Swedbank Analysis August 1, 2012 Economic Research Department Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: [email protected]www.swedbank.com Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720 Fulfilling the Maastricht criteria – mission possible for Latvia and Lithuania? There are five main criteria for the ECB and the EC to use in judging whether a candidate country is ready to adopt the euro: price stability and interest rates (the moving-target criteria, as their reference values change), government budget deficit and debt, and ex- change rate stability. Compliance with all of them should be done in a sustainable manner. Despite the well-known shortfalls of these criteria, they are unlikely to be changed in the near future. Calculation and interpretation of the moving-target cri- teria have been uncertain and not always done in a symmetric way for all criteria, and, hence, the outcome is difficult to predict. Moreover, the so-called other relevant factors used to supplement the five main cri- teria to evaluate sustainability of the convergence and readiness to join the EMU have not until recently been explicit and the stance of the ECB and the EC has sometimes differed. Both Latvia and Lithuania have good chances of fulfill- ing Maastricht criteria in April 2013 to be able to adopt the euro in 2014. The chances of meeting the criteria are somewhat bigger for Latvia, since it has more room for manoeuvre in terms of the price stability and budget deficit criteria, as well as stronger political re- solve. Whether both countries will fulfil the interest rate criterion remains uncertain, since it depends on which countries are used for the criterion calculation. While Latvia has officially stated euro adoption in 2014 as the national target, the Lithuanian government has yet to decide on it; most likely it will by the end of this year. Even if the criteria are met, there is an opportu- nity for both countries to postpone euro adoption if the euro area does not achieve sufficient progress on ad- dressing its fundamental problems.
Transcript
Swedbank Analysis August 1, 2012
Economic Research Department Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000
Fulfilling the Maastricht criteria –mission possible for Latvia and Lithuania?
There are five main criteria for the ECB and the EC to use in judging whether a candidate country is ready to adopt the euro: price stability and interest rates (the moving-target criteria, as their reference values change), government budget deficit and debt, and ex-change rate stability. Compliance with all of them should be done in a sustainable manner. Despite the well-known shortfalls of these criteria, they are unlikely to be changed in the near future.
Calculation and interpretation of the moving-target cri-teria have been uncertain and not always done in a symmetric way for all criteria, and, hence, the outcome is difficult to predict. Moreover, the so-called other relevant factors used to supplement the five main cri-teria to evaluate sustainability of the convergence and readiness to join the EMU have not until recently been explicit and the stance of the ECB and the EC has sometimes differed.
Both Latvia and Lithuania have good chances of fulfill-ing Maastricht criteria in April 2013 to be able to adopt the euro in 2014. The chances of meeting the criteria are somewhat bigger for Latvia, since it has more room for manoeuvre in terms of the price stability and budget deficit criteria, as well as stronger political re-solve. Whether both countries will fulfil the interest rate criterion remains uncertain, since it depends on which countries are used for the criterion calculation.
While Latvia has officially stated euro adoption in 2014 as the national target, the Lithuanian government has yet to decide on it; most likely it will by the end of this year. Even if the criteria are met, there is an opportu-nity for both countries to postpone euro adoption if the euro area does not achieve sufficient progress on ad-dressing its fundamental problems.
2 Swedbank Analysis • August 1, 2012
Latvia and Lithuania joined the European Union (EU) in May 2004 and are obliged to adopt the euro eventually. The first target was 2007 for Lithuania and 2008 for Latvia, but neither of these was accomplished due to high inflation and overall macroeconomic imbalances. Latvia has stated that 2014 is its official euro introduction target date, and there is a strong political will to fulfil it. Although the Lithuanian government has repeatedly expressed its determination to introduce the euro in 2014, no formal national target has been set yet. Due to the upcoming elections in October 2012, politicians and the government are trying to avoid the un-popular subject of the euro; Lithuania will probably decide whether or not to target euro adoption in 2014 by the end of this year, depending on the chances of meeting the criteria and how the economic and political situa-tion in the euro area evolves. Unsurprisingly, though, 2012 convergence reports showed that neither of the two countries had fulfilled all the nec-essary criteria by March 2012 due to high budget deficits and inflation rates.
There have been vast discussions on whether Maastricht criteria are sensible, whether they measure the right things, etc. The treatmentamong the different criteria has not always been symmetric and their in-terpretation varied over time. Still, the criteria are unlikely to be changed any time soon; thus, neither Latvia nor Lithuania should expect more fa-vourable terms than the existing criteria. Taking into account that some of the criteria are moving targets, it is still uncertain what benchmarks a country will need to hit early next year to be able to adopt the euro. In this analysis, we try to assess what the benchmarks could look like in 2013 and whether Latvia and Lithuania will be able to fulfil them.
1. What are the criteria for euro adoption?
According to Article 140(1) of the Treaty on the Functioning of the Euro-pean Union (hereinafter, the Treaty), at least once every two years, or at the request of a member state with a derogation, the European Commis-sion (EC) and the European Central Bank (ECB) assess the progress made by the euro area candidate countries in fulfilling their obligations to enter the Economic and Monetary Union (EMU). The ECB and the EC then publish their conclusions in respective convergence reports.
The process is further organised as follows: On the basis of its assessment, the EC submits a proposal to the European Council which, having consulted with the European Par-liament, and after discussion in the Council, a meeting among the heads of state or government decides whether the country fulfils the necessary conditions and may adopt the euro. If the decision is favourable, the Council, based on a Commission proposal, having consulted the ECB, adopts the conversion rate at which the na-tional currency will be replaced by the euro, which thereby be-comes irrevocably fixed.1
According to the Treaty, besides the necessary legal compatibility (e.g., law concerning independence of the national central bank, prohibition of monetary financing, etc.), there are five main criteria for the EU member
1 http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/index_en.htm. Usu-ally the central rate is used as the conversion rate. Historically parity rates were changed only three times (one for Greece and two for Slovakia), but it had always happened before the Council actually adopted the conversion rates for replacement with the euro (i.e., that were not decisions by the Council).
Five main criteria need to be met for adopting the euro
Swedbank Analysis • August 1, 2012 3
state to be able to enter the EMU (the Maastricht criteria, also known as the convergence criteria). They are presented in the table below.
The main five Maastricht (convergence) criteria
What is measured? By what? Convergence criterion
Price stability Harmonised consumer price index (HICP) 12-month average annual inflation
No higher than average value of the three best-performing EU member states +1.5 percentage points
(note: correction for outliers is pos-sible)
Durability of conver-gence achieved by the member state
Average nominal long-term interest rates for government bonds or comparable securities over the latest 12-month period for which HICP data are available
No higher than the average value of the three best-performing EU member states in terms of price stability +2 percentage points
(note: correction for outliers is pos-sible)
Sound publicfinances
Government deficit as % of GDP (ESA meth-odology, i.e., on accrual basis)
Deficit of no more than 3%, unless either (i) the ratio has declined substantially and continuously and reached a level that comes close to the reference value, or (ii) theexcess is only exceptional and temporary and the ratio remains close to the reference value
Sustainable public finances
Government debt as % of GDP
Debt of no more than 60%, unless the ratio is diminishing and ap-proaching the reference value at a satisfactory pace
Exchange rate stability
Fluctuation within a band of +/- 15% around the central rate, i.e., vis-à-vis the euro peg
Two years of participation in ex-change rate mechanism of the ERM II with no serious problems
Source: http://www.ecb.int/ecb/orga/escb/html/convergence-criteria.en.html, for more details see also ECB (2012)
Compliance with the above five criteria is evaluated against their sustain-ability, i.e., they cannot be met by accident or by one-off measures. Note that there is no clear-cut definition of what is meant by “sustainability,” though. Convergence reports evaluating progress of the member states in fulfilling their obligations regarding the achievement of EMU are written independently by the EC and the ECB, and their views on the interpreta-tion of sustainability may differ.
According to Article 140 of the Treaty, when evaluating EU countries’ economic integration and convergence “other relevant factors” (see ECB, 2012) are also examined – integration of markets, the situation and developments of the balance of payments on the current account, unit labour costs, and other price indices. However, until recently there have not been particular benchmarks, and therefore the assessment of these “other relevant factors” by the ECB and the EC has been rather vague and varied.2
2 Undoubtedly both institutions have a vast amount of in-house research on these issues, but it has not been explicit in convergence reports.
Interpretation of sustainability is not clear-cut
“Other relevant factors” are also considered in evaluating candidate countries
4 Swedbank Analysis • August 1, 2012
As of December 13, 2011, detailed rules for multilateral surveillance came into force “to ensure closer coordination of economic policies and sustained convergence of the economic performances of the Member States”3 under the so-called Six Pack. The surveillance framework in-cludes an alert mechanism for early detection of macroeconomic imbal-ances (both external and internal) in all EU member states and is called the macroeconomic imbalance procedure (MIP). The detailed design and economic rationale of the scoreboard for the surveillance of macroeco-nomic imbalances can be found in EC (2012b).
The scoreboard includes numerical indicative thresholds, which are re-ported in the table below. If a country surpasses these thresholds, it is subject to an in-depth review by the EC, the outcome of which may in-clude recommendations of preventive measures or corrective measures (in most serious cases, an extensive imbalance procedure can be initi-ated under the surveillance of the EC). Note that assessment of imbal-ances does not derive from mechanical application of the scoreboard indicators; additional information and country-specific circumstances are also taken into account.
Surpassing of the thresholds by a member state is not a reason per se to reject membership to the EMU, since an evaluation of convergence is not the aim of the MIP; however, 2012 convergence reports include a discus-sion on results from the alert mechanism report (EC, 2012a). ECB (2012, p.19) also mentions that “EU member states with a derogation that are subject to an extensive imbalance procedure can hardly be considered as having achieved a high degree of sustainable convergence.” Thus the MIP framework supplements discussion and evaluation of whether con-vergence is sustainable for prospective euro area members, although appraisal of the scoreboard results is still ambiguous for the purposes of convergence reports.
Scoreboard for surveillance of macroeconomic imbalancesIndicator Threshold1
Current account balance, % of GDP (3-year average) -4.0/+6.0%
Net international investment position, % of GDP -35%
Real effective exchange rate, HICP deflated (3-year percent-age change relative to 35 trading partners)
A new surveillance framework for macro imbalances was introduced in December 2011
The surveillance scoreboard includes specific numerical thresholds
MIP framework supplements discussion on “other relevant factors” of sustainable convergence
Swedbank Analysis • August 1, 2012 5
2. Shortfalls of the existing convergence criteria
There has been much criticism regarding what Maastricht criteria meas-ure, and, more important, what they do not measure (e.g., Buiter, 2004 and Šikulova, 2007). Furthermore, many EMU countries themselves do not comply with these criteria. For instance, in March 2012 only eight countries out of seventeen fulfilled the price stability criterion; the budget criterion for 2011 was met by only six euro area countries. Even before the crisis, in March 2007, four of the current euro members did not com-ply with the price stability and deficit criteria (the latter for 2006). How-ever, it is also clear that changing the criteria is extremely difficult and, even if politically agreed upon, might take years to be actually imple-mented.
It can be seen that, although the criteria are called convergence criteria,all of the variables included in the five main numerical criteria are nomi-nal. Until recently, real convergence (e.g., GDP and productivity growth and their levels, and labour market indicators) formally has not been measured at all, although discussed in the “other relevant factors” sec-tion. Although the MIP framework now includes thresholds of, e.g., the unemployment rate and unit labour costs, these are not considered as strict criteria to be met.
Price stability is probably the most widely discussed criterion. Undoubt-edly, price stability is vital for a country entering the EMU – under a fixed exchange rate regime, inflation that is substantially higher than that of the trade partners is likely to undermine external competitiveness. However, the existing five numerical Maastricht criteria might indirectly imply putting the brakes on economic growth (e.g., to achieve lower inflation rates) to gain access to the EMU. For instance, if a country experiences rapid pro-ductivity growth and, thus, convergence with more advanced EMU economies, it may also experience more rapid inflation without losing competitiveness or endangering sustainability.
One of the illustrations is the Balassa-Samuelson (BS) effect. This is the mechanism of the catching-up process, when faster productivity growth in tradable sectors than in nontradable ones causes quicker wage in-creases, which are later transmitted through competition for labour into the nontradable sectors and cause higher overall inflation in the catching-up countries. The BS effect in Central and Eastern Europe has been widely analysed. Although many studies find empirical support for this hypothesis, e.g., Lojschová (2003), Coudert (2004), and Mihaljek and Klau (2009), the overall evidence is rather controversial both as to the existence of the effect and its possible size due to data reliability ques-tions (e.g., the empirical split between tradable and nontradable sectors).Still, it has been often argued that the BS effect should be taken into con-sideration when evaluating compatibility with the Maastricht criteria; see, e.g., De Grauwe and Schnabl (2004) and EEAG (2007).
There are yet other processes that can lead to higher inflation without endangering competitiveness. For instance, as producers in a catching-up country penetrate foreign markets, where prices are higher, they raise prices of their output also in local markets (given their constrained capac-ity). However, if access to foreign markets at the same time improves the quality of production, competitiveness is likely not to suffer.
There is thus nothing wrong in price convergence per se if prices and wages do not increase faster than productivity and do not undermine competitiveness and sustainability. However, this is not taken into ac-
Many EMU countries themselves do not meet Maastricht criteria
Real convergence measures are not included in the five main criteria
As an economy catches up, its productivity and, price levels rise…
…which might well be sustainable and not en-danger competitiveness
6 Swedbank Analysis • August 1, 2012
count by the existing five main criteria. In addition, price convergence is a long term process – e.g., for a country with a price level at half of the EU average, it will take years and even decades to converge to the average. It should be considered that maintaining a balance between productivity and price convergence may be a very hard task for such a long time pe-riod.
Under the current framework of evaluating the convergence of candidate countries the interpretation of whether price and productivity develop-ments are sustainable is uncertain, may vary from report to report, and has been arbitrary at times. For instance, in its 2010 convergence report, when evaluating Estonia’s readiness to adopt the euro, the ECB was much more sceptical about inflation developments than the EC, pointing specifically to the catching-up potential as the main factor that could push inflation up in the medium term (thus implying that the fulfilment of the price stability criterion was not sustainable).
Another issue that affects whether a country meets the price stability cri-terion is that less advanced economies are often more energy intensive (less energy efficient) and thus more exposed to volatility in global oil prices. The same applies to global food commodity prices, since inhabi-tants in catching-up countries spend more on food than those in ad-vanced countries. As a result, the harmonised index of consumer prices (HICP) can grow more rapidly when global commodity prices go up –something that a country in the short run can do almost nothing about. Thus, core inflation (i.e., HICP excluding unprocessed food and energy) is perhaps a more appropriate indicator to use for the criterion calcula-tion. At least, it should be considered when evaluating the sustainability of the price stability criterion’s fulfilment.
To sum up, there are several possible ways to improve the existing crite-ria. First, analysing real convergence more explicitly and including it in a better way into main criteria, for instance, taking into account the BS ef-fect and productivity convergence. Another option is to use core instead of headline inflation for comparison. One more way to lessen the effect of short-term events may be to formally evaluate price developments for a longer period of time (say, three or five years instead of the current two4).Another debatable question is whether to use EMU or all EU countries for evaluating convergence of candidate countries – since there are large trade flows not only inside the EMU, but also within the EU, e.g., price and currency developments in other EU countries certainly influence the competitiveness of prospective euro area members, but is it fair to com-pare prospective euro area members to countries with flexible exchange rates. Overall, there is room for more explicit and reasonable way to comparing candidate countries with other EMU (or EU) members and more symmetric approach across the criteria, see next sections for more details.
3. Interpretation of the moving-target criteria The treatment of the inflation and long-term interest rate criteria by the ECB and the EC has differed over time and has not always been sym-metric across these criteria. These criteria are moving targets, and their calculation and interpretation (i.e., economic judgement) remain quite uncertain. This has been pinpointed by many researchers, e.g., see Buiter and Sibert (2006) and Schadler at al (2005).
First, there is no clear definition of an outlier, and while sustainability is-sues are evaluated for a candidate country, they are not looked at so 4 Since the existing criterion includes 12-month average annual inflation, it in fact takes into consideration price changes over the last 24 months.
Core inflation might be a better indicator to judge price stability
Uncertain treatment of outliers
Evaluation of price stability might be done for a longer period of time
Swedbank Analysis • August 1, 2012 7
closely for possible reference countries. That is, a very low inflation in chosen “best-performing” countries might actually be due to temporary factors. For instance, in the 2004 convergence report, Lithuania was con-sidered to be an outlier because it experienced deflation due to country-specific circumstances (-0.2%). At the same time, a very low inflation rate in Finland (0.4%) was considered “normal,” while the average of the euro area at that time was 2.1%.
In 2010, due to the global economic and financial crisis, deflation was considered to be something “normal” (the three best performers chosen showed an average of -0.5%). At the time, Ireland was excluded from the calculation and treated as an outlier because there was a substantial dif-ference between its deflation rate (-2.3%) and that of the euro area aver-age (0.3%) and other EU countries.
However, until now, nowhere has it been written what the margin is, ex-ceeding which a country is considered to be an outlier. Note that, with respect to the price stability criterion, if an outlier is indeed recognised, the next three countries with the lowest inflation are taken (this was the case both in 2004 and 2010, when outliers were recognised).
Furthermore, the moving-target criteria depend on developments not only in the euro area (which potential candidates are supposed to join), but also in other EU countries – for calculating criteria, “best-performing” EU members are considered. The more countries join the EU, the larger is the chance of getting an “odd one” (which will not necessarily be treated as an outlier). Moreover, this implies that a candidate country may be evaluated against itself. In 2010, this was actually the case for Estonia.
Second, the treatment of outliers may be asymmetric across different criteria. For instance, regarding the interest rate criterion, the first time an outlier was recognized was this year, when Ireland was excluded from the calculation because it was (and still is) in the bailout programme and had a very limited access to borrowing in international financial markets. One could assume that the same treatment will be applied again, going forward. However, Ireland was not excluded when calculating price stabil-ity criteria. It did not have the lowest inflation, but one could argue that being in the bailout programme implies country-specific circumstances (like austerity measures, undermined economic growth, and, thus, defla-tionary pressures). Thus, the asymmetric treatment of outliers across dif-ferent criteria adds to the uncertainty of meeting the criteria.
Note that, contrary to the price stability criterion, an outlier is excluded from the interest rate criterion calculation without picking up the next per-former in the row (this was the case in 2012 and also in 2010, when Es-tonia was excluded from the calculation of the interest rate criterion due to lack of an appropriate benchmark). Thus, theoretically it is possible that all three “best performers” in terms of inflation are under bailout pro-grammes and there is none to compare interest rates with. It is not com-pletely impossible, since the number of countries that ask for financial aid is increasing.
It is thus not clear how Greece, Portugal, and Ireland (those currently un-der bailout programmes) will be treated next year, and even less clear how Spain and Cyprus (countries that have asked for financial aid, but so far are not under formal bailout programmes; Spain still can borrow in international financial markets) will be treated. If these countries experi-ence very low inflation rates due to suppressed domestic demand under
Comparison against EU, not euro area, members
Asymmetric treatment across different criteria
Uncertain treatment of countries under bailout programmes
8 Swedbank Analysis • August 1, 2012
austerity, will they still be included in the calculation of the price stability criterion?
Uncertain treatment of outliers, especially under the current unprece-dented bailout programmes and conditions, creates room for the EC and the ECB to manoeuvre and there is a risk that the economic judgement may be politicised. There is a possibility that the euro area will not be will-ing to accept new members due to its current problems. In such a case, the asymmetry characterizing the way the criteria are interpreted may be used by policy makers in the euro area and make decision-making proc-ess less transparent.
4. What could the benchmarks look like in March 2013?Euro adoption in 2014 is currently the official national target in Latvia.5 In Lithuania, it is not so far the target – the decision on this is likely to be made after the parliamentary elections in October 2012. The applicationsof Latvia and Lithuania (if the latter indeed chooses to go for the euro in 2014) to be evaluated under the convergence report are expected to be submitted in April 2013, i.e., when the government budget data for 2012 according to ESA methodology are published. Therefore, the moving tar-gets – inflation and long-term interest rate criteria – will be evaluated based on data published in April 2013, i.e., data for March.
It is hard to say what the moving-target criteria will look like at that time, though. First, there is high political and economic uncertainty in the euro area and, thus, elevated interest rate volatility. Amongst the still unan-swered questions are the following: will the financial aid to Spain be con-sidered as a bailout package, will Greece exit the euro area (under cur-rent legislation, it would then need to leave the EU as well), etc. Second, as already outlined in the previous section, there is uncertainty about the way to calculate the criteria.
According to the spring EC forecast (see European Commission, 2012d), the countries with the lowest 12-month average HICP inflation in the first quarter of 2013 are forecast to be Greece (-1.4%), Sweden (1.3%), Ire-land (1.7%), Spain (1.7%), and France (1.9%). The differences between the indicators in the latter three countries are very small. Note that there are great risks to this forecast (e.g., deeper recession in the euro area, commodity prices etc.), and the reference countries might well be differ-ent. For instance, if Spain raises its value-added tax (VAT) base rate from 18% to 21% as of September 1 (as is planned) to reduce the budget deficit, then its 12-month inflation is likely to be somewhat higher in March 2013 than the EC forecast suggests.
Most likely, Greece, if it stays within the euro area and the EU, will be considered to be an outlier in price stability terms due to forecast defla-tion (and it should be, as it is not in a “normal state of play”). If Sweden, together with Ireland and Spain (or France), is considered for the price stability comparison, the criterion might be about 3% (see the next sec-tion for more details). But other countries may well be amongst the best performers. For instance, if the latest HICP developments are consid-ered, Bulgaria may be amongst countries with the lowest inflation in March 2013 – in the first five months of 2012, its average annual HICP growth was 1.9%.
High political and economic uncertainty in the euro area
Price stability criterion might be at about 3%
Swedbank Analysis • August 1, 2012 9
HICP annual inflation, %
-5
-2.5
0
2.5
5
7.5
2010 2011 2012 2013
IE GR ES SI
SE LV LT FR
Source: Eurostat, quarterly Swedbank forecasts for LV and LT, EC forecasts for other countries
3Q 4Q 1Q
There is even more ambiguity with respect to interest rates. There are no forecasts available, and the current high political and economic uncer-tainty in the euro area (resulting in high interest rate volatility) does not allow sensible predictions to be made. Judging from the 2012 conver-gence, Ireland could be excluded from the calculation of the interest rate criterion (because it is under the bailout programme)6. If financial aid to the Spanish banking sector is not considered as a bailout package and this country is still able to borrow in financial markets, it is likely to be in-cluded in the interest rate criterion. However, if it is excluded from the markets, then Sweden might be the only country used for interest ratescomparison (with the possible inclusion of France, if it has lower inflation than Spain); this would make the criterion extremely challenging to fulfil. Sweden is one of the strongest EU economies; it is perceived as one of the few “safe havens” and enjoys very low bond yields. Moreover, it is paradoxical and ironic to compare EMU candidate countries with Swe-den, since it is not even in the euro area and has a floating exchange rate.
Long-term government interest rates (EUR), %
0
3
6
9
12
15
2006 2007 2008 2009 2010 2011 2012
ES SI SE
LV LT FR
Source: Eurostat
6 Ireland has already successfully issued 3-year government bonds in February (EUR 3.6 billion) and 5-year government bonds in July 2012 (EUR 3.9 billion).
Great uncertainty regarding interest rate criterion
10 Swedbank Analysis • August 1, 2012
5. Prospects for Latvia and Lithuania
Will Latvia and Lithuania be able to comply with the Maastricht criteria in 2013? The most difficult part of answering this question seems to be foreseeing what the moving-target criteria will look like.
In the table below, we provide a summary of possible values of the price stability criterion for March 2013, depending on which countries are in-cluded, the long-term interest rates as of June 2012, and forecasts for public finances situation in 2012.
Compliance with the criteria: outlook for March 2013 (except for interest rates)
CriterionReference value (countries included) Latvia Lithuania
HICP infla-tion1
3% (IE, SP, SE)3.1% (FR, SP, SE or FR, IE, SE)2% (IE, SE, GR)2% (SP, SE, GR)
2 years, fluctuation band of +/- 15% around the central rate
Since 2005, fluctuation band of +/- 1% around the central rate
Since 2004, cur-rency board –
hard peg without foreign exchange
fluctuations1 The criterion calculated by Swedbank based on the EC forecast for 12-month average an-
nual HICP inflation in 1Q 2013, depending on which countries are considered to be outliers.2 Swedbank forecast (April 2012).3 12-month average. No forecast available.
5.1 Price stability
Latvia: The 12-month average HICP annual inflation rate is expected to be about 2.6% (Swedbank's April 2012 forecast) in March 2013. The EC spring forecast is 2.4%. A pickup in oil prices in the beginning of 2012has also been reflected in higher administratively regulated prices, namely, gas and heating tariffs as of July (adding about 0.2 percentage point to the annual inflation). However, since these tariffs are linked to the nine-month-average heavy oil price, the rise in regulated prices is smaller than the global oil price hike. Moreover, oil prices have retreated from their highs and are not expected to exert upward pressures on consumer prices in the second half of the year. Food price inflation has decelerated substantially in line with global trends, although possible bad harvests this year (e.g., drought in the US) may again push food prices up. Still, domestic demand pressures are muted – core inflation (excluding energy and unprocessed food) remains below 2%, which is lower than the head-line inflation rate.
Swedbank Analysis • August 1, 2012 11
Owing to the improved budget situation, previous tax hikes are being re-versed. There was a base VAT rate cut from 22% to 21% on July 1, 2012 (which has not yet been considered in our forecast). This tax cut is likely to reduce consumer price inflation even more, although the overall effect on prices is expected to be rather muted. As of January 1, the personal income tax will also be lowered by 1 percentage point to improve labour competitiveness, but no significant effect on prices is expected because of this.
Lithuania: We forecast average annual HICP to be around 2.8% at the end of this year, and to decline further to 2.6% by March 2013. The EC spring forecast is 3.1%, but this outcome seems increasingly unlikely, considering the price trends during the first half of this year and recent developments in global commodities markets. The main drivers of infla-tion in Lithuania are the same as in Latvia – developments in global goods and commodities markets. Domestic factors will remain muted –high unemployment will keep employee negotiation power low, and pro-ductivity growth will be in line with wage growth this year and the next.
The government has decided to increase the minimum monthly wage by LTL 50, or 6.25%, starting on August 1; this is below the hike of LTL 100 (or 12.5%) that we considered in our April forecast. Most important the monopoly Lithuanian Gas decided (and the regulator agreed) to increase gas prices for households by about 22% as of July 1. This was due to higher oil prices (the import price of gas is directly indexed to the price of oil); however, this increase now seems to be excessive, considering the steep decline of oil prices during the past few months. Our estimates show that this will add about 0.35 percentage point to annual inflation, but the effect on the March average annual inflation figure will be smaller. The price of heating in some major cities will go up in the second half of 2012, and public transport will become more expensive in Vilnius as ofAugust 15. The biggest impact, however, on inflation will be from devel-opments in commodities markets, which have so far been favourable for Lithuania (except maybe for oil). The already-contracting producer prices indicate a further decline in consumer inflation. Thus, we think our April inflation forecast is accurate and average annual HICP will trend towards 2.6%. But, as in Latvia, due to global trends there is a risk of higher food price inflation in the second half of the year.
If the price stability criterion is calculated using Ireland, Spain, France, and Sweden (any three of them) based on the EC forecast, neither Latvia nor Lithuania should experience problems in fulfilling it. It seems that 12-month average inflation in both countries will fall under 3%. The interpre-tation of sustainability may vary, though. Wage growth is still in line with productivity gains; unit labour costs have risen only marginally. In the medium term, however, risks for labour market pressures could cause more rapid inflation. Realising the catching-up potential might also sup-port price growth in the longer term, but this should not be a problem if price convergence is going hand in hand with productivity convergence (see Section 1 for more details). It is highly uncertain how these issues will be treated by the EC and the ECB – ultimately, the risk of making a more political than economic judgement will increase.
All in all, due to smaller increases in regulated prices, it seems that Latvia will be slightly better positioned if external or domestic factors push the price stability criterion lower than currently forecast by the EC.
Latvia and Lithuania are likely to fulfil the price stability criterion
12 Swedbank Analysis • August 1, 2012
5.2 Interest rates
Latvia: In June 2012, the long-term interest rate for Latvian government debt7 was 5.1%, down from 5.9% a year ago. A similar tendency is ob-served for shorter-term bonds’ interest rates – e.g., two- year bond yields are already below 2%. As economic growth continues and the budget deficit diminishes, interest rates are expected to continue retreating as well. We forecast the government budget deficit to decline from 2.2% this year to 1% the next. Public debt levels continue to be low and retreating (see below).
Lithuania: In June 2012, the long-term interest rate for Lithuanian gov-ernment debt was 5%, marginally lower than a year ago. Continued eco-nomic growth and the decline of the budget deficit will probably push the yield downwards – a clear trend can already be seen in shorter-term bonds yields, some of which are already below the pre-crisis level. Cur-rently, there might be some risk premium related to the uncertainty con-nected with the election outcome and the new government’s determina-tion to continue fiscal austerity. The risk premium should decline once the government confirms the budget for 2013. We forecast that the budget deficit will fall to 2% of GDP next year and to 1% of GDP in 2014.
Despite continuous improvement, it is still uncertain whether Latvia and Lithuania will be able to fulfil the interest rate criterion in April 2013. If Spain and France, together with Sweden, are considered in the calcula-tion of the criterion, Latvia and Lithuania are likely to fulfil it. However, fulfilling the criterion would become an almost impossible task if only Sweden is considered (and very challenging even if Sweden and France together are taken), since Sweden’s interest rates are likely to remain substantially below Latvia’s and that of the euro area. For instance, if the criterion were calculated in June 2012, neither Latvia, nor Lithuania would fulfil it (since Ireland and Greece would be excluded from calculation, and only Sweden considered).
5.3 Government deficit
Latvia: The EC forecasts a 2.1% government budget deficit for 2012. The Swedbank forecast stands at 2.2%, owing to increased government spending pressures (including wage increases in the public sector) due to better-than-expected economic growth in the beginning of the year. Cur-rently, it looks like the deficit is likely to be even lower than that. Tax revenues exceeded the plan by 9% in the first half of 2012 (up by nearly 15% from a year ago). In July, the government conceptually approved an additional LVL 70 million to be spent, which is a bit less than a half of what the ministries have requested. A supplementary budget is planned to be submitted to the parliament by the end of August. The government continues to be highly committed to keeping spending under control (it is not raising the budget deficit for this year), and, under the base scenario, Latvia should not experience any problems in fulfilling this criterion.
Lithuania: We forecast the general government budget deficit to decline to 3.0% of GDP this year and be exactly at the margin of this conver-gence criterion. The EC forecasts a slightly worse fiscal position – a defi-cit of 3.2%. However, recent data suggest that the risk of not meeting this criterion is low – national budget revenues during the first half of this year grew by 4.6% over the same period last year and exceeded the plan by
7 Issued by the central government, maturity close to 10 years, fixed coupon. Data from Eurostat (Maastricht criterion bond yields).
High uncertainty regarding the interest rate criterion
Swedbank Analysis • August 1, 2012 13
2.4%. Still, the risk of slower growth and lower budget revenues (due to the euro area woes) during the second half of this year remains. The gov-ernment is still very determined to keep spending under control and to reduce the budget deficit to at least 3.0% of GDP, and President Dalia Grybauskaite stresses the importance of fiscal austerity. The government is not planning any additional austerity measures this year, but, as the budget revenues are ahead of the plan, we do not see the need for such measures and feel that excessive austerity would cause unnecessary downward pressure on the economy.
Overall, Latvia has an ample reserve for fulfilling the budget deficit crite-rion, and Lithuania still has a good chance of meeting it as well. It is im-portant to note that both Latvia and Lithuania have managed to cut their budget deficits drastically – from 9.8% and 9.4% of GDP, respectively, in 2009 to below or close to 3% of GDP this year. The budget deficit con-vergence criterion suggests that it can be sufficient that “the ratio has de-clined substantially and continuously and reached a level that comes close to the reference value.” However, if the target of below 3% is not met straight on, it opens up discussions and possible interpretations on the acceptability of the progress and thus may preclude EMU member-ship.
5.4 Government debt
For Latvia, the EC forecasts a 43.5% government budget debt for 2012; Swedbank's forecast stands at 41.3%. There is a comfortable reserve, and it is clearly no problem for Latvia to fulfil this criterion. For Lithuania,Swedbank forecasts its general government debt to be 40.0% of GDP this year, slightly lower than the EC forecast of 40.4%. In both countries, there is a comfortable reserve and thus no risk of not meeting this crite-rion in 2012.
5.5 Exchange rate
Latvia already fulfils the exchange rate criterion. It has been in Exchange Rate Mechanism (ERM) II since 2005, and the lats is pegged to the euro with +/- 1% fluctuation allowed around the central rate. Lithuania also fulfils the exchange rate criterion. It has been in ERM II since 2004, and the litas is pegged to the euro under the currency board arrangement (no fluctuations). Also, neither Latvia nor Lithuania is expected to experience problems with fulfilling the exchange rate criterion next year. Both coun-tries proved that their currencies are stable and were able to hold the ex-change rate fixed throughout the latest crisis.
5.6 Legal compatibility
There are still a few legal compatibility issues to be solved (e.g., regard-ing the laws about the central bank, etc). Latvia is aware of this and plans to harmonise its legislation accordingly in due time. In Lithuania, there is more uncertainty – the official euro adoption target date has not been set yet, and the Bank of Lithuania seems to be sceptical about both the pros-pects for complying with all the criteria and the need to “rush” into the euro area.
5.7 Sustainable convergence and macroeconomic imbalances
Regarding the scoreboard of macroeconomic imbalances, in 2011 both Latvia and Lithuania did not comply with only 2 indicators out of 10: the net international investment position and the unemployment rate. Na-
Latvia is better prepared to fulfil the budget deficit criterion than Lithuania, but both countries are likely to meet it
Latvia and Lithuania comfortably meet government debt criterion
No problems with exchange rate criterion
Remaining macro imbalances in some areas should not be an obstacle to joining the EMU.
14 Swedbank Analysis • August 1, 2012
tional statistical data suggest that Latvia and Lithuania do not surpass the thresholds of the “n/a” indicators for which data were not included in the convergence report. With deleveraging continuing, the net international investment position will become less negative, while increasing economic activity will reduce unemployment. Nevertheless, Latvia and Lithuania are unlikely to comply with these benchmarks by next year – improvement in both these areas will not be that fast. Provided that progress in the right direction continues and given that the aim of the MIP is not to evaluate readiness to adopt the euro, this situation, however, should not become an obstacle to joining the EMU. Both countries are on the right track, and former imbalances have been by and large been corrected.
Scoreboard for surveillance of macroeconomic imbalances, 2011 (accord-ing to the 2012 convergence report)Indicator Threshold Latvia Lithuania
Current account balance, % of GDP (3 year average) -4.0/+6.0% 3.5% 1.5%
Net international investment posi-tion, % of GDP -35% -72.5% -52.2%
Real effective exchange rate, HICP deflated (3-year percentage change relative to 35 trading partners)
1 Either a range or a suggested lowest (-) /highest (+) acceptable value of the particular
indicator.
Source: ECB (2012)
5. Conclusion
Both Latvia and Lithuania have a good chance of fulfilling the Maastricht criteria in April 2013. However, the probability of adopting the euro in 2014 is somewhat bigger for Latvia, since is has more room for manoeuvre and also stronger political resolve.
For Latvia, the most challenging criterion currently is interest rates, since it involves the largest uncertainty regarding which countries will be used for comparison. Under the muddling-through baseline scenario of the global economy, no problems are expected with other criteria, although the treatment of sustainability issues remains uncertain. For Lithuania, inflation is also a hurdle, especially if global food prices go up in the second half of the year; whereas the budget deficit criterion may be breached if the euro area recession worsens and budget revenues suffer during the second half of this year.
Latvia has a slightly better chance than Lithuania to fulfil the criteria in March 2013
Swedbank Analysis • August 1, 2012 15
Taking into account that the calculation and interpretation of moving-target criteria are uncertain and not always symmetric, unpleasant surprises are still possible. Ambiguous economic judgement thus gives more room for political judgement, as at the end of the day the decision of whether to accept a new member to the EMU is taken by politicians.
If by any chance Latvia and/or Lithuania do not fulfil some of the criteriafor 2014 membership, the countries are likely to pursue the target in the following year. In Lithuania, however, political determination is less certain. As public support for the euro is weak, few politicians want to discuss openly Lithuania’s prospects. Some are openly sceptical of whether Lithuania needs to “rush into the ailing euro area to help Greece.” President Dalia Grybauskaite has recently also adopted a more conservative “wait-and-see” approach. There seem to be a more unanimous agreement to meet Maastricht criteria for the sake of stability, but not necessarily in order to adopt immediately the euro. Thus, there is a probability that Lithuania will not apply formally for euro adoption in 2014 – much of this will depend on election results in October, as well as the euro area’s progress towards a sustainable solution.
Public support for euro adoption is low in both countries, most likely resulting from negative media news about the euro area crisis. The Eurobarometer results for April 2012 show that 46% of respondents are in favour of euro adoption in Latvia (9% very much in favour) and 44% in Lithuania (10% very much in favour).8 However, only 9% of respondents in Latvia and 14% in Lithuania would like to see adoption of the euro as soon as possible.
Nevertheless, in Latvia there is a broad understanding of the benefits of joining the EMU by both the government and businesses. Major industry associations in both countries are in favour of euro adoption by a massive margin. Better communication of the euro advantages to households should be made. Activities in this area are being undertaken – e.g.,Latvian Finance Minister Andris Vilks recently signed a partnership agreement on euro changeover communication activities with the European Commission.
As for the policy issues Latvia and Lithuania must pursue, we think both countries should aim to meet the Maastricht criteria; however, the situation in the euro area should be monitored. If the fundamental problems of the monetary union are not tackled (or at the least adequate progress is not made) and things turn from worse to worst, there is always an opportunity for both Latvia and Lithuania to postpone euro adoption.
Political resolve towards euro adoption is stronger in Latvia
Public support for the euro is low, reflecting negative media news about the euro area crisis
Suggested strategy for Latvia and Lithuania: meet the Maastricht criteria and then decide whether to join the EMU
16 Swedbank Analysis • August 1, 2012
AbbreviationsBS effect – Balassa-Samuelson effect
DG ECFIN – European Commission's Directorate-General for Economic
EA – Euro area
EC – European Commission
ECB – European Central Bank
EMU – European Monetary Union
ES – Spain
ESA – European System of Accounts
EU – European Union
FR – France
GR – Greece
HICP – Harmonised index of consumer prices
IE – Ireland
LT – Lithuania
LV – Latvia
MIP – Macroeconomic imbalance procedure
SE – Sweden
SI – Slovenia
Treaty – Treaty on the Functioning of the European Union
VAT – value added tax
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Buiter, Willem H., Anne Sibert (2006), “Beauties and the Beast. When will the new EU members from Central and Eastern Europe join the Eurozone?”
Coudert, V. (2004). Measuring the Balassa-Samuelson effect for the countries of Central and Eastern Europe? Banque de France Bulletin Di-gest.
De Grauwe, Paul, Schnabl Gunther (2004), “Nominal versus real convergence with respect to EMU accession. How to cope with the Balassa-Samuelsson dilemma”, EUI Working paper RSCAS No. 2004/20
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Lojschová , A. (2003). “Estimating the Impact of Balassa-Samuelson Effect in Transition Economies”
Mihaljek, D. and Klau, M. (2009). “Catching Up and Inflation in the Baltics and Southeastern Europe: the Role of Balassa-Samuelson effect”
Schadler, Susan et al (2005), “Adopting the Euro in Central Europe Challenges of the Next Step in European Integration”, IMF Occasional Paper
Šikulova, Ivana (2007), “Maastricht inflation criterion and price convergence in the new member states”
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