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June 13, 2013

Investor Alert: Latvia to Become Newest Eurozone Member

Far from breaking up, the Eurozone is on the verge of welcoming a new member. Latvia has become the eighteenth country to win approval from the European Commission to officially enter the joint currency group.

The news is good press for the Eurozone, after so many bad headlines. Olli Rehn, the EU’s economic and monetary affairs commissioner, was quick to capitalize on it at a news conference, where he said, “Those who predicted a disintegration of the euro … were simply wrong.” He touted the country’s determination to become a member as a sign of confidence in the euro.

Latvia has walked a very hard road to get the green light, conferred in early June. Bailed out in 2008 to the tune of 7.5 billion euros ($9.9 billion), the country followed a strict austerity policy and chose not to devalue its currency, which had already been pegged to the euro for some ten years. Instead, it stuck to tough measures that included cuts to spending and increases in taxes. It was so enthusiastic about embracing cuts to public spending that the International Monetary Fund said it had gone too far and risked the country’s social safety net.

Such tight controls over what money it had—its GDP shrank by 20% when the financial crisis hit—enabled Latvia to woo investors in December with a bond issue that brought in $1.25 billion. That boost in funds allowed Latvia to pay off its bailout in January, faster than any other country and three years ahead of schedule. Now the eastern European nation has its sights set on Eurozone membership by January 1 of 2014, and it’s expected that the July meeting of EU finance ministers will see approval granted. Even though EU leaders and the European Parliament still have to give the go-ahead, no problems are expected.

The Latvian people aren’t as happy about the coming union as their leaders are. Polls show that membership in the Eurozone is nowhere near as attractive to those who have been enduring all those austerity measures as it is to the politicians determined to bring it about. The opposition to the monetary union runs about two to one against.

Peter Fitzpatrick at Fitch Ratings pointed toward the company’s expectation that final approval will be given, since “Latvia comfortably meets the Maastricht criteria on government debt, the budget deficit and long-term sovereign bond yields, inflation and exchange rate stability in the Exchange Rate Mechanism. No country that has met the quantitative criteria has had its euro application rejected.”

Fitch also said that final approval to enter the Eurozone “will trigger a sovereign rating review. Our position remains that euro adoption would deliver net benefits to the Latvian economy, and would be likely to lead to an upgrade.”

That said, there is another consideration.

While there are financial benefits to joining the euro, which the country hopes will boost its economy, there are also political reasons it’s determined to economically ally itself more closely with the West. Its former occupation by Russia has left a bitter taste. The bitterness could extend to Latvia’s banks, as well, since about half their deposits come from nonresidents, many of them hailing from places in the former Soviet Union. That could spell trouble anyway, just as it has for Cyprus with its heavy concentration of Russian deposits.

 “Recent events in Cyprus have drawn attention to Latvia’s high reliance on nonresident depositors [many of whom are believed to be Russian] in its banking sector,” according to Fitch. “It is possible that some euro area member states might have concerns about financial stability in Latvia and potential contingent liabilities for other Eurozone members, and therefore could seek a delay.”

In early May, Fitch stated that Latvia’s banking sector risks are “fundamentally different” from those in Cyprus prior to the Cyprus bailout. Still, “the Cyprus fallout has raised the risks on Latvia’s bid for euro accession in January 2014 amid a fluid political environment in Europe.”

The ratings agency also warned at the end of the month that moving to the joint currency was not a panacea, saying that “…euro adoption is not without its costs. Membership of EMU brings additional financial liabilities related to the funding of the European Financial Stability Facility and the European Stability Mechanism. Although the size of such costs is unclear, participation in the ESM would enhance fiscal financing flexibility through access to new sources of emergency external funding if needed.”

Determined to be optimistic, Latvia is meeting with investors to talk about capital markets funding opportunities. Although the country does not plan to do so immediately, it is laying the groundwork for a reentry into capital markets perhaps later in the year. Citi, JP Morgan and SG CIB have been hired to set up meetings with investors in Frankfurt, London, Paris and Vienna. The country is hoping for a resurgence of investment similar to that experienced by Estonia, which has benefited from lower interest rates and costs for currency conversion—events that have apparently swayed Estonians to be more in favor of the euro now that it’s a done deal.

Latvia may be first at the gate among its remaining Eastern European brethren to embrace the euro, but there’s not much of a line behind it. Other countries in the region are not quite so eager to join the crowd. In February, Poland postponed setting a firm date to move to the joint currency until after its 2015 general election. The Polish prime minister said at the time that the country will have met all the requirements to start using the euro by then. The governor of the Czech Republic’s central bank said at the end of May that his country would likely not move to use the euro until 2019. And Hungary said around the same time that it would be longer than a decade until it switches to the euro.

The procrastination prize has to go, however, not to anyone in Eastern Europe, but to Denmark, which in mid-May said it was postponing indefinitely any adoption of the euro. Its currency is pegged to the euro, but its citizens have watched one bailout after another in the Eurozone with dismay and if a referendum were held any time in the next several years, the answer would be no—as it was in 2000.

 

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