Independent work

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Independent work

Nationalekonomi Economics

Titel

Latvia in European Monetary Union gains and losses

Erlands Krongorns, Andris Bertins

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Institutionen för samhällsvetenskap

Latvia in European Monetary Union gains and losses

Författare: Erlands Krongorns, Andris Bertins

Handledare: A. Khalik Salman Kurs: NA003G Nationalekonomi GR (C) Kandidatuppsats i nationalekonomi 15 hp

Termin: VT 2013

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Abstract

Latvia is trying to join European Monetary Union in 2014. The purpose of this work is to understand gains and loss of European Monetary Union and how they would affect Latvia if Latvia would join in European Monetary Union. In this paper we analyze gains and loss of common single currency and how they affect all Euro area and small open Euro area countries which are similar to Latvia before and after adopting euro. Some gains are more visible than other with bigger impact, but losses in some circumstances can be bigger than all gains from monetary union.

Purpose

The question now is should Latvia join EMU or no, you will not get answer on this question in this paper. It is too complicated to say yes or no, but we will look on gains and losses and analyze how it could affect Latvia if it become a member of EMU. The importance of knowing gains and losses is very big because only smart and knowledgeable people can make right decisions.

There have been a lot of research paper about gains and losses about EMU, Daniel Portone The Costs and Benefits of the Euro in European Monetary Union, Paul Krugman Can Euro be Saved, George S. Tavlas Benefits and Costs of Entering the Eurozone all these papers analyze the EMU and the conclusions is asymmetric between Paul Krugmans view and two others.

Our research is based on European Commission view which is similar with Portones and Tavlas opinions.

Methodology

The main goal with this paper is to analyze gains and losses of being a part of EMU.

In this paper we use qualitative research, we analyze different previous written papers about gains and losses of monetary union and we determine gains and losses and compare results with empirical data between Latvia and most similar countries in EMU and euro zone by itself to prove these gains and losses and then make conclusions.

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Abbreviations

EMU European Monetary Union

EU European Union

Ls Lats

GDP Gross domestic product

NATO The North Atlantic Treaty Organization IMF International Monetary Fund

ECB the European Central Bank

US The United States

ERM II The European Exchange Rate Mechanism II ESCB The European System of Central Banks WTO World Trade Organisation

The SGP The Stability and Growth Pact EDP Excessive Deficit Procedure

TFEU the Treaty on the Functioning of the European Union

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1 Introduction

1.1 Background

Latvia has joined European Union on 2004 together with ten other countries. (Cyprus, Czech Republic, Estonia,Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia) Five of these countries have joined EMU as well. On 2004 together with EU agreement Latvia accepted agreement to join EMU in future when it will accomplished convergence criteria so called Maastricht Criteria. Latvia’s target to become a member of EMU was set on 1th of January on 2008. Latvia failed, the inflation on beginning of 2007 was too high¹. Now Latvia has made new target time to join EMU it is 1th of January on 2014.²

1.2 Outline of Chapters

The paper is divided into 8 chapters. After the introductory chapter, chapter 2 presents the model of theoretical concepts for our paper. Chapter 3 presents introduction about Latvia, chapter 4 presents information about European Monetary Union. Chapter 5 provides information on Maastricht Criteria and Latvia’s results. Chapter 6 shows gains while chapter 7 shows losses of European Monetary Union and chapter 8 offers the conclusions and final remarks made in this study.

1 Bank of Latvia, 2013, http://www.bank.lv/en/eu-and-euro/eu-and-euro

2European Commission, 08.05.2013, http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/

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3 Latvia

Source: Central Intelligence Agency

3.1 About Latvia

Situated in north-eastern Europe with a coastline along the Baltic Sea, Latvia is geographically the middle of the three Baltic republics.³

It has language links with Lithuania to the south and historical and ecumenical ties with Estonia to the north.³

 Full name:Republic of Latvia

 Population: 2.2 million (UN, 2011)

 Capital: Riga

 Area: 64,589 sq km (24,938 sq miles)

 Official language: Latvian

 Major religion: Christianity

 Life expectancy: 69 years (men), 79 years (women) (UN)

 Monetary unit: 1 lats = 100 santims

 Main exports: Timber and wood products, fish and fish products

 GNI per capita: US $11,620 (World Bank, 2010)

 Internet domain: .lv

 International dialling code: + 371⁴

3 BBC news, 18 January 2012, http://news.bbc.co.uk/2/hi/europe/country_profiles/1106666.stm#overview

4BBC news, 18 January 2012, http://news.bbc.co.uk/2/hi/europe/country_profiles/1106666.stm#overview

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3.2 Latvia’s history

The Republic of Latvia was founded on November 18, 1918. It has been continuously recognised as a sovereign state since 1920 despite occupations and rule by the Soviet Union (1940-1941, 1945-1991) and Nazi Germany (1941-1945). On August 21, 1991 Latvia declared the restoration of its de facto independence, re-established international diplomatic ties, and joined the United Nations. Latvia joined the WTO in 1998 and in 2004 became a member of the European Union and NATO.⁵

The name "Latvija" comes from the ancient Latgallians, one of four Indo-European Baltic tribes, who along with Couronians, Selonians and Semigallians formed the ethnic core of today’s Latvian people.⁵

3.3 Economy of Latvia

Latvia is a small, open economy with exports contributing nearly a third of GDP. Due to its geographical location, transit services are highly-developed, along with timber and wood- processing, agriculture and food products, and manufacturing of machinery and electronics industries. Corruption continues to be an impediment to attracting foreign direct investment and Latvia's low birth rate and decreasing population are major challenges to its long-term economic vitality. Latvia's economy experienced GDP growth of more than 10% per year during 2006-07, but entered a severe recession in 2008 as a result of an unsustainable current account deficit and large debt exposure amid the softening world economy. Triggered by the collapse of the second largest bank, GDP plunged 18% in 2009. The economy has not returned to pre-crisis levels despite strong growth, especially in the export sector in 2011-12.

The IMF, EU, and other international donors provided substantial financial assistance to Latvia as part of an agreement to defend the currency's peg to the euro in exchange for the government's commitment to stringent austerity measures. The IMF/EU program successfully concluded in December 2011. The government of Prime Minister Valdis Dombrovskis remained committed to fiscal prudence and reducing the fiscal deficit from 7.7% of GDP in 2010, to 2.7% of GDP in 2012.⁶

At the turn of the years 2011/2012 Latvia has seen eight successive quarters of growth, driven by exports that have exceeded pre-crisis peaks. While investment is positively booming too

5 Latvian Institute, 2012, http://www.latvia.lv/library/latvia-brief

6 Central Intelligence Agency, 7 May 2013, https://www.cia.gov/library/publications/the-world- factbook/geos/lg.html

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(up 25% in the first half of 2011), and consumption is picking up (4% growth in the same period), they have regained less than half of their lost ground.⁷

The majority of companies, banks, and real estate have been privatized, although the state still holds sizable stakes in a few large enterprises, including 99.8% ownership of the Latvian national airline.⁸

7Latvian Institute, 2012, http://www.latvia.lv/content/recent-developments

8 Central Intelligence Agency, 7 May 2013, https://www.cia.gov/library/publications/the-world- factbook/geos/lg.html

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4 European Monetary Union (EMU)

4.1 What is EMU

The euro is the single currency shared by (currently) 17 of the European Union's (EU) Member States, which together make up the euro area.⁹

Economic and Monetary Union (EMU) is the highest stage of the EU member states' economic integration. This is also the key instrument for achieving basic goals of the EU economic policy - stable growth and low inflation.⁹

EMU means:

 The single currency and the euro area;

 An independent monetary policy run by the European Central Bank (ECB) together with central banks of euro area countries. It is mainly targeted at price stabilisation;

 Coordination of economic and fiscal policy-making between Member States.⁹

The decision to form an Economic and Monetary Union was taken by the European Council in the Dutch city of Maastricht in December 1991, and was later enshrined in the Treaty on European Union (the Maastricht Treaty.⁹

Single European currency was first introduced on 1 January 1999 as a virtual currency for cash-less payments and accounting purposes. Three years later, on 1 January 2002, it appeared in physical form, as banknotes and coins, gradually replacing the old national currencies. Now the euro can be used without restrictions for settling payments in all euro- area countries. Although the euro is comparatively new currency, it has rapidly become the second most important international currency after the US dollar.⁹

On 1 January 2002 the euro was launched in 12 EU Member States:

 Austria

 Belgium

 France

 Greece

 Ireland

 Italy

 Luxemburg

 The Netherlands

 Portugal

 Finland

 Spain

 Germany On 1 January 2007 the euro-area was joined by

 Slovenia

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12 On 1 January 2008 cash euro was introduced in:

 Cyprus

 Malta

On 1 January 2009 national currency was changed to the euro by

 Slovakia

On 1 January 2011 the euro was implemented in

 Estonia

Today, the euro area numbers 17 EU Member States. Of the Member States outside the euro area, Denmark and the United Kingdom have 'opt-outs' from joining, although they can join in the future if they so wish. Sweden has not yet qualified to be part of the euro area.⁹

Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Bulgaria and Romania are also candidates for implementation of the euro.⁹

9 Eiro.lv, 2013, http://www.eiro.lv/eng/the_euro/the_euro_and_emu/emu_today

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5 Maastricht Criteria and Latvia’s results

5.1 Maastricht Criteria

The decision to form an Economic and Monetary Union was taken by the European Council in the Dutch city of Maastricht in December 1991, and was later enshrined in the Treaty on European Union (the Maastricht Treaty) which also set requirements for accession to the EMU.¹⁰ In practical terms, EMU means that:

The euro area enlarges gradually - more and more EU Member States introduce the euro. To introduce the euro EU Member States with a derogation (i.e. not participating in the euro area) have to satisfy conditions to adopt the single currency or the so called "Maastricht criteria".¹⁰ Table1: Maastricht Criteria

Source: Bank of Latvia

10 Eiro.lv, 2013, http://www.eiro.lv/eng/the_euro/the_euro_and_emu/emu_today

What is

measured

By what Convergence criteria

Price stability Harmonised

consumer price inflation

No higher than average value of the three best performing

Member States +1.5 percentage points Sound public

finances

Government deficit as % of GDP

Reference value: no more than 3%

Sustainable public finances

Government debt as % of GDP

Reference value: no more than 60 %

Durability of convergence achieved by the Member State

Long-term interest rates

No higher than the average value of the three best performing

Member States in terms of price stability +2 percentage points

Exchange rate stability

Fluctuation band of +/- 15% around the central rate

Two years of participation in ERM II with no serious problems

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5.2 Latvia’s results

Following Latvia's accession to the EU, the Bank of Latvia's policy is based on the strategic goal to prepare the country for a full-fledged participation in the Economic and Monetary Union. In the light of its commitment, Latvia is aiming towards both nominal and real convergence with EU Member States. Although real convergence is a long-term objective, Latvia is well on its way of achieving it.¹¹

The peg of the lats to the euro on 1 January 2005 was the first significant monetary adjustment after Latvia's accession to the EU, to be followed by joining the Exchange Rate Mechanism II (ERM II) on 2 May of the same year. ERM II is an arrangement for the pegging of the exchange rate and simultaneously a procedure for testing the maturity of a member state to adopt the euro.¹¹

Consistently with both the Convergence Programme of Latvia for 2009-2012, whose medium- term projections support Latvia's maturity to meet the Maastricht criteria in 2012, and Latvia's Economic Stabilisation and Growth Revival Programme, the government of Latvia has set 1 January 2014 as the target for the adoption of the euro. Latvia's failure to introduce the euro as early as 2008 was on account of the high inflation, whereas at this junction meeting the budget deficit criterion is the largest challenge.¹¹

Figure 1: Average annual inflation rate of the last 12 months (%)

11 Bank of Latvia, http://www.bank.lv/en/eu-and-euro/eu-and-euro

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Figure 2: Long-term interest rate on government securities (%)

Figure 3: Budget balance (% of GDP)

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16 Figure 4: Government debt (% of GDP)

Right now Latvia satisfy all Maastricht criteria, Bank of Latvia and Latvian government is doing all to join European Monetary Union in 2014, but question arises is this just to satisfy Maastricht criteria or this will be permanent.

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6 Gains of being a part of EMU

6.1 Consumer benefits

6.1.1 A more competitive market

The euro brings price transparency to the single market. Consumers can easily compare prices across borders and find the most advantageous price for a product or service – especially in the internet era – whether it is a pair of trousers or a high-end home cinema system. This is because increased price transparency has the effect of increasing competition between shops and suppliers, keeping downward pressure on prices in the euro area. This benefit from EMU will help latvian consumers to be more critical about prices of goods they encounter. For example, product A in Latvia costs 750 Ls (exchange rate Lats 0.702804=1 Euro) and the same product in Slovenia costs 1000 euro usually consumers take a quick look at price and think that 750Ls is less than 1000 euro and so he thinks he made a good buy, but unfortunately it is not true because 1000 euro is less than 750 Ls and because of EMU benefit price transparency consumer will have easer to compare prices for goods in Latvia and Slovenia or any other EMU countries and so consumers will make better decisions.¹²

6.1.2 Price stability

From Treaty on European Union article 105 - The primary objective of the ESCB shall be to maintain price stability.¹³

6.1.2.1 Benefits of price stability

The objective of price stability refers to the general level of prices in the economy. It implies avoiding both prolonged inflation and deflation.¹⁴ Price stability contributes to achieving high levels of economic activity and employment by

 improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well- informed consumption and investment decisions and to allocate resources more efficiently;¹⁴

12 European Commission, 30 October 2010,

http://ec.europa.eu/economy_finance/euro/why/consumer/index_en.htm

13 Treaty on European Union, 29.07.1992,http://eur-lex.europa.eu/en/treaties/dat/11992M/htm/11992M.html

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 reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest;¹⁴

 avoiding unproductive activities to hedge against the negative impact of inflation or deflation;¹⁴

 reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems;¹⁴

 preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation;¹⁴

 and contributing to financial stability.¹⁴

6.1.2.2 Does Monetary Union create price stability Figure 5: Inflation, consumer prices (annual %) from 1980 till 2011

Source: World Bank

Figure 5 shows the first twelve countries who adopted euro. From 1980 till 1999, when those countries weren’t in a Monetary Union, a lot of countries had high inflation and high

14 European Central Bank, 2013, http://www.ecb.europa.eu/mopo/intro/benefits/html/index.en.html -10

-5 0 5 10 15 20 25 30 35

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Austria Belgium Finland France

Germany Greece Ireland Italy

Luxembourg Netherlands Portugal Spain

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fluctuations in inflation, but after 1999 in all countries inflation are stable. So Monetary Union gives price stability.

6.1.2.3 Price stability in Latvia and Slovenia

Figure 6: Inflation, consumer prices (annual %) from 1994 till 2011

In Figure 6 is shown Latvia and Slovenia inflation from 1994 till 2011. In both countries inflation were high in 1994, but from 1997 Latvia inflation was lower than Slovenia and again higher from 2004. Slovenia adopted euro in 2007 and Slovenia inflation is becoming very close to zero, meantime Latvia still has big fluctuation in inflation.

6.1.3 Easier, safer and cheaper borrowing

Low inflation and stable prices are a key aim of the management of the euro-area economy.

Because the European Central Bank acts to keep inflation low, interest rates are also lower.

This means consumer loans are cheaper and future repayments are more predictable, so ordinary citizens can borrow more easily and cheaply, for example to pay for holidays or to buy a house. Mortgage rates have fallen from around 8%-14% in the early 1980s to an

-5 0 5 10 15 20 25 30 35 40

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Slovenia Latvia

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average of 5% now in the euro area, saving a borrower with a €100 000 outstanding loan between €170 and €750 a month on interest payments.¹⁵

Figure 7: Retail Interest rates (Housing loans to households)

Source: Eurostat

In Figure 7 we can see that after Cyprus joined the EMU on 2008 retail interest rates for housing to households reduced. Also in we can see that the same thing happened with Estonia after it joined EMU on 2011. So we want to believe that if Latvia will join EMU than this situation will repeat again and it could help to boost housing market and increase activity in construction industry which will increase jobs and the all Latvia’s economy will be better off.

6.1.4 Lower travel costs

In Monetary Union countries have lower travel costs, because those countries have common currency and don’t need to exchange when goes to another country who is in union.

If there weren’t monetary union, then when travel from one country to another country people need to exchange money to that country currency, so they lose some money which they pay for the exchange. And when travel to many countries, example Europe where lot of small

http://ec.europa.eu/economy_finance/euro/why/consumer/index_en.htm 0

5 10 15 20 25

Month 2003-07 2004-02 2004-09 2005-04 2005-11 2006-06 2007-01 2007-08 2008-03 2008-10 2009-05 2009-12 2010-07 2011-02 2011-09 2012-04 2012-11

Interest rate

Cyprus

Denmark

Estonia

Euro area (EA11-2000, EA12- 2006, EA13-2007, EA15- 2008, EA16-2010, EA17)

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countries are, they lose a lot of money in exchange. But if there is one currency they don’t lose anything and has lower travel costs.

And secondly with price transparency, they see that if the prices are too high and avoid frauds from paying to high price.

If more countries are in Monetary Union then lower travel costs.

6.1.5 More growth and job

In a single market with a single currency, doing business across borders is cheaper for companies as they no longer need to include the risk of currency fluctuations into their prices nor to pay exchange costs. Previously, these costs amounted to around €20 to 25 billion annually within the European Union. Today, they have disappeared in the euro area. This helps release capital to invest in expanding and growing business and employing more workers, thereby benefiting jobseekers and their families. Since the euro was introduced in 1999, more than 10 million new jobs have been created in the euro area, compared with only 1.5 million in the previous seven years.¹⁶

6.2 Business benefits

6.2.1 More cross-border trade

A direct benefit of the euro is that, within the euro area, there is no need for businesses to work in different currencies. A company can buy and sell throughout this area, paying and being paid in euro.¹⁷

Previously, when doing business in another EU Member State, a company would need to take account of the risk of fluctuating exchange rates – i.e. the stated foreign currency amount on the invoice might change in value before being paid. This meant either export prices were higher, or companies were discouraged from exporting within the single market. This risk has now gone, as have the costs associated with exchanging different currencies. Before the euro, these exchange costs were estimated at €20 to 25 billion per year in the EU (as much as 0.3%

to 0.4% of GDP) – much of it incurred as companies transferred goods, people and capital around Europe. With the euro, these costs have disappeared in the euro area, and this money is now available for more productive investment.¹⁷

17European Commission, 30 October 2010,

http://ec.europa.eu/economy_finance/euro/why/business/index_en.htm

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With no exchange risks and costs, cross-border trade within the euro area is encouraged. Not only can companies sell into a much larger ‘home market’, but they can also find new suppliers offering better services or lower costs – a development that is helped by the growth of e-commerce over the internet. Trade within the euro area is estimated to have increased between 4% and 10% since the introduction of the single currency.¹⁸

Figure 8: Slovenia and Latvia EU Intra trade growth (%)

Source: Eurostat

However in Figure 8 we can see that because of the financial crises after Slovenia joined EMU its intra trade growth rate declined. If we analyse this graph then we can say that there is no difference between Latvia and Slovenia intra trade growth rates even if we know that Slovenia joined EMU 2007 but the good thing about this benefit is that it boost intra trade growth rates in long run.¹⁹

6.2.2 Better borrowing, better planning, more investment

Before the euro, volatile interest rates meant unpredictable costs. With the euro, inflation has come down to a low and stable level, which also means low and stable interest rates. Firms can borrow more and more cheaply and can invest more confidently in the long term.²⁰

Long-term investment is further encouraged by the sound and prudent management of Economic and Monetary Union, which builds trust in the economy of the euro area and

http://ec.europa.eu/economy_finance/euro/why/business/index_en.htm

19 Baldwin Richard, 2006, The Euros Trade Effects, Working paper series No. 594, ECB, pages 99.

-0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

Slovenia Latvia

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reduces uncertainty about the future. Companies can invest more in growth and new technologies rather than saving money in reserve in case of an economic downturn.²⁰

It is not only citizens and business which benefit from cheaper loans: government borrowing is also less expensive, as interest payments on national debt are lower. The money saved can therefore either be used for investment in new infrastructure, or to boost research spending for jobs and growth, or for improving welfare and pension systems, or to reduce the tax burden – depending on a Member State’s priorities.²⁰

Figure 9: Government bond yields, 10 years' maturity - annual data, from 1980 till 2007

Source: Eurostat

In Figure 9 we can see that long term bonds with maturity of 10 years interest rates have dropped down significantly since 1980. It means that now for governments it is less costly to borrow money and it is easier to make big investments in infrastructure, etc and economy is better off because of lower bond interest rates.

http://ec.europa.eu/economy_finance/euro/why/consumer/index_en.htm 0

5 10 15 20 25 30

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Austria Belgium

Finland France

Germany (until 1990 the FRG) Greece

Ireland Italy

Netherlands Portugal

Spain

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Long term bonds interest rates shows the investor’s predictions about future inflation.²¹ Figure 10: Government bond yields, 10 years' maturity - annual data, from 2004 till 2012

Source: Eurostat

In Figure 10 we can see that from 2008 to 2010 Latvia’s long term bond interest rates grew rapidly because there was probability of Latvia’s currency devaluation which automatically mean high inflation in future. For Slovenia there was no such risk at the middle of financial crises because it was already joined EMU.

6.2.3 More international trade

Figure 11: Exports of goods and services (% of GDP) from 1980 till 2010

Source:Eurostat

21 Mishkin F. (2012) Tenth ed., The Economics of Money, Banking and Financial Markets, Pearson, page 178.

0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00

2004 2005 2006 2007 2008 2009 2010 2011 2012

Latvia Slovenia

0 5 10 15 20 25 30 35 40 45 50

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Euro area countries by World Bank data

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By Figure 11 is show that from 1993 is rapid growth, but from 1980 till 1993 the export of goods and services are stable at 25 and 30 % of GDP. In 1993 The European Union was formally established. And from 2002 euro was in public. When The European Union was established it gave lot of gains in trade, because

The European Union (EU) has a common trade policy, often referred to as the common commercial policy. In other words, the EU acts as a single entity on trade issues, including issues related to the World Trade Organisation (WTO). In these cases, the European Commission negotiates trade agreements and represents Europe’s interests on behalf of the EU Member States.²²

And more gains it gave when euro was introduced, because one currency it is easier to trade with countries. And countries who are out of Euro zone will trade with Euro zone, because, they will have less costs on currency exchange.

So in total we can see there is large increase in international trade from 1993 and more from 2002.

6.3 Single financial market

The more integrated financial markets are, the more efficient the allocation of capital is because investments opportunities and competition are also greater, and capital can move around to where it can be used most efficiently.²³

The introduction of the euro in 1999 proved to be a powerful catalyst to the integration of financial markets and the creation of a much larger, more efficient single financial market, which brings many economic benefits:²³

 A single financial market allows individual citizens and companies to invest throughout the euro area to obtain the best return on their savings. It creates opportunities to borrow from across the euro area, seeking out the lowest cost for their loan. Investors can also spread risks more widely.²³

 The costs of financial intermediation, such as bank charges, are lower. In the euro area there are more banks and investment funds and thus there is more competition between them. Lower costs encourage more capital flows.²³

22 Eurostat, International trade introduced, 2013

http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/International_trade_introduced

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 More capital is available to borrowers at a lower cost because there are more sources of capital. This makes the money they borrow cheaper and better tailored to the needs of the borrower.²³

 Because borrowing is cheaper this makes more capital available for further lending.

This encourages citizens and companies to borrow more to invest – which creates more economic growth and more employment, and benefits the EU economy as a whole.²³

6.4 An international currency 6.4.1 Supporting international trade

As the world’s largest trading power, with an open economy and a stable currency, the euro area is an attractive destination for other trading nations. Third-country companies are therefore increasingly willing to do business in euro. This means that when euro-area firms export or import goods they can invoice and pay in euro – reducing their costs and the risk of losses caused by global currency fluctuations. Thus, overall, the euro facilitates and encourages trade with the rest of the world.²⁴

6.4.2 Foreign appeal

The euro is also attractive to foreign governments as a reserve currency because of its strength and the confidence it inspires. In this way, they can spread the risks to their foreign exchange reserves by holding euro as well as US dollars and other currencies.²⁴

This is of benefit to the euro-area economy because widespread holdings and a high demand for euro encourages third countries to price their exports in euro – thus reducing costs to euro- area members because there are no exchange rate costs.²⁴

In addition, since the euro is in demand internationally, government borrowing by euro-area members on international markets is less expensive because there is more competition to accept euro in debt repayment.²⁴

The share of the euro in global foreign exchange reserves has risen from 18% in 1999 to over 25% in 2007. The most significant increase can be found in developing countries, where holdings are now close to 29%, from 18% held in 1999.²⁴

23 European Commission, http://ec.europa.eu/economy_finance/euro/why/single_market/index_en.htm

24 European Commission, http://ec.europa.eu/economy_finance/euro/why/international/index_en.htm

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If Latvia will become a member of EMU than it will get some share of profit from ECB which is made by euro as international currency.²⁵

25 De Grauwe P. 2012, Economics of monetary union, Oxford, page 72

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7 Loses of being a part of EMU

7.1 Loss of autonomy over economic policy

The costs of monetary union derive from the fact that when a country relinquishes its national currency, it also relinquishes an instrument of economic policy, it loses the ability to conduct a national monetary policy.²⁶

Exchange rates between countries were no longer adjusted by the individual countries to help regional economic slumps get moving²⁷

When there are only one monetary policy, but in union many countries, they can develop differently and have many different economic problem and if monetary policy is improper they can’t respond economic problems at home.

7.1.1 Asymmetric shocks

Asymmetric shocks are the reason why monetary union can be costly. Simple example can show us how monetary union can become from cheap to expensive. Let’s choose two countries A and B, for some reasons consumers starts to buy countries A goods more than B.

In this situation country B occurs demand decrease, and it means that unemployment rate increases. The same time in country A unemployment rate declines more than natural unemployment and so starts inflation. In this situation usually national central banks must use different monetary policy for country A restricted monetary policy and for country B simulative monetary policy. But if those countries are in monetary union they can’t use monetary policy, because what is good for country A is bad for country B. To get back competitiveness country B should reduce costs for making goods for example, reduce wages etc. It is the reason why monetary unions become costly.

Domenico Giannone, Michele Lenza and Lucrezia Reichlin on their research „BUSINESS CYCLES IN THE EURO AREA” concluded:

„We have identiﬁed two groups of countries. The ﬁrst is composed of EMUs members that had similar levels of GDP per capita at the beginning of our sample, in the seventies. These countries have also experienced similar business cycles throughout the sample period and the establishment of the EMU has not changed this pattern. The second group is composed by

26 De Grauwe P. 2012, Economics of monetary union, Oxford, page 5

27 Portone D. 2004, The Costs and Benefits of the Euro In European Monetary Union Countries, page 3

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member states whose level of economic activity was more heterogeneous and that have been historically more volatile. Business cycles, for these countries, have been less correlated with the rest of the euro area throughout the period and, again, no change can be detected with the inception of the single currency”²⁸

Figure 12: Latvia GDP growth, inflation and unemployment from 1995 till 2011

By Figure 12 we can see that from 1995 there was recession, high inflation which are decreasing and low growth, but then recovery till 1997 and then growth with small decline in some years till 2006 and then global crisis hit and till 2010 is recession and till now is recovery. We can see that Latvia growth levels usually are at high level, so Latvia could experience asymmetric shocks.

7.2 Countries will lose some independence over fiscal policy

The Maastricht Treaty set rules for all countries to reach in order to achieve Economic and Monetary Union: low inflation, low interest rates and controlled public debt and spending.

28 Giannone D., Lenza M. and Reichlin L, 2008, Business cycles in the euro area ,Research, page 20 -25

-20 -15 -10 -5 0 5 10 15 20 25 30

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

GDP growth (annual %)

Inflation, consumer prices (annual %) Unemployment, total (% of total labor force)

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The Stability and Growth Pact (the SGP), agreed in 1997, said that the same rules should apply once the Euro was launched.²⁹

Countries who have adopted euro, inflation and interest rates are controlled by ECB, but public debt and spending are fiscal policy and those are under national governments rules. So to control these objectives after euro is adopted The Stability and Growth Pact was introduced.

The rationale is that joining the single currency means a common interest rate, set by the ECB. If countries borrow too much it puts upward pressure on interest rates. Therefore, limits on government borrowing are needed to avoid these problems.³⁰

Problems of Growth and Stability Pact, it means countries have less flexibility in dealing with economic downturns. In a recession it makes sense to have expansionary fiscal policy. (higher spending and lower taxes) However, this increases the budget deficit. Therefore, to keep government borrowing within the criteria of the growth and stability pact means that the government cannot try and increase AD through fiscal policy.³⁰

7.2.1 What is The Stability and Growth Pact

By European Commission the Stability and Growth Pact is a rule-based framework for the coordination of national fiscal policies in the European Union. It was established to safeguard sound public finances, based on the principle that economic policies are a matter of shared concern for all Member States.³¹

The SGP contains two arms – the preventive arm and the corrective arm. The preventive arm seeks to ensure that fiscal policy is conducted in a sustainable manner over the cycle. The corrective arm sets out the framework for countries to take corrective action in the case of an excessive deficit.³¹

The corrective arm is made operational by the Excessive Deficit Procedure (EDP), a step-by- step procedure for correcting excessive deficits that occur when one or both of the rules that the deficit must not exceed 3% of GDP and public debt must not exceed 60% of GDP (or at least diminish sufficiently towards the 60%) defined in the Treaty on the Functioning of the EU (TFEU or Treaty) are breached.³¹

Non-compliance with either the preventive or corrective arms of the Pact can lead to the imposition of sanctions for euro area countries. In the case of the corrective arm, this can

29 Civitas, 14 April 2012, http://www.civitas.org.uk/eufacts/FSECON/EC10.htm

30 Economics help, 14 January 2013, http://econ.economicshelp.org/search/label/Euro

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involve annual fines for euro area Member States and, for all countries, possible suspension of Cohesion Fund financing until the excessive deficit is corrected.³¹

7.2.2 History of the SGP

The original SGP said that all countries in the Euro zone should aim to keep their annual budget deficit below 3% of GDP, and keep total public debt below 60% of GDP. If a country broke the rules, it had to take measures to reduce its deficit. If it broke the rules in three consecutive years, the Commission could impose a fine of up to 0.5% of GDP.³²

Once the Euro was launched, many countries had difficulty meeting the SGP rules. In 2003, the largest economies in the euro zone, France and Germany, broke the rules. However, because these countries promised to reach the SGP targets as soon as possible, the Commission did not take strong action against them. This made the SGP look weak and the Council of the European Union decided to suspend it. In March 2005, the European Council agreed a reformed SGP with much more flexible rules. Again in 2011 to tighten the rules.³²

7.2.3 The SGP results for Euro zone and Latvia

By Table 2 in appendix we see that from 2003 till 2012 only three countries fulfil the rules that the deficit must not exceed 3% of GDP and public debt must not exceed 60% of GDP.

And those are Estonia, Finland and Luxembourg. Greece government debt grows from 97.4%

in 2003 to 170.3 government debt of GDP in 2011. Countries who adopted euro after 2003, decreased budget deficit and public debt to satisfy criteria, but after that no of them except Estonia satisfy those criteria.

Crisis hit hard Euro zone and from 2009 13 countries don’t satisfy criteria. Right now European Commission determine every country different criteria, because of crisis, every country make Convergence reports, to show how they will reduce or still increase if they are in recession and will not have penalty.

Latvia has good results from 2003, its public debt was only 14.7% and budget deficit 1.6% of GDP. Till 2007 Latvia decreased public debt till 9% and budget deficit 0.4% of GDP, but then crisis hit Latvia and budget deficit and public debt started to grow till 2010 and from then after austerity measures and reduced till 1.2% budget deficit and 40.7% public debt in 2012 and satisfy The SGP criteria.

31 European Commission, 2013,

http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm

32 Civitas, 14 April 2012, http://www.civitas.org.uk/eufacts/FSECON/EC10.htm

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7.3 Cost of replacing currency

By Bank of Latvia opinion costs for introduction euro in Latvia would be:

 The cost of the private sector: about 115 million lats.

 Other country experience shows that costs are around 0.5% or less than 1% of GDP.

 The Ministry of Finance summarized the following costs for the public sector:

• Adaptation of Information Systems - 3.5 million lats.

• Cash changeover Latvian Post office - 1.5 million lats.

• Public awareness - 1.4 million lats.

• Additional security measures - 0.9 million lats.

• Price monitoring, etc. non-financial measures - 0.3 million lats.

• Other expenses - 1 million lats.

 Total the public sector cost: 8.6 million lats.

 Changing currency, supply and delivery and further provision with currency costs to Bank of Latvia are around 12 million lats.

 Latvia in five years will pay 28 million lats each year to European Stability Mechanism.³³

Bank of Latvia estimates that euro cost to the State as a whole will pay off in the first year.³⁴

33 Eiro.lv, 2013, http://www.eiro.lv/lat/iedzivotajiem/biezak_uzdotie_jautajumi/

34Bank of Latvia, 2013, http://www.bank.lv/es-un-eiro/jautajumi-un-atbildes-par-eiro/visbiezak-jautatais- par-eiro/kadas-bus-eiro-ieviesanas-izmaksas

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8 Conclusions

Latvia wants to join European Monetary Union in 2014. Some people predict it will boost Latvian economy strongly after joining EMU and we wanted to see if it’s true. Some gains are easier to see for example price transparency. After joining EMU people can compare prices in different countries in the same currency. Also we concluded that monetary union gives price stability (there is empirical evidence), so people don’t need to worry about high inflation rates. Before financial crises Latvia had high inflation but Slovenia does not because it was already a member of EMU. We believe that inflation rate were lower for Latvia before crises if it joined EMU earlier. However we also compared intra trade EU-27 rates for both countries since 1999 and we did not see how membership of EMU help to boost trade growth rates, probably because Slovenia joined EMU so recently, just on 2007.

Difficult to see if monetary union give more jobs, because need long term to see and there can be a lot of different factors.

Latvia right now satisfy all Maastricht criteria and can join Monetary Union, but question arises if this data will be long term because, how we saw by our paper only three countries can satisfy the SGP and a lot of countries after joining EMU begin spending and borrowing unsustainable. And that makes pressure on all monetary system. Good example is southern European countries which encounters government debt crises.

Of course there will be currency introduction costs, when need to change currency, but those are one time only and there is assumption that will pay off in first year.

8.1 Comments

Common currency means, lost of own monetary policy and get one central institution which is powerless when member countries encounters a hit by asymmetric shocks and loses of asymmetric shocks can be bigger than all gains. So it is difficult to say if Latvia will gain or loss.

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References

 Baldwin R., 2006, „The Euros Trade Effects” Working paper series No. 594, article, ECB, pages 99.

 De Grauwe P. 2012, „Economics of monetary union”, book, Oxford, page 5; 72.

 Giannone D., Lenza M. and Reichlin L., 2008, „Business cycles in the euro area”

,Research, page 20.

 Krugman P., 2011, „Can Euro be Saved”, article, The New York Times, 12 January.

 Mishkin F. S., 2012, Tenth edition, „The Economics of Money, Banking and Financial Markets”, book, Pearson, page 178.

 Hansen J.D., 2001, “European Integration: an Economic Perspective”, book, Oxford University press., pages 255.

 Portone D. 2004, „The Costs and Benefits of the Euro In European Monetary Union Countries”, article, page 3.

Electronic references

 Bank of Latvia, 2013, http://www.bank.lv/en/eu-and-euro/eu-and-euro

 Bank of Latvia, 2013, http://www.bank.lv/es-un-eiro/jautajumi-un-atbildes-par- eiro/visbiezak-jautatais-par-eiro/kadas-bus-eiro-ieviesanas-izmaksas

 BBC news, 18 January 2012,

http://news.bbc.co.uk/2/hi/europe/country_profiles/1106666.stm#overview

 Central Intelligence Agency, 7 May 2013,

https://www.cia.gov/library/publications/the-world-factbook/geos/lg.html

 Civitas, 14 April 2012, http://www.civitas.org.uk/eufacts/FSECON/EC10.htm

 Economics help, 14 January 2013, http://econ.economicshelp.org/search/label/Euro

 Eiro.lv, 2013, http://www.eiro.lv/eng/the_euro/the_euro_and_emu/emu_today

 Eiro.lv, 2013, http://www.eiro.lv/lat/iedzivotajiem/biezak_uzdotie_jautajumi/

 European Central Bank, 2013,

http://www.ecb.europa.eu/mopo/intro/benefits/html/index.en.html

 European Commission, 2013,

http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm

 European Commission, 08. May 2013,

http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/

 European Commission, 30 October 2010,

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 European Commission, 30 October 2010,

http://ec.europa.eu/economy_finance/euro/why/international/index_en.htm

 Eurostat, 2013,

http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=gov_dd_edpt1&lang=en

 Eurostat, 2013,

http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=

en&pcode=tsdde410

 Eurostat, International trade introduced, 2013

http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/International_trade_intr oduced

 Latvian Institute, 2012, http://www.latvia.lv/content/recent-developments

 Latvian Institute, 2012, http://www.latvia.lv/library/latvia-brief

 Treaty on European Union, 29.07.1992, http://eur- lex.europa.eu/en/treaties/dat/11992M/htm/11992M.html

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Appendix

Table 2: The SGP criteria results from 2003 till 2012

Budget deficit to GDP

Debt- to-GDP ratio

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

geo\time 2003 2004 2005 2006 2007

Austria -1.5 65.3 -4.4 64.7 -1.7 64.2 -1.5 62.3 -0.9 60.2

Belgium -0.1 98.4 -0.1 94 -2.5 92 0.4 88 -0.1 84

Cyprus -6.6 69.7 -4.1 70.9 -2.4 69.4 -1.2 64.7 3.5 58.8

Estonia 1.7 5.6 1.6 5 1.6 4.6 2.5 4.4 2.4 3.7

Finland 2.6 44.5 2.5 44.4 2.9 41.7 4.2 39.6 5.3 35.2

France -4.1 62.9 -3.6 64.9 -2.9 66.4 -2.3 63.7 -2.7 64.2

Germany -4.2 64.4 -3.8 66.2 -3.3 68.5 -1.6 68 0.2 65.2

Greece -5.6 97.4 -7.5 98.6 -5.2 100 -5.7 106.1 -6.5 107.4

Ireland 0.4 30.7 1.4 29.5 1.7 27.3 2.9 24.6 0.1 25.1

Italy -3.6 104.1 -3.5 103.7 -4.4 105.7 -3.4 106.3 -1.6 103.3

Luxembourg 0.5 6.1 -1.1 6.3 0.0 6.1 1.4 6.7 3.7 6.7

Malta -9.0 66 -4.6 69.8 -2.9 68 -2.7 62.5 -2.3 60.7

Netherlands -3.1 52 -1.7 52.4 -0.3 51.8 0.5 47.4 0.2 45.3

Portugal -3.7 59.4 -4.0 61.9 -6.5 67.7 -4.6 69.4 -3.1 68.4

Slovenia -2.7 27.2 -2.3 27.3 -1.5 26.7 -1.4 26.4 0.0 23.1

Slovakia -2.8 42.4 -2.4 41.5 -2.8 34.2 -3.2 30.5 -1.8 29.6

Spain -0.3 48.8 -0.1 46.3 1.3 43.2 2.4 39.7 1.9 36.3

Latvia -1.6 14.7 -1.0 15 -0.4 12.5 -0.5 10.7 -0.4 9

Debt- to-GDP ratio

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

max. - 3.0%

max.

60.0%

geo\time 2008 2009 2010 2011 2012

Austria -0.9 63.8 -4.1 69.2 -4.5 72 -2.5 72.5 -2.5 73.4

Belgium -1.0 89.2 -5.6 95.7 -3.8 95.5 -3.7 97.8 -3.9 99.6

Cyprus 0.9 48.9 -6.1 58.5 -5.3 61.3 -6.3 71.1 -6.3 85.8

Estonia -2.9 4.5 -2.0 7.2 0.2 6.7 1.2 6.2 -0.3 10.1

Finland 4.4 33.9 -2.5 43.5 -2.5 48.6 -0.8 49 -1.9 53

France -3.3 68.2 -7.5 79.2 -7.1 82.4 -5.3 85.8 -4.8 90.2

Germany -0.1 66.8 -3.1 74.5 -4.1 82.4 -0.8 80.4 0.2 81.9

Greece -9.8 112.9 -15.6 129.7 -10.7 148.3 -9.5 170.3 -10.0 156.9

Ireland -7.4 44.5 -13.9 64.8 -30.8 92.1 -13.4 106.4 -7.6 117.6

Italy -2.7 106.1 -5.5 116.4 -4.5 119.3 -3.8 120.8 -3.0 127

Luxembourg 3.2 14.4 -0.8 15.3 -0.9 19.2 -0.2 18.3 -0.8 20.8

Malta -4.6 60.9 -3.7 66.4 -3.6 67.4 -2.8 70.3 -3.3 72.1

Netherlands 0.5 58.5 -5.6 60.8 -5.1 63.1 -4.5 65.5 -4.1 71.2

Independent work