Lithuania to adopt euro in 2015 at earliest – Latvia will join in 2014

The political desire exists in Lithuania, too, but inflation must be tamed
The new Lithuanian government is officially aiming at euro zone accession in 2015, one year later than the previous government’s target. For the past year, SEB has been predicting that Lithuania will adopt the euro in 2015 at the earliest. We are sticking to that
forecast even after the change of government late in 2012. We projected that the 2014 target date was/is unrealistic because Lithuania could not meet two vital qualifying criteria – a sufficiently low, stable inflation rate and budget deficit – and it now seems as if it would have failed the inflation requirement. However, it is highly likely that Latvia, which is expected to apply formally for euro zone membership in February, will get the green light for its planned accession in 2014 after this spring’s evaluation by the European Union and European Central Bank – as SEB has been forecasting for a long time.
One important point of departure in assessing when Lithuania’s future euro zone membership will materialise is that the euro issue remains a high political priority even after the change of government late in 2012. During the election campaign that preceded last October’s parliamentary election, the euro issue – including the 2014 target date – was toned down by the then-incumbent centre-right government. This was hardly a surprise, considering that public opinion polls showed that the leading government party, the Homeland Union, would probably lose power and that a severe crisis was meanwhile under way in the euro zone, which obviously made it difficult to win votes on the desire to join the euro zone. Nor, at that time, were there any signs that the then-opposition parties would wish to continue pursuing the euro zone accession issue if they won the election. For this reason, it was somewhat surprising that the new left-led coalition
MONDAY JANUARY 21, 2013

government, when it formally took office in midDecember, chose to highlight euro adoption as one of five major economic policy goals: Lithuania should join the euro zone at the earliest possible date, it declared. Prime Minister Algirdas Butkevicius, leader of the largest government party, the Social Democrats, specified a few days later after a meeting with President Dalia Grybauskaite that the government’s target is to adopt the euro in 2015. Both Lithuania’s president and the central bank governor, Vitas Vasiliauskas, have repeatedly expressed scepticism about this date. They have maintained that Lithuania would perhaps not be ready for the euro before 2016. In an interview with Reuters on December 28, Butkevicius said that the country’s political elite agreed to a plan to join the euro zone in 2015 and that a special working group for euro preparations will be formed. He stated in the interview that Lithuania needs to adopt the euro in order to remain competitive and become more attractive to investors. The Butkevicius government is probably concerned that Lithuania will end up somewhat in the shadow of Latvia and that foreign investments will instead be directed more towards Latvia now that the country is on its way into the euro zone. The new government thus also wants to market Lithuania’s euro ambitions internationally, for example in a Reuters interview. As for economic analysis, our conclusion is that Lithuania has a decent chance of meeting the Maastricht criteria in the run-up to the 2015 target date: this can be estimated at “50-50”. However, the country would not meet all five basic criteria (actually six, if we include having an independent central bank) if an evaluation were made for Lithuanian euro zone membership in 2014. The budget criterion is actually a close call, but the country would still fall short due to excessive inflation. For Latvia, however, the Maastricht criteria are already well within reach today. This means that the country, which will also submit its application in February, according to official statements in December 2012, is highly likely to be admitted into the euro zone in
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Economic Insights

2014. The third Baltic nation, Estonia, has been part of the euro zone since 2011. Here, in brief, are the Maastricht convergence criteria for euro zone membership and our forecast of how well Lithuania and Latvia meet them at present:  The government budget deficit may not exceed 3 per cent of GDP. Lithuania’s deficit in 2012 is expected to have ended up at precisely 3 per cent but in 2013 is expected to end up slightly above this, although the government’s budget assumes 2.5 per cent. Latvia’s budget deficit is estimated at 1-1.5 per cent in both 2012 and 2013. The government debt-to-GDP ratio may not exceed 60 per cent or must be moving down towards that level at a satisfactory pace. Both in Lithuania and Latvia, sovereign debt is around 40 per cent in 2012-2013. Inflation may not be more than 1.5 percentage points higher than the average for the three EU countries with the lowest inflation. The latest available 12-month average will be used in the evaluation, i.e. March 2013-March 2012 if an evaluation is made this spring for 2014 euro zone accession. During 2012, Sweden (0.9 per cent), Greece (1.0 per cent) and Ireland (1.9 per cent) had the lowest inflation, resulting in an average of 1.27 per cent. Adding 1.5 percentage points, the limit would thus have been 2.77 per cent. In 2012, Lithuania reported inflation of 3.2 per cent, while Latvia ended up at 2.3 per cent. And no radical change can be expected when the next March-March measurement is made: Lithuania’s inflation is above the limit.

Long-term yields (10-year sovereign bonds) may be no more than 2 percentage points above yields in the three EU countries with the lowest inflation. It is doubtful, however, whether this criterion should actually be used for Lithuania and Latvia in particular, considering that historically, these countries have had relatively low government debts and thus relatively little borrowing in the long-term bond market; in other words, there are few comparable figures. The exchange rate must have been stable for two years, with membership in the exchange rate mechanism (ERM) and without any devaluation. Lithuania and Latvia qualify without problems; both countries have belonged to the ERM, since 2004 and 2005 respectively, and have fixed exchange rates.

Excessive inflation is thus Lithuania’s Achilles heel. Incidentally, high inflation was precisely why the country failed in its first attempt to join the euro zone in 2007; after their evaluation in the spring of 2006, the ECB/EU turned the country down because the criterion was 2.6 per cent (Poland, Sweden and Finland had the lowest inflation) and Lithuania showed 2.7 per cent. But even today, the country does not deviate greatly from the criterion. Looking ahead, there is also time to pursue policies that will restrain price pressures. As things look now, however, our assessment is that inflation will climb slightly towards 3.5 per cent in the next two years, in 2013 mainly due to higher energy prices. As for the budget criterion, the government seems determined to limit the deficit to a maximum of 3 per cent in the next couple of years. At the same time, we find it hard to foresee the new government pursuing a fiscal policy as tight as the previous government. Among other things, minimum wages were raised at the beginning of 2013 and the government has also announced that it wants to stimulate more investments in weak regions and eventually cut income taxes and raise taxes on capital. Our current forecast points towards a budget deficit of about 3.5 per cent of GDP in 2013. To summarise, our review of the criteria shows that Lithuania is within striking distance of completely fulfilling the criteria for its 2015 euro zone membership target, but it is not certain whether the country will make it. This is why we are sticking to our forecast of euro zone accession in 2015 at the earliest. It is also important to point out that in their evaluations of countries applying for euro zone membership, the ECB

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Economic Insights

and EU not only look at the strict quantitative Maastricht criteria but also weigh whether the downturn in inflation and the budget deficit can be regarding as lasting. This is a more qualitative assessment. The bottom line in determining whether a new country gets the green light to join the euro zone is a political decision by the other EU countries. Mikael Johansson, Head of Baltic and CEE research, SEB Economic Research + 46 8 763 80 93

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