TALLINN - Nomura International analyst Peter Attard Montalto says that Estonia, Latvia and Lithuania will keep their currencies pegged to the euro in a bid to prevent economic instability from spreading to Western Europe, reports bbn.ee. He feels that the three countries could switch to the euro as early as 2012.
"Adding more pain to the economy now [through devaluation] does not make sense, especially politically, particularly considering contagion risks to Western Europe via banking sector and financial market channels," says Montalto in his report. "We believe the [European] Commission is willing to provide whatever help is necessary to prevent a risk event."
While devaluation "cannot be ruled out," markets should realize that "[keeping the currency fixed] is a far safer way for a country to realign itself than de-pegging now."
The IMF recommended that Estonia cut its 2010 budget deficit and target fiscal balance to meet its 2011 euro-adoption terms. The government needs to cut spending more and raise taxes to achieve balanced budgets after 2011 due to a "high risk" of wider deficits once temporary budget measures expire.
UniCredit Group's main strategist Fabio Mucci says that Estonia's 2011 euro-adoption plan is ambitious. "The Estonian government has stayed with its plan to adopt the euro on the first possibility or, in 2011, despite the sharp economic recession. Controlling public resources and achieving a lower than 3 percent budget deficit is a clear challenge. The talks on next year's budget are ongoing, but I think that Estonia fails to have such a [planned] budget deficit with its tax income and increasing unemployment payments. 2010 will be difficult," Mucci said.
Professor at the University of Tartu Urmas Varblane says that Estonia's economic growth is dependent on euro-adoption. "If the decision of joining the euro-zone gets confirmation, then it distinguishes Estonia from the other Baltic countries and increases its reliability, on the international economic scene, even before Estonia has joined, and brings foreign investors," he claims.
Commenting on the gloating Estonians, The Economist writes that "Smugness is the Estonians' least attractive feature, at least in the eyes of their Baltic neighbors, Latvia and Lithuania. A surprise endorsement by the IMF for Estonia's plans to join the euro in 2011, coupled with gloom about the other two countries, will only make that worse."
All three Baltic states are facing double-digit economic declines in GDP for 2009, following the collapse of credit bubbles created by reckless lending and spending. Many question whether the three countries can maintain their fixed exchange rates, which tie the national currencies to the euro. A currency or banking collapse in the Baltic region would impact markets elsewhere, threatening economies such as Hungary's.
Plunging tax revenues make the Baltic countries' chances of meeting the criteria for joining the euro look slim. Latvia, for example, sees its government struggling to keep next year's budget deficit at 8.5 percent, a condition for the continuation of its 7.5 billion euro IMF-led bail-out program. To adopt the euro, the deficit must be sustainable, below 3 percent of GDP.
Estonia may, by the middle of 2010, have met all the criteria for joining the euro. Inflation remains low; government debt is negligible, and next year's budget calls for a deficit of 2.95 percent. The government cut spending sharply and early in the crisis. It also sped through modernization projects, financed by the EU, stimulating the economy.
Nevertheless, euro entry would not be a cure-all for the country. "It is not certain that joining the euro zone, even if it goes ahead as planned in 2011, would by itself trigger a major change in the pace of recovery of Estonia's economy," the IMF reported earlier.
Lithuanian President Dalia Grybauskaite thinks a devaluation of the national currencies of the Baltic states would be "completely useless," reports news agency ELTA. "Devaluation would be senseless in our region. It would be a shock therapy without a therapy."
She asserts that "the euro is not a goal for its own sake. The euro suggests financial discipline, which is indeed beneficial for economic development. We have only two choices: painful devaluation or a large reduction of salaries and the decision to live within one's income," she said.
Grybauskaite also says not to compare the Baltic states with Poland, which has managed to avoid deep crisis. "Poland had a different monetary policy at first. The zloty is not strictly pegged to the euro. [Devaluation] is beneficial when the country's competitiveness needs to be increased. However, there is no sense in doing that now as so far our export markets have been closed," she remarked.
The IMF, back in Latvia to review next year's budget proposal, says that Latvia's "precarious" governing coalition lacks political will, and that the crisis is unfairly hitting the poor. The lenders want Latvia to get rid of its flat tax and adopt a more progressive tax regime. Some groups in the government, including coalition member People's Party, resist such moves, saying that higher taxes would discourage entrepreneurs and that chaos in the state revenue office means that the higher rates would bring in little extra cash. Political infighting continues as the economy slides further.