three lowest rates will remain very low thus setting a hard-to-meet low threshold for Latvia also in 2012.

Given the performance of CPI inflation lately I think that the authorities have to be very concerned of whether Latvia will actually be able to meet the Maastricht inflation criterion – and this is where, as usual, the often-mentioned structural reforms pop up: An economy with some 18% unemployment is not supposed to have labour shortages in some sectors but it is nevertheless what Latvia has, which creates wage and price pressure.

The consolidation efforts are partly to avoid default but also partly to meet the Maastricht deficit criterion in order to adopt the euro. It would be ironic and pathetic but far from unthinkable that euro adoption was missed yet again due to too high inflation.

Just look at the very small window of opportunity that Estonia managed to take advantage of. As the graph below shows, CPI inflation is now accelerating quite dramatically and HICP inflation could soon break the Maastricht threshold – but that won't matter as Estonia has already entered the eurozone.

Conclusion: More budget measures aiming at lowering inflation, please!

 

Komentāri (18)

loptik 04.02.2011. 16.39

I don’t quite understand the argument. The logic goes like this: “since we have problems with the inflation criterion we should jump on the eurozone train while we have low inflation. We should hurry because we all know that after 2012 we are going to have a prolonged period of high inflation”. Sorry but that goes against the whole idea of Maastricht criteria! Which is: countries’ inflation rates should not diverge too much from the other eurozone countries’ inflation rates since such divergence poses risks to competitiveness, and as a result, to the stability of the eurozone.

If we continue with this attitude, I am afraid the Lithuania’2006 type of disappointment awaits us in the future.

But the Latvian authorities should definitely be concerned. I haven’t looked into the problem recently but my intuition is that the problem is structural. Which is: we have more weight on tradables, especially food, in CPI than developed countries. And money printing in the US, inducing commodity inflation and inflation in emerging markets (which produce most of the imported goods in our shops), is a trend which is going to continue in the future.

How to solve it? Difficult. But the near 20 percent unemployment is a clear sign that we can do a lot to increase labor market flexibility. E.g. why haven’t we seen a rise in the number cheap barber shops during the crisis? Yep, because the rents are high and regulation is excessive. Why rents are high? Because commercial real estate taxes are low and it does pay off to keep rooms empty. Why the regulation is excessive? Because nobody is aware that there is a problem. We can go sector by sector and we will see similar problems everywhere.

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    loptik > loptik 05.02.2011. 23.48

    Nu pati vairak vai mazak atbildejat uz jautajumu. Bridinaja jau 2005. gada. Un bridinaja ari velak, noteikti vairak kaa jebkursh. Ieksheja diskusija LB, cik atceros, ipashi nebija, jo tas, ka bus krahs bija skaidrs un tur nebija, ko diskutet. Savukart 25% kritumu es, personigi, neparedzeju (domaju par kadu 5% kritumu), jo nespeju paredzet Lehman krahu, un vel jo mazak, taa sekas. Neatceros gan nevienu, kursh speja. Bet visu cienju, ja kads vareja. Ar tadam zinashanam var sapelnit miljonus. Tas, kam ticet, savukart, ir katra briva izvele, ko nedomaju, ka vajadzetu ierobezhot. Daudzi toreiz ticeja Kalvitim… Un kapec nee?

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    baibabruvele > loptik 04.02.2011. 20.22

    What you said is basically what Morten said. Economy is picking up everywhere, so why are we the ones who are again about to have the highest inflation in Europe? And the answere was in the structure. In the 1001 things that could be done to work more efficiently, produce more value for same money etc. Some of these things you mentioned. And this is the most difficult part, because it won´t be enough simply to cut expenses or increase taxes. This will take lots of thinking day after day, step by step and we might suceed after, but Morten apoints very well – we might fail.

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    Dzintars > loptik 06.02.2011. 15.16

    Gundars, you fail to take into account that the Maastricht inflation criterion uses the whole consumer price index where a much fairer criterion would be related to inflation in tradable goods only. Since the Latvian price level is still relatively low we must expect more price convergence as the economy develops – the Balassa-Samuelson effect. This is primarily a convergence of nontraded prices (hair cuts, public transportation etc etc), all of which are NOT relevant for competitiveness but matter for inflation.

    This effect ensures that Latvian inflation in the very long catch up phase will be above EU27 inflation on average, making it more difficult to join the eurozone.

    Thus it makes a lot of sense to try to join the eurozone while this small window of opportunity exists.

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    loptik > loptik 04.02.2011. 20.16

    Un tad? Neesmu dzirdejis, ka LB tiktu pieprasita 100 procentiga viedoklu konvergence. Noraadu uz riskiem, kas saistiti ar so argumentaciju. Ir, protams, ari pretarguments: galu gala lemums ir politisks kaa redzam pec Igaunijas un gruti ir kadu valsti nelaist eirozona, ja ir izpilditi visi kriteriji (ar merenu rezervi). Tachu vel ir janem vera, ka var gadities situacija, ka tas “window” vispar nav un mes jau tulit aiziesim kartiga inflacijaa. Butu svetigi sakt domat, ko darisim un vai kaut ko var darit…

    Par Igauniju un Lietuvu ne parak sapratu, ko gribejat teikt, bet Igaunijas pasreizeja gandriz 6% inflacija, domaju, tiks izmantots kaa arguments pret Latvijas dalibu eirozona, ja mums bus lidzigas problemas. Un burbula laika, cik atceros, mes isteniba diskutejam ljoti daudz, negribas to vesturi atkal atkartot, bet varat paskirstit atpakal LETA.

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    baibabruvele > loptik 04.02.2011. 20.30

    I can only agree. Eurozone is a weird “zone”, the harsh criteria are only for countries outside the “zone”, the ones inside have no criteria at all in reality. How wrong is that? Most of the euro countries not only now but in forseeable future would not be able to join the Euro if they had to. Their economies including the big core countries are simply not fit enough. And euro is as fit as its member countries.

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janis_znotins 04.02.2011. 18.41

An additional interesting aspect with the inflation criterion is that the ECB and the EC have the liberty to decide which countries are “three best performing Member States in terms of price stability” in the sense of the Maastricht Treaty for the calculaton of the inflation criterion.
So, in May 2010, the ECB included in this calculation THREE Member States with NEGATIVE HICP (Portugal (-0.8%), Estonia (-0.7%) and Belgium (-0.1%)) and excluded only Ireland (-2.3%) which was “judged to be an outlier as this inflation rate is significantly lower than those of the other Member States due to the accumulation of a number of country-specific factors.” As a result, the inflation criterion was set at 1.0=(1/3*[(-0.8)+(-0.7)+(-0.1)])+1.5
So, in May 2012, who knows which countries might be judged to be outliers?…

See ECB Convergence Report (May 2010), page 9
http://www.ecb.int/pub/pdf/conrep/cr201005en.pdf

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baibabruvele 08.02.2011. 13.54

oh yes, in English “trekgnie gadi” in the biblical sense ( and that´s how Kalvitis meant it in his speech) are translated as “years of abundance” and not “fat years”. Translated as “fat years” people who don´t speak Latvian might not get the allegory with the story from the Bible about Joseph in Egypt and 7 years of abundance.

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