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

1. Swedbank Analysis August 1, 2012
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.
Economic Research Department
Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720

2. 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 treatment
among 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., Five main criteria need
law concerning independence of the national central bank, prohibition of to be met for adopting
monetary financing, etc.), there are five main criteria for the EU member the euro
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).
2 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 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 value
gence achieved by term interest rates for of the three best-performing EU
the 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 available
Sound public Government deficit as Deficit of no more than 3%, unless
finances % 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 value
Sustainable public Government debt as % Debt of no more than 60%, unless
finances of GDP the ratio is diminishing and ap-
proaching the reference value at a
satisfactory pace
Exchange 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 peg
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- Interpretation of
ability, i.e., they cannot be met by accident or by one-off measures. Note sustainability is not
that there is no clear-cut definition of what is meant by “sustainability,” clear-cut
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’ “Other relevant factors”
economic integration and convergence “other relevant factors” (see are also considered in
ECB, 2012) are also examined – integration of markets, the situation and evaluating candidate
developments of the balance of payments on the current account, unit countries
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.
Swedbank Analysis • August 1, 2012 3

4. As of December 13, 2011, detailed rules for multilateral surveillance A new surveillance
came into force “to ensure closer coordination of economic policies and framework for macro
sustained convergence of the economic performances of the Member imbalances was
States”3 under the so-called Six Pack. The surveillance framework in- introduced in December
cludes an alert mechanism for early detection of macroeconomic imbal-
2011
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- The surveillance
ported in the table below. If a country surpasses these thresholds, it is scoreboard includes
subject to an in-depth review by the EC, the outcome of which may in- specific numerical
clude 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 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 MIP framework
reject membership to the EMU, since an evaluation of convergence is not supplements discussion
the aim of the MIP; however, 2012 convergence reports include a discus- on “other relevant
sion on results from the alert mechanism report (EC, 2012a). ECB (2012, factors” of sustainable
p.19) also mentions that “EU member states with a derogation that are
convergence
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 imbalances
Indicator 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- ±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 particular
indicator.
Source: EC (2012a)
3
http://www.europarl.europa.eu/oeil/popups/summary.do?id=1180860&t=f&l=en
4 Swedbank Analysis • August 1, 2012

5. 2. Shortfalls of the existing convergence criteria
There has been much criticism regarding what Maastricht criteria meas- Many EMU countries
ure, and, more important, what they do not measure (e.g., Buiter, 2004 themselves do not meet
and Šikulova, 2007). Furthermore, many EMU countries themselves do Maastricht criteria
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, Real convergence
all of the variables included in the five main numerical criteria are nomi- measures are not
nal. Until recently, real convergence (e.g., GDP and productivity growth included in the five main
and their levels, and labour market indicators) formally has not been criteria
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 As an economy catches
mechanism 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 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 …which might well be
wages 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 competitiveness
Swedbank Analysis • August 1, 2012 5

6. 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- Core inflation might be a
terion 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 stability
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- Evaluation of price
ria. First, analysing real convergence more explicitly and including it in a stability might be done
better way into main criteria, for instance, taking into account the BS ef-
for a longer period of
fect and productivity convergence. Another option is to use core instead
of headline inflation for comparison. One more way to lessen the effect of time
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- Uncertain treatment of
sues are evaluated for a candidate country, they are not looked at so outliers
4
Since the existing criterion includes 12-month average annual inflation, it in fact takes
into 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 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 Comparison against EU,
in the euro area (which potential candidates are supposed to join), but not euro area, members
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 Asymmetric treatment
criteria. For instance, regarding the interest rate criterion, the first time an across different criteria
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- Uncertain treatment of
der bailout programmes) will be treated next year, and even less clear countries under bailout
how Spain and Cyprus (countries that have asked for financial aid, but so programmes
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
Swedbank Analysis • August 1, 2012 7

8. 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?
5
Euro adoption in 2014 is currently the official national target in Latvia. 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 applications
of 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, High political and
though. First, there is high political and economic uncertainty in the euro economic uncertainty in
area and, thus, elevated interest rate volatility. Amongst the still unan- the euro area
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 Price stability criterion
considered 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 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%.
5
http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/index_en.htm
8 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 countries
There is even more ambiguity with respect to interest rates. There are no Great uncertainty
forecasts available, and the current high political and economic uncer- regarding interest rate
tainty in the euro area (resulting in high interest rate volatility) does not criterion
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 rates
comparison (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), %
15
ES SI SE
12 LV LT FR
9
6
3
0
2006 2007 2008 2009 2010 2011 2012
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).
Swedbank Analysis • August 1, 2012 9

10. 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)
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
fluctuations
1
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 2012
has 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.
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 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 of
August 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, Latvia and Lithuania are
and Sweden (any three of them) based on the EC forecast, neither Latvia likely to fulfil the price
nor Lithuania should experience problems in fulfilling it. It seems that 12- stability criterion
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.
Swedbank Analysis • August 1, 2012 11

12. 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 High uncertainty
Lithuania will be able to fulfil the interest rate criterion in April 2013. If regarding the interest
Spain and France, together with Sweden, are considered in the calcula- rate criterion
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).
12 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- Latvia is better prepared
rion, and Lithuania still has a good chance of meeting it as well. It is im- to fulfil the budget deficit
portant 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 are
2009 to below or close to 3% of GDP this year. The budget deficit con-
likely to meet it
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; Latvia and Lithuania
Swedbank's forecast stands at 41.3%. There is a comfortable reserve, comfortably meet
and it is clearly no problem for Latvia to fulfil this criterion. For Lithuania, government debt
Swedbank forecasts its general government debt to be 40.0% of GDP criterion
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 No problems with
Rate Mechanism (ERM) II since 2005, and the lats is pegged to the euro exchange rate criterion
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 Remaining macro
Latvia and Lithuania did not comply with only 2 indicators out of 10: the imbalances in some
net 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 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
-4.0/+6.0% 3.5% 1.5%
(3 year average)
Net international investment posi-
-35% -72.5% -52.2%
tion, % of GDP
Real effective exchange rate, HICP
deflated (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-year
percentage change) +12% -15.1% -9%
House prices, consumption deflated
(annual percentage growth) +6% n/a n/a
Private sector credit flow, % of GDP +15% n/a n/a
Private sector debt, % of GDP +160% n/a n/a
General government debt, % of
GDP +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 particular
indicator.
Source: ECB (2012)
5. Conclusion
Both Latvia and Lithuania have a good chance of fulfilling the Maastricht Latvia has a slightly
criteria in April 2013. However, the probability of adopting the euro in better chance than
2014 is somewhat bigger for Latvia, since is has more room for Lithuania to fulfil the
manoeuvre and also stronger political resolve. criteria in March 2013
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.
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, 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 criteria Political resolve towards
for 2014 membership, the countries are likely to pursue the target in the euro adoption is stronger
following year. In Lithuania, however, political determination is less in Latvia
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 Public support for the
resulting from negative media news about the euro area crisis. The euro is low, reflecting
Eurobarometer results for April 2012 show that 46% of respondents are negative media news
in favour of euro adoption in Latvia (9% very much in favour) and 44% in about the euro area
Lithuania (10% very much in favour).8 However, only 9% of respondents crisis
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 Suggested strategy for
countries 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 Maastricht
problems of the monetary union are not tackled (or at the least adequate criteria and then decide
progress is not made) and things turn from worse to worst, there is whether to join the EMU
always an opportunity for both Latvia and Lithuania to postpone euro
adoption.
Lija Strašuna
Mārtiņš Kazāks
Nerijus Mačiulis
8
http://ec.europa.eu/public_opinion/topics/euro_en.htm
Swedbank Analysis • August 1, 2012 15

16. Abbreviations
BS effect – Balassa-Samuelson GR – Greece
effect HICP – Harmonised index of
DG ECFIN – European consumer prices
Commission's Directorate-General IE – Ireland
for Economic
LT – Lithuania
EA – Euro area
LV – Latvia
EC – European Commission
MIP – Macroeconomic imbalance
ECB – European Central Bank procedure
EMU – European Monetary Union SE – Sweden
ES – Spain SI – Slovenia
ESA – European System of Treaty – Treaty on the Functioning
Accounts of the European Union
EU – European Union VAT – value added tax
FR – France
References
Buiter, Willem H. (2004), “En Attendant Godot? Financial instability risks
for countries targeting Eurozone membership”
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
EC (2010), Convergence report 2010. European Economy 3/2010
EC (2012a), “Alert Mechanism Report”, COM(2012) 68, February 2012
EC (2012b), “Scoreboard for the surveillance of macroeconomic
imbalances”, European Economy, Occasional Paper 92, February 2012
EC (2012c), Convergence report 2012. European Economy 3/12
EC (2012d), European Economic Forecast Spring 2012, European
Economy 1/12
ECB (2010), Convergence report, May 2012
ECB (2012), Convergence report, May 2012
EEAG – European Economic Advisory Group (2007), “The EEAG Report
on the European Economy 2007”, Chapter 3: The new EU members
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”
16 Swedbank Analysis • August 1, 2012

17. Economic Research Department
Sweden
Cecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.se
Group Chief Economist
Chief Economist, Sweden
Magnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.se
Head of Economic Forecasting
Jörgen Kennemar +46 8 5859 7730 jorgen.kennemar@swedbank.se
Senior Economist
Anna Ibegbulem +46 8 5859 7740 anna.ibegbulem@swedbank.se
Assistant
Estonia
Annika Paabut +372 888 5440 annika.paabut@swedbank.ee
Chief Economist, Estonia
Elina Allikalt +372 888 1989 elina.allikalt@swedbank.ee
Senior Economist
Teele Reivik +372 888 7925 teele.reivik@swedbank.ee
Senior Economist
Latvia
Mārtiņš Kazāks +371 67 445 859 martins.kazaks@swedbank.lv
Deputy Group Chief Economist
Chief Economist, Latvia
Lija Strašuna +371 67 445 875 lija.strasuna@swedbank.lv
Senior Economist
Lithuania
Nerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.lt
Chief Economist, Lithuania
Lina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.lt
Senior Economist
Vaiva Šečkutė +370 5 258 2156 vaiva.seckute@swedbank.lt
Senior Economist
Swedbank Analysis • August 1, 2012 17

18. Disclaimer
This research report has been prepared by economists of Swedbank’s Economic Re-
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