Euro-adoption dilemma

EU

Wealth levels in the former communist states that recently joined the European Union are catching up with other members, thanks to heady economic growth.

But along with that growth has come inflation, now so strong it is getting in the way of another goal: euro adoption. Adopting the euro would be important proof that the countries have become part of mainstream Europe, while helping to boost exports and generally aiding macroeconomic stability. But under EU rules, inflation has to be tamed before the currency can go into use - and inflation-taming measures could cut into the economic growth that has lifted incomes.

Per capita income for the 10 former communist countries, including Poland, Hungary and the Baltic states, has risen to the point where it was 61% of the EU average in 2006, up from 47% in 1999, measured by GDP per person at purchasing-power standards. This is because economic growth is booming at more than double the rate for the rest of the 27-member free-trading block of about 500 million people. The rising wealth is helping to fulfill needs and wants in a region low on amenities for decades before the Soviet regime crumbled in 1991.

„Since the occupation ended, people have just been buying and buying, getting new cars and houses and grabbing whatever they could,” says Elina Zandersone, a student who works part time at Latvia’s Soviet Occupation Museum, which commemorates the country’s suffering under the Soviet Union’s rule and Latvia’s fight for independence. She can remember her father taking to the streets with Latvian crowds in January 1991 to stand united and barricade Russian tanks from storming Riga, the country’s capital.

The frenzied shopping spree is fueling rampant price increases: Inflation for the 10 former communist countries averaged an annualized 5.3% in August, while for the EU as a whole it was 1.9%, according to Eurostat, the EU’s statistics agency. To qualify for the euro, which was introduced into circulation in Europe in 2002 and is used by 13 states, a country needs to meet a list of criteria including limiting total state debt to no more than 60% of GDP; keeping its currency at a steady exchange rate against the euro for two years prior to adoption; and posting annual inflation that is no more than 1.5 percentage points above the average of the three lowest inflation rates of EU members.

Denmark, Malta and the Netherlands boasted the lowest rates in August, with an average of 0.9%. „We are very interested to join the euro as soon as possible, but, of course, we have this inflation problem,” says Latvia’s Prime Minister Aigars Kalvitis. Adoption of the euro is the next step for the formerly communist countries, after EU and North Atlantic Treaty Organization membership. Each of the 10 joined NATO in either 1999 or 2004.

Hungary, Poland, the Czech Republic, Slovenia, Slovakia and the three Baltic states of Lithuania, Latvia and Estonia joined the EU in May 2004, while Bulgaria and Romania joined at the start of this year. So far, only Slovenia has adopted the euro, switching over in January. Slovakia hopes to get the nod from EU finance ministers next year, with inflation and government spending under control.

Lithuania narrowly missed qualifying for euro adoption last year. Since then, „Lithuanian inflation is getting out of control,” says Lars Christensen, chief economist at Danske Bank in Denmark. The country’s inflation shot up to an annualized 7.1% in September from 5.5% in August.

The dilemma facing Latvia’s government on how to deal with its booming economy highlights a question hovering over the entire region: Should efforts focus on taming inflation, as required for euro-club membership, or greasing the economy still more to close the income gap to the rest of Europe?

Across these central and eastern European countries, meeting the criteria for the currency can involve harsh measures: raising value-added taxes, cutting social expenditures, introducing fees for medical services and overhauling pension systems. Latvia has developed the fastest-growing economy in the EU this decade after implementing free-market principles in the 1990s, such as privatizing nearly all industries and setting low tax rates.

Latvia’s corporate tax is 15%, nearly half the UK’s 28% rate. But its breakneck 11% annual economic growth rate in the second quarter propelled annual inflation to above 10% in August. Both figures were highs for EU members. Inflation continued to climb in September, to an annualized 11.4% rate. „There’s too fast development,” Kalvitis says. „On the other hand, people have to be happy with such a situation because everything develops. Riga, I think, changes every half year. ... Construction, cars, shops. You know, it’s very dynamic.”

The boom has helped Latvia close its income gap with the rest of the EU. It closed to 56% of the EU average, up from 37% at the start of the decade. Latvia, like most formerly communist states in the EU, is trying to cool its economy and reduce inflationary pressures, both to adopt the euro and prevent overheating. Kalvitis plans to ease government spending - including a freeze of government-worker wages - to post a 1% of GDP surplus next year instead of merely a balanced budget.

But he warns too much cooling could stifle needed growth and hurt convergence prospects with Europe. „We have to catch up to Europe as fast as possible, and we need more economic development than some other countries,” Kalvitis says. „We have to be very careful with our decisions.” Latvia’s GDP per capita is the lowest in the Baltics and above only Bulgaria, Romania and Poland of the 10 former communist states in the EU. … (Read more: wall street journal)

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