Should the Baltic States be allowed to adopt the Euro before they fulfil the convergence criteria?
The main issue that is being addressed here is that of whether the Baltic States can adopt the Euro before conforming to all aspects of the convergence criteria. The Baltic States are comprised of three countries, these countries include; Latvia, Lithuania and Estonia. It was also thought that Finland was included as the fourth state before World War II by the German Nazi's. The countries formed as the Baltic States in 1918, but lost their independence when they were involuntary incorporated into the Union of Soviet Socialist Republics (USSR). They gained their independence back when the USSR collapsed in the early 1990's. The three countries began implementing economic reforms and by 1993 each country had launched their own individual currencies. The countries have shown a consistent economic growth from the period of 2001-2006. During this period there was increased activity in trade combined with a higher level of activity in construction, transport and communications & manufacturing.
The European Economic and Monetary Union (EMU) was purposely created to create harmony between the European Union (EU) member states and to introduce a single currency, this currency being the Euro. In order for this to happen, three stages were implemented; stage one was to abolish the barriers that restricted capital, so they became freely moveable between the EU member states. Also within this stage it was aimed to see a closer assistance between the central banks. Stage two was implemented between 1 January 1994 and 31 December 1998; within this period of time the establishment of the European Monetary Institute (EMI) and this was created to ensure and deal with all the technical preparations for the introduction of the single currency. The third stage began on the 1 January 1999 and this stage is to support the fixing of exchange rates, the transfer of monetary competence to the European Central Bank (ECB) and to implement the single currency of the Euro.
The Exchange Rate Mechanism (ERM) was one of the foundations that was needed in order for the EMU to function.
The ERM can be defined as ‘A system in which each member state of the European Union can agree to limit the extent of its currency fluctuations against other members' currencies within the mechanism. Most countries of the EU are members of the ERM.' (Heather: 445).
The ERM can be defined as ‘A semi-fixed system whereby participating EU countries allowed fluctuations against each other's currencies only within agreed bands. Collectively they floated freely against all other currencies.' (Hinde and Sloman: 623). The hope was that this would lead to a single European Currency, where there will be only very small fluctuations in the exchange rate, an example is the fluctuation between the pound between the England, Scotland and Wales, and although there is a fluctuation it is only small. This is what the fluctuation would be like between the member states.
The purpose of the ERM was to help stabilise exchange rates and encourage trade within Europe and control inflation. http://news.bbc.co.uk/1/hi/in_depth/europe/euro-glossary/1216833.stm
The main aim of the ERM was to set a limit that each country's exchange rate could fluctuate between. Countries including the UK could no longer manage to maintain their currencies between these two limits and therefore had to leave. This occurred for the UK on 16 September 1992, and the day was names Black Wednesday. A new system was set up and the introduction of the Exchange Rate Mechanism II (ERM II) was established.
The ERM II was set up on 1 January 1999; its aim to present is to provide a structure ‘provide a framework for exchange rate policy cooperation between the Euro system and EU member states that have not yet adopted the Euro.' http://www.ecb.int/home/glossary/html/glosse.en.html#175
It is seen that ERM II is voluntary but encourage for countries who want to adopt the Euro, are expected to join due to the fact that there is criteria that must be met for a series of two years before they can adopt the currency. This criterion is known as the convergence criteria. It can be defined as by the ECB that every member state must meet the four convergence criteria before they adopt the Euro and they must also ensure that their national legislation is compatible with the Treaty and the Statue of the European System of Central Banks and of the European Central Bank. http://www.ecb.int/home/glossary/html/glossc.en.html
The purpose of the criteria is to ensure there is a maintained level of price stability throughout the Euro zone.
The Euro has an ambitious plan to develop a single currency and monetary union, the Euro involves all members to have a common monetary policy, therefore for it to be successful countries have to meet certain criteria; thus being called convergence criteria. Before The Baltic States can join the Euro, they must meet the criteria.
Convergence criteria can be defined as a criteria that a country must meet in order for them to become part of the Euro currency.
The Baltic States should comply with these criteria in order for them to join the Euro. There are four components that make up the convergence criteria, these are; low inflation, low government borrowing, maintaining a stable exchange rate- no devaluations in the previous two years and interest rates must be close to the European Central Bank's interest rates.
‘Inflation: should be no more than 1 ½ per cent above the average inflation rate of the three countries in the EU with the lowest inflation.
Interest Rates: the rate on long-term government bonds should be no more then 2 per cent above the average of the three countries with the lowest inflation.
General government debt: should be no more than 60 per cent of GDP.
Exchange rates: the currency should have been within the normal ERM bands for at least two years with no realignments or excessive intervention.'(Sloman and Hinde: 738).
There are many advantages to having a fixed exchange rate; it provides a good environment for trading with international countries, there is also a general lower risk by maintaining a fixed exchange rate and this will also lower interest rates. It does however mean that you have to give up your monetary policy.
Fixed exchange rates rely on credibility, the higher the interest rates the less credible.
Benefits of devaluation-increase in exports and increase in employment.
Incentive at times to devalue the exchange rate for internal policies with devaluing this creates the problem of inflation.
Gov have income to increase money supply, fixed exchange rates only work if you stick it out which could mean a high rate of unemployment.
If currency is depreciating it looks good, providing you don't have the problem of importing raw materials and exporting the final product.
When running a fixed exchange rate the exchange rate stays the same, the adjustment is in the balance of payments deficit.
In order to change a balance of payments deficit without changing the exchange rate you have to increase interest rates this will incur the shifting of the supply curve to the left, this will therefore make people poorer by an increase in unemployment. It also suggested that people should not buy foreign goods. The other option is to shift the demand curve to the right; this will incur better rates of return which will attract overseas investors.
Have high interest rates in domestic currencies or low interest rates in foreign currencies in euro or Swiss franc.
If you borrow money in a foreign currency and the currency collapses still have to pay back the money and repayments could double. Unemployment starts to rise.
Massive increase in labour costs leading to wage price spiral.
Sweden dependant on Latvia in Baltic States, Sweden be big loser in time of devaluation as lends to Baltic States
Lithuania and Estonia operate a currency board so have no opportunity to create a money supply; this therefore means that they do not have any forms of reserves that they can use. Latvia does have the option to inflate its money supply but chooses not too. As the Baltic States are small countries they have very little latitude with what they do.
There are many problems that can arise if the Baltic States are accepted into the Euro before they have met the convergence criteria.
The first of these issues include the uncertainty of interest rates, these could be found to be unsuitable for the economy. By becoming part of the EMU this involves all countries to have a similar interest rate so if the Baltic States were to be apart of this then they would have to show evidence in an economic plan as to how they would ensure that there interest rates would be lowered within the future months to come.
Up until 2008, Latvia was the fastest growing economy within Europe, the GDP growth into double s; this could therefore cause a higher rate of interest to prevent inflation. On the other hand Latvia has experienced a significant decrease in output since 2008 with the International Monetary Fund (IMF) suggesting that they should devalue to help stabilise the economy. If they were to devalue this would lower the exchange rate.
By the Baltic States joining the EMU this could create major problems by reducing the number of policy options that are available.
Latvia has also seen an increase in the amount that is being borrowed by the Government; this has lead to many fears of bankruptcy for the country. As there have been many fears it has caused a downgrade of credit ratings. Therefore this shows that it is more expensive for the European Union to finance Latvia's debt as there is a much higher risk involved.
From the 2008 report http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2008:0248:FIN:EN:PDF
None of the Baltic States meets the criteria of price stability, all of the states meet the Government budgetary control and the exchange rate criterion, Latvia and Lithuania meet the convergence of long-term interest rates but Estonia does not meet this. All three countries have been within the ERM II for longer than two years, there is nothing wrong with this but realise that ten years later they are still not reaching the specific criteria in order to be able to enter and adopt the Euro. Many countries have been turned down when trying to enter the Euro zone because they have not met the full criteria. Neither Italy nor Finland had been in the ERM for 2 years which is the required length of time in order to enter into the Euro, it was noted that the commission had said the countries were close to the value that was needed to meet the criteria. (Sloman and Hinde: ). The Commission and the European Central Bank decides whether or not the country is allowed to enter into the Euro zone, they review countries once every two years but a member state can request to be reviewed, this is according to the Treaty. http://ec.europa.eu/economy_finance/the_euro/joining_euro9413_en.htm
The Baltic States has a higher inflation rate than Europe but they want to maintain their fixed Exchange Rate to ensure they comply with the criteria of the convergence for two years.
The Baltic States have two options as they do not want to affect their fixed exchange rate as this would result in not meeting the convergence criteria. The two options include increasing their interest rates or to increase their taxes.
There are many advantages to the Baltic States of being apart of the single currency, these include the elimination of the cost of converting currencies into other forms of currency, this is because every time one currency needed to be exchanged this would incur a cost. Since there is no exchange of currency between the EMU countries this has eliminated this issue. (Sloman and Hinde: 739)
Another advantage which makes it's easier for the users of the currency, will be that they will be able to compare the prices from other European countries, this will help firms be able to obtain cheaper raw material and consumers to buy cheaper goods. (Sloman and Hinde:739)
Inflation performance should see an improvement due to the fact that The European Central Bank (ECB) set the interest rates for the entire Euro zone, they will be committed to keeping inflation low, so countries that normally carry a high inflation will benefit from this. (Sloman and Hinde: 739)
If the Baltic States were to enter into the Euro area, their main Central Banks which are The Bank of Latvia, The Bank of Lithuania and The Bank of Estonia will become apart of the National Central Banks (NCB) of the Euro zone. This therefore will mean that in an event of an economic shock; the Baltic States will no longer be able to devalue their currency to encourage exports and slow imports. Instead they must ensure that they use structural and budgetary policies to manage their economies. There are also disadvantages, these include;
Communication between member states will become difficult due to the fact that there are many different languages which are spoken and therefore will create a barrier in being able to communicate with each other. (Sloman and Hinde:739)
There will be a high one off cost of converting to the new currency, such as changing labels in shops, training staff and obtaining new computer software will all cost high amounts of money. (Sloman and Hinde: 739)
Being apart of the Euro would have an effect on interest rates; they can no longer be controlled independently. The European Central Bank (ECB) control this and therefore this is a disadvantage as it will not look specifically in benefiting the Baltic States but will look to the whole of the Euro Zone to ensure it benefits as many countries as possible.
Another disadvantage is that of emotional costs; some people within countries see a currency as a sign of independence and heritage and this is taken a way if they join the Euro. (Gillespie: 437)
In conclusion it has been seen that not every country has met each criterion needed from the convergence criteria in order to become part of the Euro zone. Although saying this, countries were not far from meeting the full criteria and were therefore allowed to adopt the Euro. From a statement that was made from the board of people about the extreme economic crisis that has particularly hit the Baltic State countries was said that there would be no lenience in the convergence criteria and the countries needed to meet the criteria. It is clear to see that out of the three countries the closest country to adopting the Euro the soonest is Latvia due to them pulling out every stop to ensuring that their GDP is at the 3% mark in the next year or so.
Rethinking European Union foreign policy, Ben Tonra and Thomas Christiansen, Manchester University Press, 2004
The International Relations of the European Union, Steve March and Hans Mackenstien, Pearson Longman, 2005
European Union Foreign Policy, Hazel Smith, Pluto Press, 2002
Economics a concise guide, Barry Harrison, second edition, Longman Group UK Limited, 1991
Understanding the Economy, Andrew Dunnett, 3rd Edition, Longman Group UK Limited, 1992
Foundations of Economics, Andrew Gillespie, Oxford University Press, 2007
Understanding Economics, Ken Heather, 3rd edition, Financial Times Prentice Hall, 2000
Economics for Business, John Sloman and Kevin Hinde, 4th edition, FT Prentice Hall, 2007
Economics for Business and Management, a student text, Alan Griffiths and Stuart Wall, FT Prentice Hall, 2005
Applied Economics, Alan Griffiths and Stuart Wall, 10th Edition, FT Prentice Hall, 2004
Marketline- the Baltic States