From rubles to euro

by Oleg Bozhko

The Baltic states' capital market has been preparing for transition from their previous long-standing currency – rubles – to the incoming euro for already 13 years. On the final stage of transition from one of the world's weakest (in the early 1990s) currencies in the region to one of the most strongest (presently) they may run into some trouble, e.g. the possible growth of inflation after these states' accession to EU.

The Baltic nations keep competing between themselves for the right to join the euro zone first. Estonia intends to do this in 2006, Lithuania in 2007 (after initially planning the move in 2006) and Latvia in January, 2008. 

Only poorest states meet euro zone's requirements

Cartoon: S. Tulenev, Chas

It looks like the EU authorities have begun thinking whether the enlargement process has not picked up too fast a pace, understanding somehow that accession's negative effects of ten new quite poor, although not less ambitious member states could easily outweigh benefits. First clarifications have already been heard that the newcomers do not need to rush into euro zone, i.e. the club of developed Western European nations.

In the meantime the Baltic economies had already complied with the Maastricht criteria set for membership in the euro zone, to say nothing about the EU, thus these states have been sort of running ahead of time. Quite possible that this is an indication of formality of the Maastricht criteria (levels of inflation and national debt, budget deficit and interest on long-term government bonds), since even less developed countries (by GDP per capita) can easily meet these criteria. 

Contrary to national currencies of other new EU candidate states, Baltic currencies have fixed rates pegged either to euro or to SDR, as is the case of Latvia. Latvia, by the way, has also announced its plan to peg lat to euro as of January 1, 2005. But in case of a fixed rate mechanism, it is useless to test national currency against the European Exchange Rate Mechanism (EMR II); it is required that the national currency should fluctuate against euro by no more than 15% over the EMR period.

As the Estonian kroon and the Lithuanian litas are pegged to euro at the level of 15.6 kroons and 3.45 litas respectively, theses rates will remain unchanged in the coming one-two years, or so. Moreover, this exchange rate is guaranteed both by national central banks and the state (in Lithuania there is a special law about national currency stability).

However, both European and Baltic officials put a good face on the matter, preferring not to raise the issue about uselessness of ERM II to economies with fixed rates of national currency (in the next enlargement wave this will include Bulgaria, too). Baltic officials tacitly do not want to irritate officials in Brussels; the latter tacitly consent possibly due to a confidential plan for change of the rules for "too quick" newcomers.

Interesting to note that some economically strong EU candidates with floating, not fixed-rate national currencies (e.g. Poland, Hungary and Czech Republic) have failed so far to meet the Maastricht criteria and the Economic Growth and Stability Pact, the terms of which are binding for the EU member states. Their stumbling blocks here are either high budget deficit – about 5.5% of GDP – or inflation. But these countries do not even count on joining the euro zone earlier than 2009-2010.

Bouncing between current account deficit and inflation

Due to progressive economic growth, the Baltic States have been handling their budget deficits well recently. Thus, in Latvia the budget deficit in 2003 reached 1.88% of GDP, and none of its Baltic neighbors had a deficit even close to the critical, according to the EU rules, 3 percent. Regretfully, this is not the case with the current account deficit which by the Bank of Latvia's estimates reached around 10% of GDP last year (and about 15%, in Estonia).

 Inflation dynamics in Baltic states, 2000-2003

	2000	2001	2002	2003
Latvia	2.6	2.5	1.4	2.9
Lithuania	2.1	1	0	-1.3
Estonia	6.7	5.4	3.1	1.3
Sources: Hansabank Markets, BNS.

 It is interesting that the fall of the US dollar in last two years has been attributed to "huge" current account deficit of the United States which is barely above 5% of GDP, or two or three times lower than in the Baltic states (with the exception of Lithuania). To the Baltic candidate states' advantage, this indicator is not even listed among Maastricht criteria or mentioned in the Growth and Stability Pact.

But the threat of inflation could become real for all candidate countries once they join the EU. Last year Latvia already saw a nearly double growth of inflation (3.9% from January 2003 to January 2004) which is not in line with the Maastricht criteria, being more than 1.5 percentage points above the average inflation level in the EU member states where these figures were at their minimum.  

Let's illustrate the inflation growth model by a two connected vessels without, so far, focusing on separate products' groups, such as excise goods, energy resources, real estate, etc. where price growth is directly related to the EU membership. Imagine markets of individual countries as water reservoirs positioned at different altitudes. The more developed the national market and the stronger the national currency, the higher above the ground stands the vessel.

In the early 1990s when former Soviet republics' markets (vessels, in our example) gained free excess to the Western markets, the prices (water levels in our example) rose steeply. Somehow, in the second half of the 1990s the "water levels" in the Baltic vessels became almost stable as inflow from the West was balanced by the outflow to the CIS' reservoirs (markets).

"Water difference" (or our prices) on the once common ruble market can be explained by the stable Baltic currencies: during the last two years the US dollar rate in Lithuania fell from 4 litas to 2.7 litas and in Estonia from 18 kroons to 12.5 kroons (while in Russia the US dollar was just very slightly down from 30.5 rubles to 28.5 rubles over the same period).

The coming EU enlargement will break this fragile balance, i.e. throughput of the pipe linking Baltic vessels with the Western ones will increase while outflow to vessels in the East will reduce (as the EU requirements concerning trade with CIS countries will take effect).

It will take several years to restore the "water balance". In the meantime the level of prices (water) in the Baltic market (vessel) will rise 2-3 times faster than it is presently. Even the EU saw the inflation wave surge after introduction of euro notes; although euro for business transactions has been in circulation over 3 years.  

So, it looks like the dream of the Baltic States about switching to euro in 2006-2007 will have to wait some 2-3 years more before it can turn into reality. It is quite possible that newcomers will be admitted to the euro zone all at once by the same pattern as in the EU enlargement. And the most impatient newcomers will have to wait for the outsiders to meet the Maastricht criteria which would put off the introduction of euro for the former until some time early in the next decade.