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Swedbank Analysis No.9 - August 2, 2012


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Swedbank Analysis No.9 - August 2, 2012: …

Swedbank Analysis No.9 - August 2, 2012:
Fulfilling the Maastricht criteria – mission possible for Latvia and Lithuania?

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  • 1. Swedbank Analysis August 1, 2012Fulfilling 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. Economic Research Department Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720
  • 2. Latvia and Lithuania joined the European Union (EU) in May 2004 andare obliged to adopt the euro eventually. The first target was 2007 forLithuania and 2008 for Latvia, but neither of these was accomplished dueto high inflation and overall macroeconomic imbalances. Latvia hasstated that 2014 is its official euro introduction target date, and there is astrong political will to fulfil it. Although the Lithuanian government hasrepeatedly expressed its determination to introduce the euro in 2014, noformal national target has been set yet. Due to the upcoming elections inOctober 2012, politicians and the government are trying to avoid the un-popular subject of the euro; Lithuania will probably decide whether or notto target euro adoption in 2014 by the end of this year, depending on thechances of meeting the criteria and how the economic and political situa-tion in the euro area evolves. Unsurprisingly, though, 2012 convergencereports showed that neither of the two countries had fulfilled all the nec-essary criteria by March 2012 due to high budget deficits and inflationrates.There have been vast discussions on whether Maastricht criteria aresensible, 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 changedany time soon; thus, neither Latvia nor Lithuania should expect more fa-vourable terms than the existing criteria. Taking into account that some ofthe criteria are moving targets, it is still uncertain what benchmarks acountry will need to hit early next year to be able to adopt the euro. In thisanalysis, we try to assess what the benchmarks could look like in 2013and 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 atthe request of a member state with a derogation, the European Commis-sion (EC) and the European Central Bank (ECB) assess the progressmade by the euro area candidate countries in fulfilling their obligations toenter the Economic and Monetary Union (EMU). The ECB and the ECthen 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.1According to the Treaty, besides the necessary legal compatibility (e.g., Five main criteria needlaw concerning independence of the national central bank, prohibition of to be met for adoptingmonetary financing, etc.), there are five main criteria for the EU member the euro1 Usu-ally the central rate is used as the conversion rate. Historically parity rates were changedonly three times (one for Greece and two for Slovakia), but it had always happened beforethe Council actually adopted the conversion rates for replacement with the euro (i.e., thatwere not decisions by the Council).2 Swedbank Analysis • August 1, 2012
  • 3. state to be able to enter the EMU (the Maastricht criteria, also known asthe convergence criteria). They are presented in the table below.The main five Maastricht (convergence) criteriaWhat is measured? By what? Convergence criterionPrice stability Harmonised consumer No higher than average value of price index (HICP) 12- the three best-performing EU month average annual member states +1.5 percentage inflation points (note: correction for outliers is pos- sible)Durability of conver- Average nominal long- No higher than the average valuegence achieved by term interest rates for of the three best-performing EUthe member state government bonds or member states in terms of price comparable securities stability +2 percentage points over the latest 12-month (note: correction for outliers is pos- period for which HICP sible) data are availableSound public Government deficit as Deficit of no more than 3%, unlessfinances % of GDP (ESA meth- either (i) the ratio has declined odology, i.e., on accrual substantially and continuously and basis) reached a level that comes close to the reference value, or (ii) the excess is only exceptional and temporary and the ratio remains close to the reference valueSustainable public Government debt as % Debt of no more than 60%, unlessfinances of GDP the ratio is diminishing and ap- proaching the reference value at a satisfactory paceExchange rate Fluctuation within a Two years of participation in ex-stability band of +/- 15% around change rate mechanism of the ERM II with no serious problems the central rate, i.e., vis- à-vis the euro pegSource:, for more detailssee also ECB (2012)Compliance with the above five criteria is evaluated against their sustain- Interpretation ofability, i.e., they cannot be met by accident or by one-off measures. Note sustainability is notthat there is no clear-cut definition of what is meant by “sustainability,” clear-cutthough. Convergence reports evaluating progress of the member statesin fulfilling their obligations regarding the achievement of EMU are writtenindependently 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’ “Other relevant factors”economic integration and convergence “other relevant factors” (see are also considered inECB, 2012) are also examined – integration of markets, the situation and evaluating candidatedevelopments of the balance of payments on the current account, unit countrieslabour costs, and other price indices. However, until recently there havenot been particular benchmarks, and therefore the assessment of these“other relevant factors” by the ECB and the EC has been rather vagueand varied.22 Undoubtedly both institutions have a vast amount of in-house research on these issues,but it has not been explicit in convergence reports.Swedbank Analysis • August 1, 2012 3
  • 4. As of December 13, 2011, detailed rules for multilateral surveillance A new surveillancecame into force “to ensure closer coordination of economic policies and framework for macrosustained convergence of the economic performances of the Member imbalances wasStates”3 under the so-called Six Pack. The surveillance framework in- introduced in Decembercludes an alert mechanism for early detection of macroeconomic imbal- 2011ances (both external and internal) in all EU member states and is calledthe macroeconomic imbalance procedure (MIP). The detailed design andeconomic 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- The surveillanceported in the table below. If a country surpasses these thresholds, it is scoreboard includessubject to an in-depth review by the EC, the outcome of which may in- specific numericalclude recommendations of preventive measures or corrective measures thresholds(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 scoreboardindicators; additional information and country-specific circumstances arealso taken into account.Surpassing of the thresholds by a member state is not a reason per se to MIP frameworkreject membership to the EMU, since an evaluation of convergence is not supplements discussionthe aim of the MIP; however, 2012 convergence reports include a discus- on “other relevantsion on results from the alert mechanism report (EC, 2012a). ECB (2012, factors” of sustainablep.19) also mentions that “EU member states with a derogation that are convergencesubject to an extensive imbalance procedure can hardly be considered ashaving achieved a high degree of sustainable convergence.” Thus theMIP framework supplements discussion and evaluation of whether con-vergence is sustainable for prospective euro area members, althoughappraisal of the scoreboard results is still ambiguous for the purposes ofconvergence reports.Scoreboard for surveillance of macroeconomic imbalancesIndicator Threshold1Current 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- ±11%age change relative to 35 trading partners)Export market shares (5-year percentage change) -6%Nominal unit labour costs (3-year percentage change) +12%House prices, consumption deflated (annual percentage +6%growth)Private sector credit flow, % of GDP +15%Private sector debt, % of GDP +160%General government debt, % of GDP +60%Unemployment rate (3-year average) +10%1 Either a range or a suggested lowest (-) / highest (+) acceptable value of the particularindicator.Source: EC (2012a)3 Swedbank Analysis • August 1, 2012
  • 5. 2. Shortfalls of the existing convergence criteriaThere has been much criticism regarding what Maastricht criteria meas- Many EMU countriesure, and, more important, what they do not measure (e.g., Buiter, 2004 themselves do not meetand Šikulova, 2007). Furthermore, many EMU countries themselves do Maastricht criterianot comply with these criteria. For instance, in March 2012 only eightcountries out of seventeen fulfilled the price stability criterion; the budgetcriterion for 2011 was met by only six euro area countries. Even beforethe 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, Real convergenceall of the variables included in the five main numerical criteria are nomi- measures are notnal. Until recently, real convergence (e.g., GDP and productivity growth included in the five mainand their levels, and labour market indicators) formally has not been criteriameasured at all, although discussed in the “other relevant factors” sec-tion. Although the MIP framework now includes thresholds of, e.g., theunemployment rate and unit labour costs, these are not considered asstrict 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 fixedexchange rate regime, inflation that is substantially higher than that of thetrade partners is likely to undermine external competitiveness. However,the existing five numerical Maastricht criteria might indirectly imply puttingthe brakes on economic growth (e.g., to achieve lower inflation rates) togain access to the EMU. For instance, if a country experiences rapid pro-ductivity growth and, thus, convergence with more advanced EMUeconomies, it may also experience more rapid inflation without losingcompetitiveness or endangering sustainability.One of the illustrations is the Balassa-Samuelson (BS) effect. This is the As an economy catchesmechanism of the catching-up process, when faster productivity growth in up, its productivity and,tradable sectors than in nontradable ones causes quicker wage in-creases, which are later transmitted through competition for labour into price levels rise…the nontradable sectors and cause higher overall inflation in the catching-up countries. The BS effect in Central and Eastern Europe has beenwidely analysed. Although many studies find empirical support for thishypothesis, e.g., Lojschová (2003), Coudert (2004), and Mihaljek andKlau (2009), the overall evidence is rather controversial both as to theexistence 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 withoutendangering competitiveness. For instance, as producers in a catching-up country penetrate foreign markets, where prices are higher, they raiseprices of their output also in local markets (given their constrained capac-ity). However, if access to foreign markets at the same time improves thequality of production, competitiveness is likely not to suffer.There is thus nothing wrong in price convergence per se if prices and …which might well bewages do not increase faster than productivity and do not undermine sustainable and not en-competitiveness and sustainability. However, this is not taken into ac- danger competitivenessSwedbank Analysis • August 1, 2012 5
  • 6. count by the existing five main criteria. In addition, price convergence is along term process – e.g., for a country with a price level at half of the EUaverage, it will take years and even decades to converge to the average.It should be considered that maintaining a balance between productivityand price convergence may be a very hard task for such a long time pe-riod.Under the current framework of evaluating the convergence of candidatecountries the interpretation of whether price and productivity develop-ments are sustainable is uncertain, may vary from report to report, andhas been arbitrary at times. For instance, in its 2010 convergence report,when evaluating Estonia’s readiness to adopt the euro, the ECB wasmuch more sceptical about inflation developments than the EC, pointingspecifically to the catching-up potential as the main factor that could pushinflation up in the medium term (thus implying that the fulfilment of theprice stability criterion was not sustainable).Another issue that affects whether a country meets the price stability cri- Core inflation might be aterion is that less advanced economies are often more energy intensive better indicator to judge(less energy efficient) and thus more exposed to volatility in global oil price stabilityprices. 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 sustainabilityof the price stability criterion’s fulfilment.To sum up, there are several possible ways to improve the existing crite- Evaluation of priceria. First, analysing real convergence more explicitly and including it in a stability might be donebetter way into main criteria, for instance, taking into account the BS ef- for a longer period offect and productivity convergence. Another option is to use core insteadof headline inflation for comparison. One more way to lessen the effect of timeshort-term events may be to formally evaluate price developments for alonger 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 forevaluating convergence of candidate countries – since there are largetrade flows not only inside the EMU, but also within the EU, e.g., priceand currency developments in other EU countries certainly influence thecompetitiveness of prospective euro area members, but is it fair to com-pare prospective euro area members to countries with flexible exchangerates. Overall, there is room for more explicit and reasonable way tocomparing candidate countries with other EMU (or EU) members andmore symmetric approach across the criteria, see next sections for moredetails.3. Interpretation of the moving-target criteriaThe treatment of the inflation and long-term interest rate criteria by theECB and the EC has differed over time and has not always been sym-metric across these criteria. These criteria are moving targets, and theircalculation and interpretation (i.e., economic judgement) remain quiteuncertain. This has been pinpointed by many researchers, e.g., seeBuiter and Sibert (2006) and Schadler at al (2005).First, there is no clear definition of an outlier, and while sustainability is- Uncertain treatment ofsues are evaluated for a candidate country, they are not looked at so outliers4 Since the existing criterion includes 12-month average annual inflation, it in fact takesinto consideration price changes over the last 24 months.6 Swedbank Analysis • August 1, 2012
  • 7. closely for possible reference countries. That is, a very low inflation inchosen “best-performing” countries might actually be due to temporaryfactors. 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 ratein Finland (0.4%) was considered “normal,” while the average of the euroarea at that time was 2.1%.In 2010, due to the global economic and financial crisis, deflation wasconsidered to be something “normal” (the three best performers chosenshowed an average of -0.5%). At the time, Ireland was excluded from thecalculation 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, withrespect to the price stability criterion, if an outlier is indeed recognised,the next three countries with the lowest inflation are taken (this was thecase both in 2004 and 2010, when outliers were recognised).Furthermore, the moving-target criteria depend on developments not only Comparison against EU,in the euro area (which potential candidates are supposed to join), but not euro area, membersalso in other EU countries – for calculating criteria, “best-performing” EUmembers are considered. The more countries join the EU, the larger isthe chance of getting an “odd one” (which will not necessarily be treatedas an outlier). Moreover, this implies that a candidate country may beevaluated against itself. In 2010, this was actually the case for Estonia.Second, the treatment of outliers may be asymmetric across different Asymmetric treatmentcriteria. For instance, regarding the interest rate criterion, the first time an across different criteriaoutlier was recognized was this year, when Ireland was excluded fromthe calculation because it was (and still is) in the bailout programme andhad a very limited access to borrowing in international financial markets.One could assume that the same treatment will be applied again, goingforward. However, Ireland was not excluded when calculating price stabil-ity criteria. It did not have the lowest inflation, but one could argue thatbeing 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 excludedfrom 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 dueto lack of an appropriate benchmark). Thus, theoretically it is possiblethat 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 aidis increasing.It is thus not clear how Greece, Portugal, and Ireland (those currently un- Uncertain treatment ofder bailout programmes) will be treated next year, and even less clear countries under bailouthow Spain and Cyprus (countries that have asked for financial aid, but so programmesfar are not under formal bailout programmes; Spain still can borrow ininternational financial markets) will be treated. If these countries experi-ence very low inflation rates due to suppressed domestic demand underSwedbank Analysis • August 1, 2012 7
  • 8. austerity, will they still be included in the calculation of the price stabilitycriterion?Uncertain treatment of outliers, especially under the current unprece-dented bailout programmes and conditions, creates room for the EC andthe ECB to manoeuvre and there is a risk that the economic judgementmay 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 beused by policy makers in the euro area and make decision-making proc-ess less transparent.4. What could the benchmarks look like in March2013? 5Euro adoption in 2014 is currently the official national target in Latvia. InLithuania, it is not so far the target – the decision on this is likely to bemade after the parliamentary elections in October 2012. The applicationsof Latvia and Lithuania (if the latter indeed chooses to go for the euro in2014) to be evaluated under the convergence report are expected to besubmitted in April 2013, i.e., when the government budget data for 2012according to ESA methodology are published. Therefore, the moving tar-gets – inflation and long-term interest rate criteria – will be evaluatedbased 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, High political andthough. First, there is high political and economic uncertainty in the euro economic uncertainty inarea and, thus, elevated interest rate volatility. Amongst the still unan- the euro areaswered 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 theway 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 firstquarter 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 betweenthe indicators in the latter three countries are very small. Note that thereare 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 from18% to 21% as of September 1 (as is planned) to reduce the budgetdeficit, then its 12-month inflation is likely to be somewhat higher inMarch 2013 than the EC forecast suggests.Most likely, Greece, if it stays within the euro area and the EU, will be Price stability criterionconsidered to be an outlier in price stability terms due to forecast defla- might be at about 3%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 pricestability comparison, the criterion might be about 3% (see the next sec-tion for more details). But other countries may well be amongst the bestperformers. For instance, if the latest HICP developments are consid-ered, Bulgaria may be amongst countries with the lowest inflation inMarch 2013 – in the first five months of 2012, its average annual HICPgrowth was 1.9%.5 Swedbank Analysis • August 1, 2012
  • 9. HICP annual inflation, % 7.5 5 3Q 4Q 1Q 2.5 0 -2.5 IE GR ES SI SE LV LT FR -5 2010 2011 2012 2013 Source: Eurostat, quarterly Swedbank forecasts for LV and LT, EC forecasts for other countriesThere is even more ambiguity with respect to interest rates. There are no Great uncertaintyforecasts available, and the current high political and economic uncer- regarding interest ratetainty in the euro area (resulting in high interest rate volatility) does not criterionallow sensible predictions to be made. Judging from the 2012 conver-gence, Ireland could be excluded from the calculation of the interest ratecriterion (because it is under the bailout programme)6. If financial aid tothe Spanish banking sector is not considered as a bailout package andthis 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 themarkets, then Sweden might be the only country used for interest ratescomparison (with the possible inclusion of France, if it has lower inflationthan Spain); this would make the criterion extremely challenging to fulfil.Sweden is one of the strongest EU economies; it is perceived as one ofthe few “safe havens” and enjoys very low bond yields. Moreover, it isparadoxical and ironic to compare EMU candidate countries with Swe-den, since it is not even in the euro area and has a floating exchangerate.Long-term government interest rates (EUR), % 15 ES SI SE 12 LV LT FR 9 6 3 0 2006 2007 2008 2009 2010 2011 2012 Source: Eurostat6 Ireland has already successfully issued 3-year government bonds in February (EUR 3.6billion) and 5-year government bonds in July 2012 (EUR 3.9 billion).Swedbank Analysis • August 1, 2012 9
  • 10. 5. Prospects for Latvia and LithuaniaWill Latvia and Lithuania be able to comply with the Maastricht criteria in2013? The most difficult part of answering this question seems to beforeseeing what the moving-target criteria will look like.In the table below, we provide a summary of possible values of the pricestability criterion for March 2013, depending on which countries are in-cluded, the long-term interest rates as of June 2012, and forecasts forpublic finances situation in 2012.Compliance with the criteria: outlook for March 2013 (except for interestrates) Reference value Criterion (countries included) Latvia Lithuania 3% (IE, SP, SE) 3.1% (FR, SP, SE or HICP infla- FR, IE, SE) 2.6%2 2.6%2 tion1 2% (IE, SE, GR) 2% (SP, SE, GR) 5.7% (SP, SE) Long-term 5.5% (FR, SP, SE) interest rate 5.5% 5.2% 4.4% (FR, SE) (June 2012)3 3.9% (SE) Government 3% of GDP 2.2%2 3.0%2 deficit (2012) Government 60% of GDP 41.3%2 40.0%2 debt (2012) Since 2004, cur- 2 years, fluctuation Since 2005, rency board – Participation band of +/- 15% fluctuation band hard peg without in ERM II around the central of +/- 1% around foreign exchange rate the central rate 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 stabilityLatvia: The 12-month average HICP annual inflation rate is expected tobe about 2.6% (Swedbanks April 2012 forecast) in March 2013. The ECspring 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 percentagepoint to the annual inflation). However, since these tariffs are linked to thenine-month-average heavy oil price, the rise in regulated prices is smallerthan the global oil price hike. Moreover, oil prices have retreated fromtheir highs and are not expected to exert upward pressures on consumerprices in the second half of the year. Food price inflation has deceleratedsubstantially in line with global trends, although possible bad harveststhis year (e.g., drought in the US) may again push food prices up. Still,domestic demand pressures are muted – core inflation (excluding energyand unprocessed food) remains below 2%, which is lower than the head-line inflation rate.10 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 likelyto reduce consumer price inflation even more, although the overall effecton prices is expected to be rather muted. As of January 1, the personalincome tax will also be lowered by 1 percentage point to improve labourcompetitiveness, but no significant effect on prices is expected becauseof this.Lithuania: We forecast average annual HICP to be around 2.8% at theend of this year, and to decline further to 2.6% by March 2013. The ECspring forecast is 3.1%, but this outcome seems increasingly unlikely,considering the price trends during the first half of this year and recentdevelopments in global commodities markets. The main drivers of infla-tion in Lithuania are the same as in Latvia – developments in globalgoods 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 byLTL 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 themonopoly Lithuanian Gas decided (and the regulator agreed) to increasegas prices for households by about 22% as of July 1. This was due tohigher oil prices (the import price of gas is directly indexed to the price ofoil); however, this increase now seems to be excessive, considering thesteep decline of oil prices during the past few months. Our estimatesshow that this will add about 0.35 percentage point to annual inflation, butthe 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 of2012, 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 forLithuania (except maybe for oil). The already-contracting producer pricesindicate a further decline in consumer inflation. Thus, we think our Aprilinflation forecast is accurate and average annual HICP will trend towards2.6%. But, as in Latvia, due to global trends there is a risk of higher foodprice inflation in the second half of the year.If the price stability criterion is calculated using Ireland, Spain, France, Latvia and Lithuania areand Sweden (any three of them) based on the EC forecast, neither Latvia likely to fulfil the pricenor Lithuania should experience problems in fulfilling it. It seems that 12- stability criterionmonth average inflation in both countries will fall under 3%. The interpre-tation of sustainability may vary, though. Wage growth is still in line withproductivity gains; unit labour costs have risen only marginally. In themedium term, however, risks for labour market pressures could causemore rapid inflation. Realising the catching-up potential might also sup-port price growth in the longer term, but this should not be a problem ifprice convergence is going hand in hand with productivity convergence(see Section 1 for more details). It is highly uncertain how these issueswill be treated by the EC and the ECB – ultimately, the risk of making amore political than economic judgement will increase.All in all, due to smaller increases in regulated prices, it seems that Latviawill be slightly better positioned if external or domestic factors push theprice stability criterion lower than currently forecast by the EC.Swedbank Analysis • August 1, 2012 11
  • 12. 5.2 Interest ratesLatvia: In June 2012, the long-term interest rate for Latvian governmentdebt7 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 yieldsare already below 2%. As economic growth continues and the budgetdeficit diminishes, interest rates are expected to continue retreating aswell. We forecast the government budget deficit to decline from 2.2% thisyear 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 theyield downwards – a clear trend can already be seen in shorter-termbonds 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 thegovernment confirms the budget for 2013. We forecast that the budgetdeficit 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 High uncertaintyLithuania will be able to fulfil the interest rate criterion in April 2013. If regarding the interestSpain and France, together with Sweden, are considered in the calcula- rate criteriontion of the criterion, Latvia and Lithuania are likely to fulfil it. However,fulfilling the criterion would become an almost impossible task if onlySweden is considered (and very challenging even if Sweden and Francetogether are taken), since Sweden’s interest rates are likely to remainsubstantially below Latvia’s and that of the euro area. For instance, if thecriterion were calculated in June 2012, neither Latvia, nor Lithuania wouldfulfil it (since Ireland and Greece would be excluded from calculation, andonly Sweden considered). 5.3 Government deficitLatvia: The EC forecasts a 2.1% government budget deficit for 2012.The Swedbank forecast stands at 2.2%, owing to increased governmentspending pressures (including wage increases in the public sector) due tobetter-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. Taxrevenues exceeded the plan by 9% in the first half of 2012 (up by nearly15% from a year ago). In July, the government conceptually approved anadditional LVL 70 million to be spent, which is a bit less than a half ofwhat the ministries have requested. A supplementary budget is plannedto be submitted to the parliament by the end of August. The governmentcontinues to be highly committed to keeping spending under control (it isnot 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 declineto 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 thiscriterion is low – national budget revenues during the first half of this yeargrew by 4.6% over the same period last year and exceeded the plan by7 Issued by the central government, maturity close to 10 years, fixed coupon. Data fromEurostat (Maastricht criterion bond yields).12 Swedbank Analysis • August 1, 2012
  • 13. 2.4%. Still, the risk of slower growth and lower budget revenues (due tothe euro area woes) during the second half of this year remains. The gov-ernment is still very determined to keep spending under control and toreduce the budget deficit to at least 3.0% of GDP, and President DaliaGrybauskaite stresses the importance of fiscal austerity. The governmentis not planning any additional austerity measures this year, but, as thebudget revenues are ahead of the plan, we do not see the need for suchmeasures and feel that excessive austerity would cause unnecessarydownward pressure on the economy.Overall, Latvia has an ample reserve for fulfilling the budget deficit crite- Latvia is better preparedrion, and Lithuania still has a good chance of meeting it as well. It is im- to fulfil the budget deficitportant to note that both Latvia and Lithuania have managed to cut their criterion than Lithuania,budget deficits drastically – from 9.8% and 9.4% of GDP, respectively, in but both countries are2009 to below or close to 3% of GDP this year. The budget deficit con- likely to meet itvergence criterion suggests that it can be sufficient that “the ratio has de-clined substantially and continuously and reached a level that comesclose to the reference value.” However, if the target of below 3% is notmet straight on, it opens up discussions and possible interpretations onthe acceptability of the progress and thus may preclude EMU member-ship. 5.4 Government debtFor Latvia, the EC forecasts a 43.5% government budget debt for 2012; Latvia and LithuaniaSwedbanks forecast stands at 41.3%. There is a comfortable reserve, comfortably meetand it is clearly no problem for Latvia to fulfil this criterion. For Lithuania, government debtSwedbank forecasts its general government debt to be 40.0% of GDP criterionthis 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 rateLatvia already fulfils the exchange rate criterion. It has been in Exchange No problems withRate Mechanism (ERM) II since 2005, and the lats is pegged to the euro exchange rate criterionwith +/- 1% fluctuation allowed around the central rate. Lithuania alsofulfils the exchange rate criterion. It has been in ERM II since 2004, andthe litas is pegged to the euro under the currency board arrangement (nofluctuations). Also, neither Latvia nor Lithuania is expected to experienceproblems 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 compatibilityThere 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 plansto harmonise its legislation accordingly in due time. In Lithuania, there ismore uncertainty – the official euro adoption target date has not been setyet, 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 theeuro area. 5.7 Sustainable convergence and macroeconomic imbalancesRegarding the scoreboard of macroeconomic imbalances, in 2011 both Remaining macroLatvia and Lithuania did not comply with only 2 indicators out of 10: the imbalances in somenet international investment position and the unemployment rate. Na- areas should not be an obstacle to joining the EMU.Swedbank Analysis • August 1, 2012 13
  • 14. tional statistical data suggest that Latvia and Lithuania do not surpass thethresholds of the “n/a” indicators for which data were not included in theconvergence report. With deleveraging continuing, the net internationalinvestment position will become less negative, while increasing economicactivity will reduce unemployment. Nevertheless, Latvia and Lithuania areunlikely to comply with these benchmarks by next year – improvement inboth these areas will not be that fast. Provided that progress in the rightdirection continues and given that the aim of the MIP is not to evaluatereadiness to adopt the euro, this situation, however, should not becomean obstacle to joining the EMU. Both countries are on the right track, andformer 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 LithuaniaCurrent account balance, % of GDP -4.0/+6.0% 3.5% 1.5%(3 year average)Net international investment posi- -35% -72.5% -52.2%tion, % of GDPReal effective exchange rate, HICPdeflated (3-year percentage change ±11% -0.6% 3.5%relative to 35 trading partners)Export market shares (5-year per- -6% 24.7% 26.4%centage change)Nominal unit labour costs (3-yearpercentage change) +12% -15.1% -9%House prices, consumption deflated(annual percentage growth) +6% n/a n/aPrivate sector credit flow, % of GDP +15% n/a n/aPrivate sector debt, % of GDP +160% n/a n/aGeneral government debt, % ofGDP +60% 43% 39%Unemployment rate (3-year aver-age) +10% 17.1% 15.6%1 Either a range or a suggested lowest (-) /highest (+) acceptable value of the particularindicator.Source: ECB (2012)5. ConclusionBoth Latvia and Lithuania have a good chance of fulfilling the Maastricht Latvia has a slightlycriteria in April 2013. However, the probability of adopting the euro in better chance than2014 is somewhat bigger for Latvia, since is has more room for Lithuania to fulfil themanoeuvre and also stronger political resolve. criteria in March 2013For Latvia, the most challenging criterion currently is interest rates, sinceit involves the largest uncertainty regarding which countries will be usedfor comparison. Under the muddling-through baseline scenario of theglobal economy, no problems are expected with other criteria, althoughthe treatment of sustainability issues remains uncertain. For Lithuania,inflation is also a hurdle, especially if global food prices go up in thesecond half of the year; whereas the budget deficit criterion may bebreached if the euro area recession worsens and budget revenues sufferduring the second half of this year.14 Swedbank Analysis • August 1, 2012
  • 15. Taking into account that the calculation and interpretation of moving-target criteria are uncertain and not always symmetric, unpleasantsurprises are still possible. Ambiguous economic judgement thus givesmore room for political judgement, as at the end of the day the decision ofwhether 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 criteria Political resolve towardsfor 2014 membership, the countries are likely to pursue the target in the euro adoption is strongerfollowing year. In Lithuania, however, political determination is less in Latviacertain. As public support for the euro is weak, few politicians want todiscuss openly Lithuania’s prospects. Some are openly sceptical ofwhether Lithuania needs to “rush into the ailing euro area to helpGreece.” President Dalia Grybauskaite has recently also adopted a moreconservative “wait-and-see” approach. There seem to be a moreunanimous agreement to meet Maastricht criteria for the sake of stability,but not necessarily in order to adopt immediately the euro. Thus, there isa probability that Lithuania will not apply formally for euro adoption in2014 – much of this will depend on election results in October, as well asthe euro area’s progress towards a sustainable solution.Public support for euro adoption is low in both countries, most likely Public support for theresulting from negative media news about the euro area crisis. The euro is low, reflectingEurobarometer results for April 2012 show that 46% of respondents are negative media newsin favour of euro adoption in Latvia (9% very much in favour) and 44% in about the euro areaLithuania (10% very much in favour).8 However, only 9% of respondents crisisin Latvia and 14% in Lithuania would like to see adoption of the euro assoon as possible.Nevertheless, in Latvia there is a broad understanding of the benefits ofjoining the EMU by both the government and businesses. Major industryassociations in both countries are in favour of euro adoption by a massivemargin. Better communication of the euro advantages to householdsshould be made. Activities in this area are being undertaken – e.g.,Latvian Finance Minister Andris Vilks recently signed a partnershipagreement on euro changeover communication activities with theEuropean Commission.As for the policy issues Latvia and Lithuania must pursue, we think both Suggested strategy forcountries should aim to meet the Maastricht criteria; however, the Latvia and Lithuania:situation in the euro area should be monitored. If the fundamental meet the Maastrichtproblems of the monetary union are not tackled (or at the least adequate criteria and then decideprogress is not made) and things turn from worse to worst, there is whether to join the EMUalways an opportunity for both Latvia and Lithuania to postpone euroadoption. Lija Strašuna Mārtiņš Kazāks Nerijus Mačiulis8 Analysis • August 1, 2012 15
  • 16. AbbreviationsBS effect – Balassa-Samuelson GR – Greeceeffect HICP – Harmonised index ofDG ECFIN – European consumer pricesCommissions Directorate-General IE – Irelandfor Economic LT – LithuaniaEA – Euro area LV – LatviaEC – European Commission MIP – Macroeconomic imbalanceECB – European Central Bank procedureEMU – European Monetary Union SE – SwedenES – Spain SI – SloveniaESA – European System of Treaty – Treaty on the FunctioningAccounts of the European UnionEU – European Union VAT – value added taxFR – FranceReferencesBuiter, Willem H. (2004), “En Attendant Godot? Financial instability risksfor countries targeting Eurozone membership”Buiter, Willem H., Anne Sibert (2006), “Beauties and the Beast. When willthe new EU members from Central and Eastern Europe join theEurozone?”Coudert, V. (2004). Measuring the Balassa-Samuelson effect for thecountries of Central and Eastern Europe? Banque de France Bulletin Di-gest.De Grauwe, Paul, Schnabl Gunther (2004), “Nominal versus realconvergence with respect to EMU accession. How to cope with theBalassa-Samuelsson dilemma”, EUI Working paper RSCAS No. 2004/20EC (2010), Convergence report 2010. European Economy 3/2010EC (2012a), “Alert Mechanism Report”, COM(2012) 68, February 2012EC (2012b), “Scoreboard for the surveillance of macroeconomicimbalances”, European Economy, Occasional Paper 92, February 2012EC (2012c), Convergence report 2012. European Economy 3/12EC (2012d), European Economic Forecast Spring 2012, EuropeanEconomy 1/12ECB (2010), Convergence report, May 2012ECB (2012), Convergence report, May 2012EEAG – European Economic Advisory Group (2007), “The EEAG Reporton the European Economy 2007”, Chapter 3: The new EU membersLojschová , A. (2003). “Estimating the Impact of Balassa-SamuelsonEffect in Transition Economies”Mihaljek, D. and Klau, M. (2009). “Catching Up and Inflation in the Balticsand Southeastern Europe: the Role of Balassa-Samuelson effect”Schadler, Susan et al (2005), “Adopting the Euro in Central EuropeChallenges of the Next Step in European Integration”, IMF OccasionalPaperŠikulova, Ivana (2007), “Maastricht inflation criterion and priceconvergence in the new member states”16 Swedbank Analysis • August 1, 2012
  • 17. Economic Research DepartmentSweden Cecilia Hermansson +46 8 5859 7720 Group Chief Economist Chief Economist, Sweden Magnus Alvesson +46 8 5859 3341 Head of Economic Forecasting Jörgen Kennemar +46 8 5859 7730 Senior Economist Anna Ibegbulem +46 8 5859 7740 AssistantEstonia Annika Paabut +372 888 5440 Chief Economist, Estonia Elina Allikalt +372 888 1989 Senior Economist Teele Reivik +372 888 7925 Senior EconomistLatvia Mārtiņš Kazāks +371 67 445 859 Deputy Group Chief Economist Chief Economist, Latvia Lija Strašuna +371 67 445 875 Senior EconomistLithuania Nerijus Mačiulis +370 5 258 2237 Chief Economist, Lithuania Lina Vrubliauskienė +370 5 258 2275 Senior Economist Vaiva Šečkutė +370 5 258 2156 Senior EconomistSwedbank Analysis • August 1, 2012 17
  • 18. DisclaimerThis research report has been prepared by economists of Swedbank’s Economic Re-search Department. The Economic Research Department consists of research units inEstonia, Latvia, Lithuania, and Sweden, is independent of other departments of Swed-bank AB (publ) (“Swedbank”) and responsible for preparing reports on global and homemarket economic developments. The activities of this research department differ fromthe activities of other departments of Swedbank, and therefore the opinions expressed inthe reports are independent from interests and opinions that might be expressed byother employees of Swedbank.This report is based on information available to the public, which is deemed to be reli-able, and reflects the economists’ personal and professional opinions of such informa-tion. It reflects the economists’ best understanding of the information at the moment theresearch was prepared and due to change of circumstances such understanding mightchange accordingly.This report has been prepared pursuant to the best skills of the economists and withrespect to their best knowledge this report is correct and accurate, however neitherSwedbank nor any enterprise belonging to Swedbank or Swedbank directors, officers, orother employees or affiliates shall be liable for any loss or damage, direct or indirect,based on any flaws or faults within this report.Enterprises belonging to Swedbank might have holdings in the enterprises mentioned inthis report and provide financial services (issue loans, among others) to them. Aforemen-tioned circumstances might influence the economic activities of such companies and theprices of securities issued by them.The research presented to you is of an informative nature. This report should in no waybe interpreted as a promise or confirmation of Swedbank or any of its directors, officers,or employees that the events described in the report shall take place or that the forecaststurn out to be accurate. This report is not a recommendation to invest into securities or inany other way enter into any financial transactions based on the report. Swedbank andits directors, officers, or employees shall not be liable for any loss that you may suffer asa result of relying on this report.We stress that forecasting the developments of the economic environment is somewhatspeculative in nature, and the real situation might turn out different from what this reportpresumes.IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT, THEN YOU ACTSOLELY ON YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THEECONOMIC REASONABILITY AND THE RISKS OF SUCH ACTION INDEPEND-ENTLY.