European Affairs

Summer 2005

 

Economy and Finance

Lithuania - The Case for Quick Euro Entry

By Ramune Zabuliene

 

Lithuania has decided to join the euro as soon as possible and believes it can fulfill the entry conditions by the start of 2007, provided the national authorities continue to pursue prudent economic policies. We see many benefits in rapid participation in the single currency, and few, if any, disadvantages.

On the plus side, euro membership would completely eliminate exchange rate risk and abolish the risk premium in our interest rates, which would be set at European level, eliminate currency exchange transaction costs and make cross border payments easier, faster and cheaper. The euro would further integrate our domestic market with those of our partners. Price differentials for goods and services would become more transparent, enhancing competition.

Lithuania’s financial market would become an integral part of the world’s second deepest financial market, and our banks would be able to participate in the Eurosystem’s open market operations. This would allow banks to manage their liquidity more efficiently and obtain cheaper financing. A common currency would make some financial instruments more accessible, facilitate the use of more advanced risk management techniques, trigger further expansion of banking, particularly asset management products, and reduce their fees. More generally, the euro would fundamentally strengthen our financial system, make it more resilient to financial shocks, and stimulate investment and trade.

We hardly see any drawbacks in such a strategy. Lithuania, which already operates a fixed exchange rate regime through a currency board, gave up independent monetary policy more than a decade ago and has not since used it as an economic policy tool. Similarly, postponement of euro membership would not allow us to run higher budget deficits that might undermine current account sustainability. Introduction of the euro would not thus narrow our macroeconomic management policy choices.

Future inflationary pressures in our economy will have little to do with the euro. Various studies show that inflation rose very moderately, by only between 0.1 and 0.3 percentage points, in countries that have already introduced the single currency. It is true that the new EU member states will inevitably have somewhat higher inflation than the euro area as a whole over the medium to long term. But that will be due not to the euro, but to persisting differences in price levels and the complex phenomenon of catching up.

There are some costs involved in monetary reform, including printing and distributing new money, collecting and destroying old money, recalculating balances, changing information technology systems and spending on public information campaigns. But some of these costs, such as withdrawing old bills from circulation and updating IT systems, are not directly related to the euro; and the other costs will have to be borne sooner or later, as euro membership is obligatory for the new member states. There is no evidence that postponing the euro could deliver cost savings.

Lithuania is well on the way to meeting the so-called convergence criteria that are preconditions for euro entry. Our currency, the litas, has been linked to the euro in the European exchange rate mechanism (ERM2) for nearly a year without any problem - and we have voluntarily adopted a zero fluctuation margin, instead of the looser band of plus or minus 15 percent against the euro called for by the mechanism’s rules. We should have no difficulty in meeting the requirement of two years in ERM2 without severe exchange rate tensions.

The price stability criterion will be the most difficult for all the new member states, as it will take some time to lower their rather high inflation rates. At the same time, a benchmark of no more than 1.5 percent above the average inflation rate of the three best performing EU member states remains rather challenging. Particularly worrisome is the effect of higher oil prices, which for a number of reasons have a greater impact on inflation in Lithuania than in many other countries.

"Lithuania is well on the way to meeting the convergence criteria that are preconditions for euro membership"

Our estimates show that Lithuania’s 12-month average annual inflation rate around the middle of 2006 might be about 2.6 percent, right on the edge of the current reference value. On the other hand, exceptionally low inflation in the three best-performing countries, Finland, Denmark and Sweden, may not persist. And the Lithuanian government stands ready to pursue adjustment policy measures, such as more ambitious fiscal consolidation and rigid control of administered prices, if they are necessary to meet the inflation criterion.

Lithuania will have little difficulty meeting the budgetary criterion - a budget deficit not exceeding three percent of GDP - as our deficit is estimated to be 2.5 percent of GDP in 2005 and 1.8 percent in 2006. At the same time the central bank would only
welcome more ambitious fiscal consolidation, which might, under some circumstances, become a necessity rather than a desire. General government debt will stay at around 20 percent of GDP, which is well below the 60 percent convergence criterion, and Lithuania should have no problem complying with the long term interest rates requirement.

So, while the euro will undoubtedly be beneficial for Lithuania, continued, thorough preparation will be necessary. Fulfillment of the economic convergence criteria at the beginning of 2007 is
realistic, but the national authorities must carefully monitor macroeconomic developments and pursue cautious economic policies.

In joining the euro, we shall be guided by the best practices in other countries. Given the scope of the necessary preparations, the remaining timeframe before possible euro introduction is rather challenging. Nevertheless, reliance on our own expertise and on the experience of euro area countries, alongside the fact that preparations started some time ago, makes us feel confident that we shall be ready on time.

Ramune Zabuliene is Deputy Chair of the Board of the Bank of Lithuania. She previously served as Economic Adviser to the Mayor of the City of Vilnius and Adviser to the Prime Minister of Lithuania. She has also been a consultant and executive officer at the World Bank and head of the World Bank’s Lithuania Office.