Latvia faces stern tests in euro

From his office near Latvia's border, Valka deputy major Viesturs Zarins can see the future. It's down the road, right at the supermarket and past the derelict house.

Across a disused border post lies Estonia, a euro currency nation that Latvia will next year emulate. From a quirk of history this town is split between the two countries, where some street vendors deal in euros and others in Latvian lats.

Latvia's adoption of the euro on January 1 may encourage investment and lower borrowing costs. The country's entry into Europe's single currency is also symbolic. It heralds another step by a former Soviet republic, still heavily dependent on Russia for energy, into the West.

But two months from Latvia's euro entry, locals like Zarins are unimpressed. Officials on both sides of the border are more concerned about uniting separate water, lighting and sewerage systems. There are few shops, some so bare and non-descript they appear to be stuck in a Soviet-era time warp.

Loyal to the Latvian maiden of their notes and coins, Latvians suspect the euro will raise prices - as they did up the road in Estonia. They fear the problems Latvia faces are intractable.

"I'm not that optimistic," said Zarins, referring to a local unemployment rate of around 12 per cent. "The main issue is unemployment. I don't see that the euro will solve this issue."

On the ground, touted benefits of the single currency fall on deaf ears. Unemployment on both sides of Valka is roughly the same. Estonia attracts more Latvians, but mainly because their side of the town is larger, has a better hospital and holds more rock concerts.

"It's our own currency, different from other countries, more beautiful," Laura Cera, a 23-year-old mother of two, said on the edge of a windswept housing estate. "Jobs? I don't think it will change."

Prices in the few shops are already being printed in euros. Because of the exchange rate, the euro figure is higher, reinforcing fears of inflation.

Problems of unemployment and emigration remain. Polls show voters of what will be one of the euro zone's poorest members still oppose membership. The potential destabilizing influence of Russia has surfaced - Moscow has stepped up trade and diplomatic pressure on the Baltics.

The European Union is generally happy Latvia is joining the currency bloc, bringing another voice in favour of fiscal prudence. But some say the euro zone is bringing in a problem child - a playground for Russian oligarchs and where foreign money, much of it Russian, accounts for half of bank deposits.

"Certainly there will be some quick gains," said Martins Kazaks, chief economist for Swedbank in Latvia. "But there are some risks. We should not fall asleep while driving."

"What happens with the education system, regional development or the business environment? What happens with infrastructure ... labour markets?"

AN INSURANCE POLICY

With Russia assertive on the border, the government is keen to emphasise the gains of tying itself close to the West. The government is mainly Latvian-speaking, while the opposition is mostly supported by a large Russian-speaking minority.

The split is reflected in attitudes towards the euro. Some ethnic Latvians say Russian-speaking communities are hostile to the euro because of a reliance on Russian media for the news.

Moscow appears frustrated at its lost influence and is using remaining leverage to pressure them to stay close. Russia suspended dairy products imports from Lithuania this month, weeks before it hosts an EU summit. Russia and Belarus held one of their largest military exercises near Latvia this year.

"This (euro entry) is certainly another insurance policy for some of the risks that we sometimes see when it comes to sometimes very changing relations with Russia," said Latvian Foreign Minister Edgars Rinkevics.

This year, NATO has scrambled jets 37 times to check on Russian jets approaching Latvia's border. That compares to once in 2004 when NATO first began patrolling here.

"It is important that countries like Latvia and Estonia, given their geopolitical situations, are in the eurozone," said Defence Minister Artis Pabriks.

Latvia is viewed by many EU policymakers as a poster child of austerity, an example of what southern Europe could achieve. Latvia's government has signaled it will side with northern Europe over economic policy.

Refusing to devalue its currency after the 2008 global financial crisis, Latvia pursued a policy of spending cuts coupled with redundancies and wage cuts that wiped out a fifth of its GDP.

Its public debt is now around 41 per cent of GDP, below the EU ceiling of 60 per cent, and its currency was pegged to the euro in 2005 after it joined the EU. Latvia is now the EU's fastest growing economy, expanding by 5.5 per cent in 2012.

"We certainly want to work and closely cooperate in the Nordic-Baltic-Polish-German kind of league," Rinkevics said. "I want to see that this group of countries is really leading Europe with sounder policies."

But on the ground there are concerns European enthusiasm belies problems for an economy that has been bleeding workers to its richer neighbours. The population has fallen from a peak of 2.67 million in 1989 to 2 million in 2012.

There are also concerns, echoed in Estonia, that a poor country may find itself contributing to future euro zone bailouts. "(This is) one of the things being debated and seen as a negative consequence," said Latvian Prime Minister Valdis Dombrovskis.

DOUBTS

Skepticism is felt a short drive outside Riga, where an historic centre is quickly replaced by drab Soviet-era buildings. On one such complex lies Olainfarm, Latvia's second largest drug manufacturer.

Board member Salvis Lapins hopes the company will benefit from lower foreign exchange costs. But he fears a rise in inflation - seen in Estonia. The last currency switch, from a Soviet rouble to the Latvian rouble and then to the lat - saw inflation explode and eat into savings. The memory lingers.

"Whatever the government says, there will be price rises," Lapins said. "This will inevitably lead to salary pressures."

A labour shortage is complicating life for the firm, which had sales of around 70 million euros last year and employs over 1,000 workers. Half of senior research positions have come from abroad - mainly Russia and Belarus. There are difficulties in finding mid-level staff like equipment operators.

"Ten years ago they were talking about some huge Coca Cola factory for the whole of Eastern Europe. That is simply not possible," Lapins said. "If you need to hire a thousand people you don't have those people. I don't see any big company developing in Latvia in the next 50 years."

But growth in companies like Olainfarm will be essential for the wider economy. OECD senior economist Andreas Woergoetter says Latvia will need to grow 4-5 per cent annually to avoid more emigration.

"They live in a rich neighborhood. They don't have a lot of time for income convergence. Major reforms will be necessary to achieve growth rates of that magnitude," said Woergoetter.

One of Latvia's hardest tasks will be to ensure growth does not produce bubbles. House prices in Riga are rising, boosted by a policy that has allowed mostly wealthy Russians to gain residency - and access to the Schengen area of unimpeded travel across Europe - by investing around 140,000 euros (S$240,000) in property.