Baltic martyrs for the euro

The Baltic states, despite facing double-digit falls in GDP this year, are striving to limit their budget deficits with a view to adopting the euro as soon as possible. Rather than pursuing devaluation and counter-cyclical fiscal policies, they are cutting wages to restore competitiveness and hoping that the euro will repair investor confidence. None of them, however, looks likely to meet the conventional benchmarks for euro-zone entry soon. As a result, unilateral euro-adoption or devaluation are strong possibilities.

Estonia raised the standard rate of value-added tax (VAT) from 18% to 20% on July 1st as part of an ongoing effort to keep the budget deficit within 3% of GDP this year, so that the country can be positively assessed against the Maastricht criteria in early-to-mid 2010 and join the euro zone at the start of 2011. Latvia, despite suffering the deepest recession of any EU state, has a finance minister who insists that the budget deficit will be brought down to 3% of GDP in 2010—from a level that is likely to be close to 10% of GDP this year—in order to bring his country into the euro zone in 2012. Lithuania has not yet formally adopted a target, but 2013 has often been talked about. There too, the finance ministry is seeking to keep a lid on the budget deficit, even at a time when the domestic economy needs all the help it can get in terms of state spending and low taxes, to keep the country within sight of the Maastricht criteria of exchange-rate stability, price stability, low public debt and budget deficits, and long-term interest rates in line with those of European economic and monetary union (EMU) members.

Zealous converts

The Baltic states are recent converts to the benefits of rapid euro adoption; ironically, this has happened at a time when the EU-wide downturn has made it more difficult for candidates to meet the terms for entry into EMU. Until the crisis accelerated in late 2008, the governments of Estonia, Latvia and Lithuania had a fairly relaxed attitude to the timing of their entry into the euro zone.

The onset of economic crisis has led to a dramatic change of heart. Now two macroeconomic challenges stand out for the Baltic states. First, there has been a sharp fall in capital inflows, reflecting extreme wariness on the part of foreign investors. This creates doubt over the states' ability to meet their external financing requirements, even though current-account deficits have fallen sharply. Second, there is a need to raise competitiveness. On some measures this was an issue before the downturn, albeit one covered by the emerging-market boom. Now that many of the Balts' competitors have seen their currencies weaken against the euro, at a time when the kroon, lat and litas have held their pegs, it is pressing.

Devaluation to a sustainable level would arguably solve both problems, yet it has been ruled out. Partly this is a consequence of years of the euro-pegs. Widespread faith in them encouraged borrowers to take out loans in euro. As a result, devaluation would bankrupt many enterprises and households.

Instead, governments in Latvia and the other states have pursued a course of internal devaluation, cutting wages and waste in order to regain lost competitiveness. To soothe investor worries, meanwhile, the Estonian and Latvian governments are moving as quickly as possible towards the euro. They see early entry into the euro zone as the only credible means of dispelling the current concerns about possible devaluation. On this view, accession to EMU at the current exchange rate will remove a damaging source of uncertainty, so encouraging renewed flows of foreign direct investment (FDI) and financial investment, and bring forward economic recovery.

Pain aplenty

The downside of this course is now apparent. Real GDP in all three countries is falling very rapidly—in the first quarter of 2009 all three suffered double-digit year-on-year declines—and unemployment is rising quickly. Domestic demand is falling even more quickly than GDP, causing receipts from indirect taxes such as VAT to fall. This tends to stretch budget deficits, but the disciplines of EMU entry demand that budgetary shortfalls should not exceed 3% of GDP. Estonia, which aims to be assessed next year on the basis of its 2009 performance, has already engaged in two rounds of spending cuts in order to keep the budget deficit in check. In the first quarter of the year, however, the deficit was at 80% of the maximum level permitted by the Maastricht fiscal criterion. More cuts will certainly be needed, but this will be very difficult for the minority administration and it will deepen the economy's contraction—which in turn could hurt budget revenue and thus increase the pressure for further spending cuts.

The focus for all three states is rightly on budget deficits, as the Baltic currencies have been in the exchange-rate mechanism (ERM2) for several years, public debt is low and long-term interest rates do not appear problematic. Inflation could be a problem, however. This is the one moving target among the Maastricht criteria. Consumer-price inflation in a candidate country must be no higher than 1.5 percentage points above the three best-performing EU states with regard to inflation. Until now, those states with the lowest inflation rate have been considered the best performers. With deflation in some EU states a strong possibility, this could present serious problems for Lithuania and Latvia. The European Central Bank (ECB) has offered some comfort, by insisting that states experiencing deflation will not be considered for inclusion among the ‘best three'. However, it would be a help to all three Baltic states if the ECB acquiesced to suggestions that states with inflation rates closest to the ECB's medium-term target of 2% should be considered the best performers. Estonia is now experiencing deflation, but Lithuania's inflation rate was 9.3% on the EU measure in May.

Falling short

The odds are against any Baltic state achieving the fiscal criterion by its target date. The Economist Intelligence Unit expects that Estonia will run a deficit of 3.7% of GDP this year; we expect that Latvia's deficit will be 8% this year, 6% in 2010 and 3.8% in 2011; and we do not expect Lithuania's deficit to be lower than 5% of GDP in either 2009 or 2010. The notion that Latvia could shift from a budget deficit likely to be in the high single digits or perhaps even 10% of GDP this year, to one of 3% of GDP in 2010 or even 2011, seems particularly fanciful.

It is possible that the existing EMU membership could choose to cut the Balts some slack. In a situation where Estonian GDP has shrunk by 15%, as it is likely to do this year, to record a budget deficit of less than 4% of GDP is an astonishing achievement. Already the Baltic governments have undertaken austerity measures that could not be seriously contemplated in old Europe. However there are no indications that leniency will be forthcoming. The French representative at the ECB said recently that it was too early for the Baltic states to enter EMU. The euro zone has been strained by the crisis, with yields on member states' bonds having diverged. The prospect of taking on more troubled members is not an appealing one. In the case of the Baltic states, with their deeply distressed banks, EMU members may be wary of permitting entry for fear that they will be expected to contribute to the costs of recapitalisation.

Plans B and C

If Estonia is indeed rebuffed in mid-2010, either because it has failed to meet the budget criterion or the collapse in output raises doubt over its readiness to join at the current exchange rate, there could be serious consequences. Early EMU entry has been the main focus of economic policy in Estonia, so there is a significant danger that households and businesses in Estonia would react to the prospect of a further lengthy delay in accession to the euro zone by trying to convert their domestic currency deposits to euro. If this led to a serious run on the domestic currency, it would lead to either de facto euroisation at the current exchange rate—if Estonia received sufficient external support to finance the replacement of the kroon by the euro; around €3.2bn (US$4.4bn) would be needed to cover all kroon deposits—or a decision to suspend the currency board, leading to a sharp devaluation in the kroon. Given the high level of euro deposits in Estonia (already 30% of the total), the suspension of the currency board would probably lead to the widespread use of the euro as the country's secondary or even main currency.

This would have direct implications for Latvia and Lithuania. In many respects, euroisation is the logical next step from adopting a currency board for countries seeking to join EMU. The national authorities give up exchange-rate flexibility and an independent monetary policy under both systems. As the central bank cannot "print money", in either a currency board arrangement or a euroised economy, the national authorities' ability to stabilise the banking system in a crisis is limited. The main difference between the two systems is that the option of devaluation is easier in a currency board arrangement (devaluing in a euroised economy would require a new national currency to be set up). For states fearful that their existing currency board arrangements could be threatened, euroisation would appear an attractive option.

An alternative course would be to bite the bullet on devaluation. This would put euro-denominated borrowers into huge trouble, but the policy of sharply cutting nominal wages is gradually doing this in any case. If it is continued, it threatens the banks with the same scale of loan losses as in the devaluation scenario—although the losses would emerge more gradually than if the currency were suddenly to be devalued. Perhaps significantly, the head of SEB, one of the Swedish banks with the greatest exposure to the Baltics, publicly acknowledged this equivalence for the first time in May.

Although the Baltic governments are sticking to their programmes of internal devaluation and euro adoption, the public discourse is shifting. The costs of devaluation may not be appreciably higher than the costs of the present course, particularly in a situation where there is no guarantee that the Estonian or Latvian applications to join EMU will be favourably received in 2010-11. Some clearer signals from the ECB and the EMU members, one way or the other, could help the Baltic governments to make a better informed decision about how best to serve the interests of their populations.