Ilmars Rimsevics: The Latvian strategy for the euro transition
Opening remarks by Mr Ilmars Rimsevics, Governor of the Bank of Latvia, at the Conference "Banking
and Finance in the Baltics 2004", Riga, 25 October 2004.
* * *
Ladies and Gentlemen!
It is my pleasure indeed to be here today and to address this distinguished audience, to make use of
this opportunity of sharing views regarding Latvia's EMU accession!
For a number of years Latvia has worked hard to become a NATO member, to become an EU
member. We have successfully put these challenges behind us. The question now is - what lies
ahead? To my mind the most exciting exercise and challenge faced by the Latvian central bank, our
government and our society in general is the EMU accession project.
This project has been outlined relatively recently and is being implemented as we speak. It is no less
demanding, I guess, than achieving NATO and EU membership. Quite a lot has been said already
about the budget deficit and overheating of the Latvian economy and I think that the message of the
central bank has been heard. Therefore I would like to concentrate more specifically this morning on
how we see the road ahead of us.
As you know, in accordance with the EU legislation stipulates that, by joining the EU, we commit
ourselves to introducing the euro as legal tender in Latvia sooner or later. Latvia undertook to observe
this legislation with a convincing majority of votes in the 2003 referendum. Hence the question is not
the question is WHEN it will happen.
WHETHER the euro will be introduced in Latvia,
For this process to be as successful as possible, it should be guided by three basic principles. It
should:
• easy to understand and transparent
be - i.e. any person living in Latvia, without doing any
complicated calculations, must be able to follow how the exchange rate between the lats and
the euro is set and quickly make sure whether the existing rate has been set correctly ;
• provide for equal treatment
of all individuals and group interests of enterprises - i.e. no
social group should gain advantages at the expense of other groups as a result of the
change of the peg;
• provide for stability - i.e. it must not give rise to speculation and weaken the
macroeconomic stability in the country.
The euro is becoming the most frequently used currency in the Latvian foreign trade transaction
(Fig. 2*). The majority of Latvian entrepreneurs also want stronger ties between the Latvian currency
and the euro (Fig. 3*). With that and the principles just mentioned in mind, the Government and the
Bank of Latvia have worked together to develop a three-stage strategy for the introduction of the euro
(Fig. 4.*):
At the beginning of 2005, the lats is pegged to the euro. Latvia will strive to join the Exchange Rate
Mechanism (ERM) II soon thereafter.
•
In 2007 - spring, at the earliest - the EU institutions give their evaluation of Latvia's readiness
to join the euro area
•
after receiving a positive evaluation, Latvia would expect to receive an invitation to join the
EMU. Then, at the beginning of 2008, the introduction of the euro will begin. Let us explore
each stage in more detail.
First - about the first stage that is only a couple of months away.
change of the lats' peg exchange rate
That is - about the and the chosen level between the lats and
the euro. We have considered all arguments and summed up all the pluses and minuses.
As most of you may know, the Bank of Latvia has made a decision to peg the lats to the euro on
January 1 of 2005
in accordance with the market rate. This market rate would be registered on the
last business day, December 30, 2004. By pegging the lats to the euro, the Bank of Latvia will neither
lats: it will neither be devalued, nor re-valued.
increase nor decrease the value of the
Use of SDR formula in setting lats exchange rates
remind ourselves of the
To better understand the basis for our decision, it might be helpful to
mechanism
whereby the exchange rate between the lats and the euro is set at present. As you know,
the lats is pegged to the SDR basket of currencies, the IMF unit of settlement - the Bank of Latvia's
official exchange rate between the lats and the SDR is 0.7997:1. It has remained unchanged since the
beginning of the peg in February 1994.
Taking into account the exchange rates between the currencies in the SDR basket and the fixed
exchange ratio between the lats and the SDR basket, the official lats' rate against the other currencies,
including the euro, is also determined every business day. Since the mutual exchange rates of the
principal world currencies, which are all part of the SDR basket - the US dollar, euro, Japanese yen
and British pound sterling - are constantly, and often significantly, fluctuating in the global currency
market, the exchange rate of the lats against the US dollar, euro and other currencies undergoes
similar fluctuations (Fig. 5.*). Thus, for instance, today's exchange rate between the lats and the euro
(0.676 lats for one euro) has been set as follows: on October 22, at about 8:30 a.m. the mutual
exchange rates of the SDR basket currencies were registered and, applying the SDR formula, the
SDR/USD exchange rate was calculated. Since the LVL is pegged to the SDR, it is easy to calculate
the LVL/USD exchange rate. The LVL/EUR exchange rate is obtained by multiplying the EUR/USD
exchange rate with the LVL/USD exchange rate.
The same formula to be used for lats repeg
This same principle, using the exchange rates on the global market, will be employed when setting the
lats exchange rate against the other currencies on the last business day of this year, December 30,
and this rate - based on the mutual exchange rates of the principal world currencies and the
relationship between the lats and the SDR basket fixed by the Bank of Latvia - will be the one that will
apply as the Latvian entrepreneurs and the population at large start their first working day of 2005,
January 3. The lats exchange rate fluctuations against the other currencies will be determined by the
fluctuations of the euro exchange rate against these currencies on the global currency markets. Taking
into account the global fluctuations of exchange rates so far, it is a rather safe prediction that, as of
next year, the fluctuation band of the lats' exchange rate against all other currencies, except the euro,
will widen. For example, if the lats had been pegged to the euro already at the beginning of this year,
then in the time period between January and October its exchange rate against the US dollar would
have increased not only by 0.4% as it in fact did (Fig. 6-7*) but by 1.1%.
More exchange rate fluctuation for currencies other than lats and euro
Thus an increase in exchange fluctuations is possible for entrepreneurs who conduct important trade
transactions in currencies other than lats or euros. Every time when discussing the schedule for the
re-pegging, the central bank has warned that these entrepreneurs should be thinking about ways of
give sufficient time for
preventing the possible currency risk increases. To this end - that is, to
preparation
both to the entrepreneurs and the banking sector - the date for the currency re-peg was
chosen: more than a year after the referendum on Latvia's accession to the European Union.
According to the poll conducted by the Bank of Latvia of entrepreneurs and bankers, one year is
enough time for anyone to evaluate, without undue haste and also without needless procrastination,
the consequences of the currency re-peg on their everyday life and to make all the relevant
arrangements.
Joining ERM II will serve as an additional stimulus for all the relevant state institutions to expend
maximum effort to ascertain that Latvia fully meets all the requirements in the shortest time possible
and thus maintains its credibility in the eyes of both the local population and foreigners.
Fluctuation band +/- 1%
Although the official exchange rate of the lats set by the Bank of Latvia will remain fixed, the interbank
market rate, which the banks use in their mutual currency transactions, will allow for a certain
fluctuation band. That will ensure successful functioning of the foreign exchange system without
continual interventions by the Bank of Latvia. Although the EU Treaty provides for permissible
currency fluctuations of +/- 15% of the set central exchange rate within ERM II, the Bank of Latvia is
planning to one-sidedly limit the lats exchange rate against the euro to +/-1% of the central rate. This
would have two important advantages.
•
First, the hitherto existing width of the fluctuation band, which has proved beneficial in
practice, would be maintained.
• Second, maintaining the existing +/-1% fluctuation band around the fixed rate would ensure
a steady and streamlined transition from one peg to the other.
It is a well known fact that over the past few years the interbank lats exchange rate has not fully
coincided with the central rate set by the Bank of Latvia, hovering instead around the lower limit of the
fluctuation band because of the continued high demand for lats. If the situation remains unchanged at
the moment when the lats is re-pegged to the euro at the end of 2004 and beginning of 2005, then the
lats interbank rate will also remain closer to the lower limit of the new fluctuation band around the fixed
lats exchange rate against the euro. That will allow us to re-peg the lats, avoiding sudden and
unexpected jerks in the lats exchange rate. In our opinion, it will serve to improve the transparency of
the process and prevent unnecessary speculations.
Meeting Maastricht criteria
After joining ERM II, the next step toward the introduction of the euro will be meeting all the relevant
Maastricht criteria. We have spoken about them quite a lot. As we have seen also in the previous
presentation - the only criterion we are not fulfilling at the moment is inflation. However, we believe
that there is sufficient time for Latvia to meet it. A year or so ago we were perhaps not thinking that this
would be such a difficult task: as you know the inflation forecast for this year is closer to 7%. But
forecast by the Bank of Latvia of inflation for 2005 puts it between 4 and 4.5% and we believe that by
the time Latvia has to bring its inflation in line with the Maastricht criteria - by the end of 2006 and
beginning of 2007 - we will be able to fulfil the inflation criterion as well. In fact I am convinced that
there are no other challenges apart from inflation for us to receive a positive convergence report in
which the European institutions, the European Commission and the EU Council, recognize Latvia's
readiness to join the euro area and introduce the euro. In accordance with the effective EU legislation,
joining ERM II means that the earliest such a report is received would be the spring of 2007. If this
report is favourable to Latvia, then, as of 2008, replacing the lats with the euro could begin. Speaking
about this plan of introducing euro, I should say that it looks realistic.
The interval between the spring of 2007 and the beginning of 2008 is needed for the entrepreneurs
and merchants to make the preparations necessary to provide for a smooth and problem-free euro
introduction process. We also believe that during this interim period all prices should be quoted both in
lats and in euros, which would allow the population to get used to the new price structure and prevent
an unnecessary price hikes.
However, it is not possible to quote the prices in both lats and euros before a positive convergence
report has been received and Latvia is invited to become a full-fledged EMU member.
The government euro plan in a nutshell
This is what the Latvian Government strategy for euro introduction of euro looks like in a nutshell,
developed jointly by the Finance ministry and the central bank. It is our opinion that only a consistent
and sequential implementation of the steps I have just outlined constitutes the optimum strategy
meeting the relevant requirements: it is transparent, economically sound and understandable, it
prevents discrimination and any, even theoretical, possibility of speculation. We believe that any other
option would be a violation of the principles of transparency, equal access or stability and therefore
would not be optimal.
Another scenario that has been often suggested in relation to the re-peg envisions pegging the lats to
the euro not in accordance to the market rate of the given day but on the basis of the average
exchange rate of the entire year 2004. This scenario is based on the argument that on the last days of
any year there are always increased fluctuations on the currency markets. First, I should point out that
data at our disposal seem to indicate that this is not quite the case (Fig. 8*). Second, such a solution
would violate the requirement that the re-peg be transparent: it would be very hard or even impossible
to justify choosing the average exchange rate of the last 12 months over, say the last six or sixteen.
Moreover, given the exchange rate dynamics between the lats and the euro this year, it is quite
possible that the existing market rate would only differ from the average rate for the whole year for less
than one santims (a few base points) (Fig. 9*). It is highly doubtful that correcting the exchange rate in
this small amount would have a serious effect on the economic processes. At the same time,
implementing this scenario would set a needless precedent of the exchange rate of the lats
undergoing desultory changes as soon as it has been re-pegged. That would be in direct contradiction
to the objective of stability and predictability and would give rise to needless speculations. Therefore
we believe that implementing this scenario would also be less than feasible.
To recapitulate, I would like to stress once more that since Latvia's accession to the European Union
one of the main tasks shared by the Bank of Latvia and other state institutions is to ensure that Latvia
join the euro area in a timely and balanced manner and to replace the lats with the euro. The currently
adopted euro introduction strategy envisions that under successful cooperation between the
Government, the Bank of Latvia and commercial banks, Latvia will be able to meet all relevant criteria
and begin introducing the euro as of 2008. I can assure you that, as far as the Bank of Latvia is
concerned, we will spare no effort to ensure that this process in all its stages is as peaceful and even,
and successful as possible.
The Latvian Strategy for the Euro
The Latvian Strategy for the Euro
Transition
Transition
Ilmārs Rimšēvičs
Governor of the Bank of Latvia
October 25, 2004
The The importance importance of of the the euro euro in in the the Latvian Latvian economy economy is is
gradually growing
gradually growing
Structure of the SDR basket and Latvian foreign trade currencies
Foreign
USD
17%
22% trade turnover
17%
2002.
13%
EUR
32%
4%
4%
SDR
12%
39%
basket
GBP
of
curren
Foreign
JPY
cies
trade turnover
1st quarter
36%
2004 Other
47%
57%
Results of the euro poll: by and large,
Results of the euro poll: by and large,
enterprises enterprises support support the the BoL BoL strategy strategy
Answers to the question:
Which, from the perspective of your company, would be the
desirable peg of the lats?
60
50
40
30
20
10
0
Euro SDR Dollar Any
BIS Review 65/2004
Euro introduction timetable
Euro introduction timetable
2007 2008
2004 2005 2006
Latvian convergence Latvia joins
Latvia accedes
Lats pegged to
report published EMU,
to the EU
the euro, Latvia
introduces
joins ERM II
the euro
Lats' peg to the SDR basket means less
exchange rate fluctuation
0.85
0.70
0.90
0.95
0.65
1.00
0.60
1.05
LVL/USD
EUR/USD
1.10
0.55
1.15
0.50
1.20
0.45 1.25
I II III IV I II III IV I II III IV I II III IV I II III IV I II III
1999 2002 2003 2004
2000 2001
LVL/USD EUR/USD
Lats Lats exchange exchange rate rate against against SDR SDR set set by by the the BoL BoL and and
quoted quoted on on the the interbank interbank market market
Lats/SDR
0.8100 0.8100
0.8080 0.8080
0.8060 0.8060
0.8040 0.8040
0.8020 0.8020
0.8000 0.8000
0.7980 0.7980
0.7960 0.7960
0.7940 0.7940
0.7920 0.7920
0.7900 0.7900
Jan.2003 Mai.2003 Sep.2003 Jan.2004 Mai.2004
LB ask LB bid KB ask KB bid
Lats exchange rate against the euro set by the BoL and
Lats exchange rate against the euro set by the BoL and
quoted on the interbank market
quoted on the interbank market
0,69
0,68
0,67
0,66
0,65
0,64
0,63
0,62
0,61
0,60
Jan.2003 Mai.2003 Sep.2003 Jan.2004 Mai.2004 Sep.2004
LB ask LB bid KB ask KB bid LVL/EUR spot
Currency market volatility is not greater on
Currency market volatility -- is not greater on
the the last last day day of of the the year year
Exchange Exchange rate rate of of the the euro euro against against the the lats: lats : would would
pegging pegging to to the the average average instead instead of of the the market market rate rate be be
more favourable?
more favourable?
0.6850
0.6825
LVL/EUR spot rate Average LVL/EUR rate in 2004
0.6800
0.6775
0.6750
0.6725
0.6700
0.6675
0.6650
0.6625
0.6600
0.6575
0.6550
0.6525
0.6500
1-Jan
8-Apr 6-Mai 9-Sep
15-Jan 29-Jan
12-Feb 26-Feb 22-Apr 20-Mai 12-Aug 26-Aug 23-Sep
11-Mar 25-Mar
BIS Review 65/2004