Tuesday, 22 January 2019

Quietly opening the door

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  • Quietly opening the door

The former soviet Baltic state of Lithuania was welcomed into the club of euro countries at its second attempt.

This year saw the eurozone welcome its newest member: Lithuania. A tiny economy that has long pegged its currency to the euro, the union was never likely to attract much attention. But what attention it did get was universally favourable, with all predicted disruption averted, representing a welcome piece of good news for the troubled currency block.

In January, Lithuania became the last of the Baltic states to formally join the eurozone. In doing so it is finally completing a journey it had attempted to take in 2006, when the attempt was aborted at the last moment due to inflation being slightly above the permissible threshold.

This time, with inflation at a negative 1.7%, compared with 0.2% a year ago, there was no reason for Lithuania not to become the 19th member of the eurozone.

The prospect of joining the euro had divided opinions in Lithuania.

“A small majority of people were actually against this change because they thought the transition might be quite disruptive, but people are happy now because things went smoothly,” said Simonas Gustainis, managing partner at BaltCap, a private equity and venture capital group investing in the Baltic states.

Price rise fears

The big worry had been that joining the euro would usher in a wave of price rises, as it had for some other accession countries in the past. However, with Europe now experiencing deflation, that had never looked likely to be a major problem.

Others had argued that former Soviet states were well positioned to cope with the challenges of changing the domestic currency, and Lithuania itself has experienced multiple currency changes in recent decades.

However, its last change was decades ago and in recent memory Lithuania has enjoyed a relatively stable currency in the lita, which has long been pegged to the euro.

In reality, the smooth transition owed more to the experience on the European side of the process than the Lithuanian side.

“The ECB and the technocrats have experience of how this works now and that has ensured the process has been smooth, with no mishaps,” said Marcus Svedberg, chief economist at East Capital. The fact that the lita had been pegged to the euro since 2002 also helped ensure this smooth transition.

However, with the change-over complete, Lithuania will now be inextricably linked to its largest trading partner. Membership of the single currency has therefore reduced market and exchange rate risk for its corporates and reduced borrowing costs, not only for companies but for the state itself.

Gustainis said: “Our businesses in Lithuania have not been particularly affected by the change. There was a small risk of the lita decoupling with the euro if there was a financial crisis, which has now disappeared, so that is helpful. But in terms of their ability to finance themselves there has been no change. The financial system was already very sound and most borrowing was in euros anyway, so for the banks there is no change.”

New set of challenges

But Lithuania now faces a new set of challenges. “Over time, Lithuania is likely to see a reduction in the cost of credit and a reduction in interest rates, which will ultimately push up real estate prices relative to consumer prices,” said Sylvain Broyer, head of economics at Natixis.

Broyer warned that European monetary policy could prove too expansive for Lithuania.

“It will need a more restrictive fiscal policy to balance growth and ensure household and corporate debt does not increase rapidly and create similar problems to those seen in Spain and Ireland,” he said.

The country had been a strong candidate for euro accession, the ECB having been more careful about letting nations join than it was back in the days when Greece was waived in – as demonstrated by Lithuania’s failure to join in 2006.

“Back then, Lithuania didn’t fulfil just one criterion, as its inflation exceeded the required minimum by a hair’s breadth,” said Liza Ermolenko, emerging markets economist at Capital Economics. “This time round the economy comfortably fulfilled all of the criteria: its inflation is extremely weak – it’s in deflation – and public finances are in a healthy state.”

As such, its entry into the eurozone will make no discernible difference to the economy of the eurozone itself. Lithuania represents around 0.5% of the block’s overall GDP. Europe may be taking on a relatively weak economy, but its new member brings certain, non-economic advantages.

“It is good PR for Europe that, despite all its problems, it still has countries wanting to join the eurozone,” said Svedberg.

Political impact

“The real impact of Lithuania joining the euro was political,” said Broyer. “The addition of the 19th member led to a change in the voting system within Europe, which increased the pivotal power of the ECB board. Without Lithuania joining the euro we may never have had European QE.”

Lithuania had demonstrated considerable commitment to its euro peg, maintaining it even in 2008–09 when its exchange rate looked very overvalued, undermining its competitiveness. And while this commitment has caused it pain at times, such as in the depths of the financial crisis, it has already enjoyed the benefits of proxy membership.

“The markets had priced in Lithuania’s accession, helping it to perform better than its Baltic peers in 2014,” said Svedberg.

“The central bank said it would boost growth by around 1.3% per year, which is probably a bit on the optimistic side. I doubt it will be worth that much because the country was already part of the eurozone in all but name, considering the currency peg and the expectation that it would eventually join. But it always helps for FDI when there is stability and this does make the prospect of a devaluation less likely, so it is positive for Lithuania.”

Although joining the euro always looked likely, it was not a foregone conclusion. Technically, it also had the option of remaining outside the currency union and removing the euro peg to devalue the currency.

There were disadvantages to joining the euro as well as advantages, said Ermolenko. “It officially drags Lithuania into the eurozone crisis and it means the country no longer has the last resort option of monetary policy independence, which it did not use due to its peg but had in case of emergency,” she said.

She added: “As a small country stuck between Europe and Russia it had to make a choice, and though a significant minority in the country are pro-Russian, the choice was never in doubt. It is a very different situation to Ukraine, which is much closer to Russia geographically and culturally. Lithuania has always felt more European than Slavic. Where the Ukrainian language is similar to Russian, Lithuanian is completely different.”

However, Svedberg said that rejecting euro membership, while making economic sense, was never a real option.

“Lithuania has had different governments but one thing they shared was a commitment to joining the euro. Lithuanians saw it as a return to Europe, it represented political integration and security.”

What eurozone membership will not do is transform the outlook for an economy that faces many economic and political challenges.

Tricky relationship

“The future does not look too bright for Lithuania,” said Ermolenko. “It has a tricky relationship with Russia, which which it does a lot of trade; given the eurozone economy is not strong either, that could hurt its economy. It will have to rely on domestic demand for growth. But the big concern is its falling competitiveness.”

With domestic demand being the key driver of growth, it will be interesting to watch what happens to Lithuania’s current account, as well as credit and debt levels, she added. However, “so far there seem to be few reasons to be concerned”.

A bright spot could be the prospect of moderately improved oil prices in the second half of the year and beyond, which would be a boon for Lithuania’s small oil industry, and for its economy. Although cheaper oil is tantamount to a small tax cut for consumers, it is a net negative for the economy as a whole.

But for now, with Lithuania out of the way, others, such as the Czechs, are again discussing entry. That seems a long way off for now, but Europe can at least congratulate itself that it still has members wanting to join, and that it has the experience to usher them in without drama or fanfare.

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