The past two decades have been turbulent for the Latvian economy. After gaining independence in 1991, the country made quick economic reforms to meet the criteria to join the European Union (which happened in 2004). The Europeans saw Latvia as a success story because the country had an average annual growth of 10 percent between 2004 and 2007 — greater than growth in Estonia and Lithuania, the other Baltic countries, which joined the European Union in 2004 and also experienced high growth rates.
However, this economic growth was fueled by cheap credit, massive current account deficits and wage increases that exceeded productivity. As a result, Latvia felt the full impact of the international crisis in 2009, when its gross domestic product contracted by 17.7 percent, the highest annual drop in EU history. Unemployment soared from 5.4 percent in the final quarter of 2007 to 20.7 percent in the first quarter of 2010 (at that time, the highest unemployment rate in the European Union). Parex Bank, the country's second-largest bank, was nationalized, and Riga was forced to request a 7.5 billion-euro loan (equivalent to $10.7 billion in 2009) from the International Monetary Fund and the European Union.
Latvia's Reforms
Latvia decided to undertake massive fiscal consolidation, equal to 15 percent of the country's gross domestic product. This included tax hikes (Riga raised the value-added tax from 18 percent to 21 percent, applied excise taxes on tobacco, alcohol and natural gas, and increased the real estate tax, among others) and substantial expenditure cuts (including a reduction of the number of employees in the public sector, wage cuts, the abolishment and merging of public institutions, the elimination of subsidies in sectors such as agriculture and transportation, and cuts in social welfare, health care and education).
These measures helped to stabilize Latvia. The country's economy grew 5.5 percent in 2011 and 5.6 percent in 2012, while the European Union grew only 1.6 percent in 2011 and contracted 0.3 percent in 2012. Moreover, Eurostat has projected that Latvia will grow 3.8 percent in 2013 and 4.1 percent in 2014, the highest growth rates in the European Union. Unemployment in Latvia was 14.1 percent in the final quarter of 2012, considerably below Spain, Greece and Portugal. Riga also took the central government deficit from 9.8 percent to 1.2 percent of gross domestic product between 2009 and 2012, while gross debt (which went from 19.8 to 36.9 percent of gross domestic product between 2008 and 2009) is currently stabilized at 40.7 percent.
This has made Latvia a controversial case in the European Union, particularly at a time when austerity measures are under discussion in Brussels and most EU capitals. Defenders of Riga's policies argue that Latvia proves that a sound fiscal stabilization program can lead to economic growth. From this perspective, Riga's early reaction to the crisis enabled a fast economic recovery, while countries in the eurozone periphery such as Greece, Spain and Portugal are suffering the consequences of their failure to apply effective reforms in time.
However, critics argue that the reforms have worsened the quality of life in the country. According to Eurostat, four out of 10 Latvians are at risk of poverty and social exclusion, the third-highest rate in the European Union after Romania and Bulgaria. This segment of the population has been particularly hurt by recent spending cuts in health care and welfare. In a 2012 report, the International Monetary Fund expressed concern about Latvia's growing income inequality and recommended that Riga apply a comprehensive reform of the social safety system to fight poverty. In this context, emigration from Latvia — whose population is barely 2 million people — grew from roughly 10,000 in 2010 to 30,000 in 2011.
Domestic Constraints
The government of Prime Minister Valdis Dombrovskis is determined to join the eurozone. On Jan. 31, the Latvian Parliament approved a law on fiscal discipline designed to keep the government's debt below 60 percent and deficit below 3 percent of gross domestic product, the thresholds established by the European Union for countries willing to join the currency union (the so-called Maastricht criteria).
While the EU Commission's endorsement is a significant step toward the euro, the issue will generate a strong debate at home. Recent opinion polls suggest that roughly two-thirds of the population of Latvia is against joining the common currency. Latvia's currency, the lat, has been pegged to the euro since 2005, but fear of a renewed economic crisis and the potential risk of inflation explain public rejection of the decision to join the currency bloc.
According to Latvian law, a referendum on eurozone membership is not necessary, but a nongovernmental organization called Latvia For Lats is trying to prevent Latvia from entering the currency union. The organization first tried to collect signatures for a referendum on Latvia's euro accession, but the Central Election Commission rejected the proposal in March. Latvia For Lats is currently collecting signatures for a referendum to dissolve the Parliament, an event that would delay Latvia's eurozone accession.
Additionally, some lawmakers from the centrist opposition party the Union of Greens and Farmers are pushing for a referendum. But Harmony Center, Latvia's main opposition alliance, recently announced that it did not support the idea of the referendum.
After receiving the European Commission's endorsement, Latvia needs support from the EU heads of state and government, who will meet June 27-28; the EU economic ministers, who will meet in July; and the EU Parliament, whose decision will be announced no later than July.
Joining the euro is a significant part of Latvia's geopolitical strategy to grow closer to Western Europe in order to reduce Russian influence in the country. Entering the currency union is the next step of a strategy that began with Riga's accession to the European Union and NATO. Additionally, Dombrovskis recently stated that he is concerned about the growing political fragmentation between eurozone and non-eurozone countries and suggested that it is in Latvia's interest to belong to the "core" of Europe (understood as the currency union). As a result, Latvia likely will become the 18th member of the eurozone, even if the decision is controversial at home.
