It’s now or never … not in a long time • IR.lv

It’s now or never … not in a long time

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Foto: Tomass Urbelionis, F64/BFL
Morten Hansen

 

Opinion polls on the currency provide some conflicting information. While some 80% would like to see the fixed exchange rate continue, only 30-something per cent are in favour of introducing the euro by 1 January 2014, although euro introduction is the ultimate fixed exchange rate for the lat vis-à-vis the euro.

But if people think that Latvia can “just” enter the Eurozone at some other time of its own choice they are quite wrong – there may be just a small window of opportunity that may not open again for several years to come. This has of course also been part of the debate here but I thought I would try to explore it in more detail in this entry.

Since September 2012 Latvia has met the Maastricht inflation criterion (see e.g. here or also Figure 2 of this entry) and it will continue to do so during the spring and thus through the assessment period but it is far from certain that it will continue to do so – rather, it is more realistic that Latvia will NOT fulfil the criterion and this for the following reasons:

1) The criterion is very strict – inflation must be lower than the average of the three lowest (non-negative) inflation rates in the EU plus 1.5 percentage points. In a union of 27 countries (soon 28; Croatia is about to enter) there will always be a handful of countries with very low inflation thus creating a low criterion value.

2) The so-called Balassa-Samuelson effect, that prices are lower in poorer countries than in richer ones. This effect is shown in Figure 1 below.

Figure 1: Price levels of the EU27 countries (2nd axis) against GDP per capita (1st axis), 2011 (Latvia is red, Estonia blue, Lithuania green)


Source: Eurostat

Note: Luxembourg is excluded – its GDP is exceptionally high partly because of many people working there but not living there while its price level is constrained by the proximity of Belgium, France and Germany.

The graph displays a clear relationship between the level of GDP per capita and the general level of prices. Latvia is relatively poor in the EU having a bit less than 60% of the EU average in terms of GDP per capita and its prices are lower, too, at less than 70% of the average of prices in the Union.

For those not familiar with the Balassa-Samuelson effect, here is a quick explanation. Think of a good or a service that cannot be exported or imported, e.g. my favourite example, a hair cut. Last time I had a hair cut in Denmark was some eight years ago. The price was around 35 lats and should explain why I choose to have what remains of my hair cut here. Why such a massive price difference? Denmark is a rich country (some 120% of the EU average in terms of GDP per capita) and thus wages are generally high, also for those who cut hair. But to pay such people a high salary the price of a hair cut must be high. A hair cut in Latvia is relatively cheap because wages by EU standards are relatively low, reflecting relatively low GDP per capita. If you want to experience the Balassa-Samuelson effect the hard way, just go to Norway and “enjoy” its prices…

But what happens when Latvia (hopefully) continues to converge towards the EU GDP average? If so, the country experiences productivity growth that is higher than elsewhere in the EU; this raises wages, also for the hair cutting people although their productivity can hardly increase – but it will do so; otherwise no one would cut hair anymore. When these wages go up the price of a hair cut has to rise, too, and will also start to converge to the EU average and in this process prices will rise faster here than in e.g. Denmark, or, in other words, inflation will be higher in Latvia than in Denmark or other richer EU countries. Please note that a) this effect is not dramatic – one-two percentage points per year but that may be enough to miss the Maastricht inflation criterion and b) this effect takes place when the country is growing i.e. when wages grow faster than prices due to productivity growth. Sort of “positive” inflation, if one might say so.

Just think about how Estonia managed to join the Eurozone. Estonia is richer than Latvia but still relatively poor in an EU context and thus with a relatively low price level and is also subject to the Balassa-Samuelson effect, see again Figure 1. How did Estonia pass the inflation criterion? In the midst of the economic crisis when there was no GDP growth, no convergence and thus no price pressure – as can be seen from Figure 2. Estonia fulfilled the inflation criterion from November 2009 until October 2010, just one short year of window of opportunity.

Figure 2: The Maastricht inflation criterion (in green) and comparable Latvian and Estonian inflation rates


Source: Eurostat and own (tedious) calculations

As mentioned before, Latvia does fulfil the inflation criterion right now but not least due to quite a bit of creativity: VAT was lowered from 22% to 21%; that is a one-off effect downwards on prices that will soon vanish from the inflation numbers, 2012 saw no tax increases that could have increased inflation and one can argue that although economic growth has resumed there is still so much left of the crisis in terms of unemployment that there has been no serious wage pressure to leave an impact on inflation. Yet…

In short: It is either now in terms of joining the eurozone or most likely not for several years.

Note: One often hears the argument that by joining the Eurozone, inflation will surge. Inflation indeed rose in Estonia (‘surged’ would be an exaggeration), see again Figure 2 but do note that a) inflation went up already before joining the zone on 1 January 2011 and b) that quite a bit of it could be Balassa-Samuelson related and c) due to e.g. some higher taxes that were simply delayed so as not to breach the criterion. Here is a dissection of Estonian inflation experience since joining the Eurozone (in Latvian).

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga

 

Komentāri (33)

aivarstraidass 18.02.2013. 11.10

This is nice analysis, but it raises a question – whether inflation criterion in its current form has been reasonably selected. Why do we compare our inflation to the average of 3 countries with the smallest inflation (rather than, say, EU median inflation; or, perhaps, lower quartile – i.e. the level that is surpassed by 75% of the eurozone members)? Any computation involving the “lowest three” variables in a large population may lead to large effects caused by a few outliers. If some EU members are experiencing heavy recession, or they are not eurozone members themselves (as is the case with Sweden)- they can easily spoil the chances for every other country aspiring to fulfill the euro convergence criteria.

Or, perhaps, the inflation criterion is perfectly fine, but Latvia is unfit to join the eurozone in a sustainable way? Would it make sense to create Europe with two types of euros – one for countries with strong exports (and accordingly – high prices and low inflation), another one – for countries with weak exports, low prices and a potential for higher inflation (Latvia, Greece, Slovakia, Romania, Cyprus, Portugal, etc.)?

Some 30 years ago USSR had introduced at least 3 different types of rubles – one was the regular ruble used by Soviet people, another was a currency unit used for internal trading between Comecon countries, and the third kind of ruble was “the foreign exchange ruble” used to account for the stuff that had to be purchased for hard currency.

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    kristrun > aivarstraidass 18.02.2013. 14.08

    Sorry, Morten! Just similar comments always take place, when somebody tries to put out his mind in russian. Also, entweder alles oder nichts.

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    Dzintars > aivarstraidass 18.02.2013. 15.25

    No problem and no offense taken. Just feel tempted to write a bit in Danish to add to the linguistic confusion…. :-)

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    janis17 > aivarstraidass 18.02.2013. 18.33

    I don’t see any advantages of “two different EUR” strategy.
    Main concept of working money is “trustable value”. We can remember soviet rubles, “black market prices” etc. – and compare with USD per example.
    In some countries outside USA USD is national currency without possibility to make their own monetary policy. But it’s still better then russian rouble types.
    Only problem with EUR in Latvia I see that “money runs to rich” – it means exporting countries (as Germany) sucking out EURs from not so strong exporters (as Latvia). Normally we can regulate this with exchange rate and/or emitting of LVL. In EUR case there must be some adjustment fund as Kohesian fund but quite bigger for long term development problem solving I think. Otherwise foreighn debts will rise sky high together with all problems they can bring.

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Iluta Jurēviča 19.02.2013. 14.15

The whole Euro entry is in perils until I.Rimševics is a head of Bank of Latvia. His monetary policy of 2002-2005 was simply brilliant to destroy any hope for accomplishment of inflation criterion. It is nice to ask this gentleman – what are his masters in GRU thinking now about Latvia entering EMU? In 1993 he was more outspoken. Think in real terms, in Latvia you can see only a certain reflection of geopolitical reality. And start with Judy Shelton book The Coming Soviet Crash, sucker.

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    Iluta Jurēviča > Iluta Jurēviča 20.02.2013. 08.59

    Viss Rimšēvica vadības periodu var raksturot tā – LB uzvedās kā LR ekonomikai un tautsaimniecībai sveša banka, kas uzvedās kā komercbanka. Tikpat labi centrālās bankas funkcijas varēja nodot Swedbankai vai SEB bankai, rezultats būtu tāds pats, iespējams pat labāks. Centrālā banka ierobežo inflāciju ar monetāro politiku vai ar kreditēšanas ierobežošanu (banku rezerves). LB nedarīja ne vienu, ne otru, bet peldēja kā austrumu spekulanti un skadināvo oportunisti to vēlējās… Visi aktīvi ir pievilcīgi spekulantiem, ja to valūtas vērtība ir devalvēta par 25%. Domāju, ka inflācijas vilnis Igaunijā un Lietuvā bija ļoti spēcīgi refleksēts no Latvijas, jo Baltijas tirgus ir mazs.

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    Iluta Jurēviča > Iluta Jurēviča 20.02.2013. 08.43

    mūsu valstī visi telo muļķus, lai gan dara elementāras lietas. Lats bija piesaistīts SDR, kas faktiski ir USD. Jau 2002.gadā bija skaidrs, ka LR ceļš ir uz ES, tāpēc kā minimums bija jānofiksē LVL pret EUR kā to izdarīja Lietuva, Igaunija jau no laika gala bija DM piesaistīta. Bet tā vietā LB izdarīja visu, lai devalvētu LVL. Gaidīja līdz EUR/USD attiecības pīķim 2005 gadā. Un pēc piesaistes EUR, LVL kopā jau ar EUR kritās attiecībā pret USD. Tas nozīmēja, ka mēs vēl dabūjām inflāciju uz degvielu un kurināmo. Bet LB uzaudzēja savas valūtas rezerves tādos tempos kā Ķīna. Viss pārējais jau ir monetārās politikas klasika, kas notiek ar inflāciju, kad devalvē valūtu, utt. Vārdos LB ar visu sirdi gribēja eiro, bet darbi liecina par pretējo…

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    Pastniece > Iluta Jurēviča 20.02.2013. 00.18

    Vai Jūs varat, lūdzu, paskaidrot sīkāk? Kādā veidā LB monetārā politika no 2002. līdz 2005. gadam bija nepareiza un kas bija jādara savādāk?

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simpsons 20.02.2013. 01.11

The green line in figure 2 looks indeed low. It is surprising that with 2% inflation Latvia can barely squeeze in the Maastricht criteria.
In future there are still two instruments how to manage the inflation.
1)Increase Lat/Euro fluctuation corridor to the maximum permitted 2% and make Lat appreciate. All imports will become cheaper.
2) Make Statistics bureau issue ‘appropriate’ inflation numbers. Given that Italy achieved ‘right’ deficit figures and Greece decreased government debt to acceptable level with creative accounting, generating ‘appropriate’ inflation figure would be in European traditions.

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