bne -

As expected, Latvia on June 5 was given the green light from the European Commission and European Central Bank to join the euro. The institutions' approval was accompanied by expressions of concern over Latvia's banks and economy, but the Baltic country looks ready to leverage the news to issue more bonds.

With the European Commission's convergence report showing that Latvia comfortably beat most fiscal criteria for joining the Eurozone, a recommendation to the Council of Ministers to accept the Baltic country's application was always likely. A final decision - seen as a formality following the nod from the Commission and ECB - from EU member states is expected on July 9.

However, while Latvia has been praised for steering a course of strict austerity to find its way out of the deep recession it fell into in 2009 and put its fiscal affairs in order to meet the Eurozone's thresholds for deficit and inflation, the EU institutions noted two major concerns.

In the first instance, the high level of foreign (read: Russian) deposits in its banks is a concern, as has already been noted in Brussels this year in the wake of the banking collapse and subsequent messy negotiations in Cyprus. While the Latvian banking sector has long stored volumes of cash from Russia, inflows increased sharply over the past two years and is now at the forefront of minds across Europe.

Non-resident deposits currently amount to almost 40% of Latvia's annual GDP, and constitute around half of the total deposit base - a share which is substantially higher than in most other EU countries. "The reliance by a significant part of the banking sector on non-resident deposits as a source of funding, while not a recent phenomenon, is again on the rise and represents an important risk to financial stability," the ECB said.

At the same time, the institutions express worry that the adoption of the euro could hit a small economy still struggling for convergence with its Western peers in the EU, provoking inflation and magnifying the effects of the shadow economy. "Maintaining low inflation rates in Latvia will be challenging in the medium term, given monetary policy's limited room for maneuver," the ECB said. "Experience during the boom years of 2005 to 2007 shows that it may be difficult to control domestic price pressures and avoid renewed economic exuberance."

However, officials in Brussels were obviously keen to extoll the virtues of a country that is offering such a strong vote of confidence in the battered Eurozone, and is also often held up as an example of the benefits of austerity.

Commissioner for Economic and Monetary Affairs Olli Rehn said: "Latvia's experience shows that a country can successfully overcome macroeconomic imbalances, however severe, and emerge stronger. Following the deep recession of 2008-9, Latvia took decisive policy action, supported by the EU-IMF-led financial assistance programme, which improved the flexibility and adjustment capacity of the economy within the overall EU framework for sustainable and balanced growth. And this paid off: Latvia is forecast to be the fastest-growing economy in the EU this year."

He added: "Latvia's desire to adopt the euro is a sign of confidence in our common currency and further evidence that those who predicted the disintegration of the euro area were wrong."

Hard earned

The Bank of Latvia welcomed the approval, stating that it is a well-earned reward for the country's harsh austerity efforts over the past four years. "A positive Convergence Report is no surprise," the central bank said in a statement. "[I]t is neither coincidence nor good luck; it is a result of hard work of recent years, overcoming the crisis and developing a stable economic policy framework enabling Latvia to ensure macroeconomic stability and balanced long-term economic growth sustainable also in the future."

With an eye on criticism at home and abroad against the move to enter the troubled single-currency, the central bank insisted the case is compelling. "Latvia's euro changeover is a logical step since the euro as a currency plays a significant role in the Latvian economy already now. The euro is both the main settlement currency in Latvia's foreign trade transactions and the major currency in the balance sheets of Latvia's financial sector. Latvia has close economic and financial links with the euro area and the introduction of the euro will enable Latvia to engage in the ongoing discussions and analysis when developing the future policies of the euro area, becoming a participant in the process that will inevitably affect Latvia's economic outlook as well."

Notes Swedbank, a big player on Latvia's bankign market: "There are a few challenges/recommendations brought out for Latvia, for instance, regarding the big share of non-resident deposits in the banking system. Similarly to the case of Estonia, the ECB has concerns about sustainability of price stability in Latvia, given the continuing catching-up process with developed EU countries. However, we believe that these concerns and/or challenges will not be an obstacle for Latvia introducing the euro in January 2014."

Analysts at RBS say they fully expect Latvia to get the final go ahead in the summer, and for Riga to move swiftly to take advantage. "The final decision on July 9th for Latvia to adopt the Euro from January 2014 is nothing but a formality in our opinion," they write, "and should be a trigger for rating upgrades. We expect the Treasury to take advantage of these positive developments and tap international markets with a EUR1bn external placement in the coming few weeks."

Indeed, as bne has reported, Latvia has already lined up meetings with investors for June 10 with a view to issuing debt later this year, while earlier this week both Fitch and Moody's said that they are ready to review their ratings on the sovereign for upgrade once the country gets the nod to join the euro. Moody's said on June 4 that approval would reduce susceptibility to event risks and support the agency's positive outlook on its rating, which currently sits at the second lowest investment grade of 'Baa2'.

RBS says it expects to see an issue totaling €1bn soon, with other currencies to follow next year. "Latvia's hard currency borrowing target for 2013 is €1.14bn (LVL800m) and is mainly being raised to pre-finance 2014 debt repayments. The treasury is yet to tap international markets this year following the $1.25bn raised in December. We anticipate the treasury will likely issue a bond with a tenor of 10 years, given that most outstanding bonds are currently USD denominated. Following the €1bn placement, the Treasury would likely issue the remaining in CHF or a Scandinavian currency which would be of a shorter maturity, with the possibility of a yen-denominated issue in 2014.