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Q&A: Andris Vilks, Latvian finance minister

With Latvia set to join the eurozone in 2014, and Moody's upgrading its bond rating this week, finance minister Andris Vilks is confident of the benefits to the country in joining the single currency – and aware of the efforts needed to convince a sceptical population.

 What will be the biggest benefits to Latvia’s economy from eurozone membership – closer European integration, cost reduction, FDI flows, greater say in European economic and financial decision-making, support from the ECB?

The main benefits will be the ability to increase the potential of our economy, more sustainable growth, a better structured economy and more FDI. It will also move Latvia further towards European integration, which is an important goal for us, and will give us the opportunity to express our views as a board member of the ECB. As a result of joining the euro, we expect Latvia to become a stronger, larger economy and to achieve a faster convergence speed with other EU members.

Andris Vilks, Latvian finance minister

Was there any hesitation within the government or the central bank about pushing ahead with the application for euro membership in view of the instability in the currency during the past two years and in the immediate aftermath of the Italian elections?

On the contrary – from our perspective, the debt crises in eurozone member states and the market reaction to them have prompted a long overdue policy action to strengthen the coordination of fiscal policy and accelerate reforms, which means Latvia would be joining a much stronger eurozone than in, say, 2008.

So the government and central bank were unanimous in wanting to move forward with adoption?

Yes, definitely. The eurozone is moving in the right direction – member states and the central European institutions are finally working together to ensure that the conditions of membership are fully met.

Was the increasing polarization of the EU into ins and outs a factor in your decision to press ahead with the adoption process?

To be honest, this was not really a tough decision for us as we have never wavered in our intention to join the eurozone. We are now comfortable that we will be able to take our place among the countries that comply with all the requirements for fiscal discipline. Indeed, we hope that, thanks to our impressive recent growth and fiscal performance, we will be able to serve as an example of the rewards to be reaped from strict compliance with the Maastricht criteria.

How might Latvia’s economy be affected by the choice of timing for eurozone entry of other EU member states in CEE?

We have very strong and improving business ties with other countries in CEE – 16% of our exports go to our Baltic neighbour Lithuania and 6% to Poland – so we warmly welcome efforts by those countries towards euro adoption. We see a large part of the growth in Europe over the next few years coming from the Baltics and central Europe, and if EU member states in the region can meet the criteria for euro adoption it would strengthen their own economies as well as helping ours.

If those countries don’t move ahead with eurozone membership, would that be a setback for Latvia?

No. We are confident that we will gain substantial benefits from eurozone membership in any case. However, we are very encouraged to see that serious discussions on membership have been reopened recently in Lithuania, Poland and even Czech Republic. We hope that our progress towards adoption will serve as a positive example for those countries, in the same way as we have benefited from observing the process in Estonia.

According to the most recent Eurobarometer, Latvians are more concerned than the citizens of any other potential eurozone member about issues including loss of national identity, loss of control over national finances and abusive price-setting during the transition to the euro. How do you propose to address such concerns?

Loss of identity is no longer a major issue for Latvians but we have a greater challenge than any other country that has previously adopted the euro in that we have to explain to the public what is going on across the eurozone. Nevertheless, support for adoption is growing. Around 36% of Latvians are in favour of euro adoption, one-third are against, and just under a third are undecided. Clearly we have a lot of work to do in explaining the situation in countries such as Greece and Spain, and also in addressing some rational concerns relating to the confiscation of monetary forms in the Soviet era.

However, we are confident that we can convince the public that the worst of the crisis is over in the wider eurozone, and that we can achieve a painless transition to the single currency. We are lucky in that we can point to the positive experience of Estonia, a country that Latvians understand and trust, in adopting the euro. Not only was the transition there extremely smooth in terms of logistics, but the impact on price stability was limited to 0.2% to 0.3%.

For us, the most important thing is to talk pragmatically about the issue. We openly acknowledge that we will have to make payments towards the ESM but we need to stress the added value euro adoption can bring to our economy. We also need to reiterate that, with a pegged currency, we are already effectively using the euro but without benefiting from the support mechanisms for countries that are within the eurozone.

How will you go about convincing the public of the benefits of euro adoption?

Demand for information about the eurozone and the European economy has been so high that we’ve had to start our explanatory programme earlier than any other country that has introduced the euro. We are already running an extensive programme of conferences, roundtables, news coverage and information films, etcetera.

What do you assess the cost of joining the single currency for Latvia?

We estimate that the changeover costs at the state level will be recouped within the first year. With regard to the ESM, we view our contributions – around €220 million over five years – as equivalent to buying an insurance policy. We are all aware of the importance of the financial assistance that we received from outside institutions in recent years, so we both understand the need to take out insurance for ourselves against future problems and to provide support for other economies that run into trouble.

Do you have any doubts about the future viability of the single currency? Do you think that the euro is an optimal currency area?

If there were any doubts about the viability of the euro in the past they have been convincingly dispelled by the policy steps taken over the past couple of years by the various European institutions and policymakers. The decision of the ECB to emerge as lender of last resort has greatly reduced the risk of potential break-ups, while the adoption of the fiscal compact has ensured that fiscal policy in the euro area will be conducted in a clear, counter-cyclical framework, thus again minimizing the risks of a potential debt overhang.

Are you worried that, as a small country, Latvia’s role in setting policy within the eurozone will be limited?

No. Our influence on monetary policy is non-existent, even though the lat has been pegged to the euro since 2005, so becoming a part of the euro club will obviously give us more of a say on monetary policy, as well as on non-monetary decisions of EU. With euro adoption, we will finally be able to have an impact on issues that are crucial for our economy.

What are the implications of eurozone membership for Latvia’s banking sector and are you prepared for full EU oversight of the banking sector?

Our banking sector is in very good shape and is well integrated into the European banking system – the euro comprised 60% of total bank balance sheet assets at end-2012, while the share of total loan portfolios was 80%, so the changeover to the euro is a logical step and has few implications for the banking sector. What is more, most of the banks in Latvia also operate in Estonia, so they have recent experience of making the changeover to the single currency. And, of course, eurozone membership will for the first time give our banks access to ECB liquidity support instruments in times of trouble.

We are in favour of very pragmatic solutions with regard to eurozone support mechanisms and banking union – we understand how important these instruments are for stability and we are ready to participate in them. Our banks are very well capitalized and we have learned from our previous mistakes.

How will Latvia manage macro-prudential regulation as part of the euro?

According to the EC proposal, the responsibility for macro-prudential provision should be shared between the ECB and the national macro-prudential institution. We are working with the central bank and the Financial and Capital Market Commission to design a suitable institutional framework for Latvia, and for this again we are able to draw on our recent experience of external guidance while we were within the international loan programme.

What tools can be used to control inflation in Latvia if it is growing faster than the euro average?

To some extent we expect inflation in Latvia to be slightly above the eurozone average, as income convergence takes place along with price convergence. If high inflation is a by-product of higher productivity growth then it is a natural phenomenon and shouldn’t be overly compressed. However, if high inflation is a result of domestic demand growth outstripping domestic supply then a more restrictive fiscal policy should be the first line of defence against those inflationary pressures.

We passed the fiscal discipline law in January – that requires us to balance the budget within three years – that should ensure that politicians will not in future be able to increase inflationary pressures by stimulating demand. We have also introduced key reforms around real estate taxation and capital gains tax, as well as tightening bank regulation and imposing stricter requirements on mortgage lending. In an emergency, we have scope to tighten lending requirements and fiscal policy still further.

Are you concerned that the euro could become a soft currency geared towards southern Europe, resulting in costs for better managed economies such as Latvia?

Again, I say no. In our view, the ECB has a clear mandate for price stability that should ensure the euro remains a strong currency, and the common currency of a group of countries that are capable of managing their economies and finances. As a member of the eurozone, we would certainly vote to keep monetary policy on the path the ECB is following.

If southern European labour markets become more competitive, how will Latvia and other Eastern European countries with large intra-EU export sectors compete? What will prevent a deflationary race to the bottom?

As our experience shows, even with a pegged currency, some downward wage adjustment is possible, and the recovery of competitiveness also entails productivity gains. Increases in productivity will facilitate wage and price growth in Latvia without endangering our competitive position against other eurozone countries. Better functioning labour markets in southern Europe would boost overall EU economic growth but we know from our recent experience that we have the tools and flexibility to boost our own competitiveness if necessary.

What is your response to critics who say that efforts to ensure compliance with the Maastricht criteria have exacerbated inequalities in Latvian society?

Such criticism is due to either a misunderstanding or an intentional misrepresentation based on the false conceptions that increasing deficit spending or devaluating the currency in Latvia during the financial crisis would have resulted in more growth, more jobs, less emigration, etcetera. Latvia was the fastest-growing economy in the EU last year and I am quite confident that it will post strong growth this year as well. Our exports are also among the strongest in the EU and, more importantly, are out-pacing those of our European peers that did devalue their currencies.

Talking a long-term view, internal devaluation is the best and most direct response to problems in any country’s business model, public administration and society. It deals with the roots of those problems and it can be painful, but it shows results, whereas simply devaluing the currency makes it possible to avoid essential economic reforms. In addition, we had to take a responsible attitude towards our Baltic neighbours, who would have suffered if we had opted for a currency devaluation.

Emigration figures are also often cited by critics of Latvia’s strategy, but it should be noted that emigration from Poland is at the same as from Latvia and still increasing, despite the fact that Poland avoided a recession in 2009. The fact is that as long as the wage differential between CEE countries and other EU members is so large, emigration will remain high, and that’s something that will take years to reverse.

Would the government’s approach to managing Latvia’s recovery have been different without the requirement to meet the Maastricht criteria?

No. Latvia would have needed to meet the Maastricht criteria with or without the target of euro adoption because that fiscal discipline is what restored investor confidence. Small countries can’t afford to ignore the markets and the fact that we’ve achieved strong growth, low inflation, declining interest rates and low public debt in line with our promises has sent the strongest possible signal to investors about Latvia’s commitment to fiscal discipline and stability.

How would the crisis have affected Latvia and its banking sector if the country had already been part of the euro?

We would have been in a very different situation, and this is something we are very anxious to communicate to the public. As a eurozone member, we would definitely have seen a less severe contraction of the economy, lower unemployment, lower emigration and more financial sector stability. Eurozone membership would have provided vital liquidity shock absorption to the Latvian banking sector via access to the ECB’s support instruments, which could in turn have avoided the need to bail out the largest domestically owned bank. And we would also have been able to avoid the need for the international loan assistance programme. Unfortunately, high inflation meant that we were not able to join the eurozone before the crisis, although we met the other criteria for entry.

Is there anything else you would add on the subject of the broader eurozone and Latvia’s progress towards adoption?

Above all, I would stress that although the economic situation in the eurozone and the broader EU is still challenging, I am convinced that the worst is behind us. Last year was very difficult for everyone and the troubles in the wider region made it very difficult for us to talk or even think about the potential for Latvia to adopt the euro in 2014 as planned.

However, in the end we saw the ECB and other European institutions, as well as member states, take the necessary steps to resolve the situation and that enabled us to press ahead with our plans for eurozone membership. We have learned from our mistakes and we hope that other countries will also be able to learn from them, and that we can communicate how we were able to stabilize our economy and how we managed our social dialogue.

As a very pro-European country, we look forward to being fully integrated into the eurozone and being able to work together with other members to help strengthen the currency area, because we are concerned that Europe is losing its competitiveness. There is a lot of work still to be done in relation to fiscal discipline and labour market reforms, and that will require more flexible thinking and more responsibility on the part of policymakers. The original rules devised for the eurozone were admirable but unfortunately they were ignored for many years by many member states, and we are seeing the results of that.

As a country, we are ahead of the cycle and growing strongly, but it’s very important that the rest of Europe is also moving in the right direction. That is happening but those decisions came very late and we have lost a lot of time in Europe, so it’s crucial that markets and society demand ongoing reforms and improvements.

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