Latvia

Why Latvia could lose with the Euro

June 6, 2013: 2:20 PM ET

The tiny Baltic state might be a step further in joining the eurozone, but membership may be more trouble than it's worth.

130606140544-latvia-614xaFORTUNE -- Despite all the eurozone's debt problems, some still want to be a part of it.

This week, the government of Latvia cheered when the European Central Bank gave the tiny Baltic state a nod to become the 18th member of the eurozone. The fact that any country wants to call the euro its official tender might signal renewed faith that the currency zone will survive, but Latvia may also be in for more trouble than membership is worth.

Latvia has come a long way, however: In 2009, amid the global financial crisis, the country's GDP shrank sharply by some 20%. It also received a $10.1 billion bailout from the European Union and International Monetary Fund, but Latvia has since turned its economy around. The country has aggressively reduced its budget deficit, cut government spending, and raised taxes. All this helped Latvia fulfill the financial requirements of the Maastricht Treaty, which effectively deems it fit to join the world's biggest currency union.

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The euro seemed like the natural next step, regardless of all the troubles the currency has brought countries like Spain and Greece. After all, as Latvia Prime Minister Valdis Dombrovskis has said, the lats has been pegged to the euro for 10 years. And as much as 90% of Latvia's private and corporate debt are already in euros.

Latvia isn't the only country overlooking the euro's troubles. In 2011, Estonia adopted the single currency; its President Toomas Hedrik Ilves recently said the euro is a "great currency" that has benefitted the economy and boosted investors' confidence. Lithuania, the third Baltic state, plans to follow in 2015.

Like Estonia and Lithuania, Latvia is a relatively small and poor country compared with most of the rest of the currency zone. True, all kinds of economic perks come with joining the euro; among other things, it essentially makes it easier and less costly for a member to trade goods and services with other members. But for Latvia's government, getting to call the euro its home currency has more to do with politics than economics.

"Latvia is a small country still haunted by its past -- in this case, the Russian occupation," says Gabriela Marin Thornton, European Union affairs professor at Texas A&M University. "They prefer to be strongly tied to the West." And entry into the eurozone is one way of doing that.

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Latvia's economy might be doing OK now, but there are still issues. Latvia's banks are a concern. About half of all deposits represent non-resident deposits, much of them from Russia, Balarus, Uzbekistan, and other countries of the former Soviet Union. This is because they feel parking their money in Latvia is safer than at home. What's more, many in Latvia are jobless. Its unemployment rate is 12.8%, slightly above the eurozone average of 12.2%.

Joining the eurozone would effectively keep Latvia from independently controlling its economy -- for instance, setting its own interest rates -- if things take a turn for the worse. Such have been among the problems of the eurozone's peripheral countries, says Kim Clausing, economics professor at Reed College.

"It's as if the U.S. had to ask Japan and Canada if it could lower interest rates," Clausing adds. "Latvia should be more cautious until they're convinced they're not going to be the next Greece or Spain."

While the government of Latvia doesn't seem very convinced given they seem so eager to join, many of its citizens aren't as excited about the euro -- polls show only about one-third of Latvians favor adopting the currency. In the end, who will be right?

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