Although inflation in the Republic of Latvia (A-/Stable/A-2) has spiked in 2004, the country should still become a full member of the European Economic and Monetary Union (EMU) later in the current decade, says a report issued on December 14, 2004, by Standard & Poor’s Ratings Services.
This prospect will shield the foreign currency ratings on the sovereign from the negative pressures generated by Latvia’s sizable external deficits.
“There is broad cross-party consensus on the objective of joining the Eurozone in 2008, which was confirmed by the new Latvian Prime Minister Aigars Kalvitis in early December 2004,” said Standard & Poor’s credit analyst Remy Salters. “Moreover, the country has so far maintained a strong track record of prudent macroeconomic policy and adherence to EU membership requirements, leaving little reason to doubt that it will act with equal focus to meet EMU convergence criteria.”
Following a good performance in terms of disinflation and price stability in the past decade, Latvia’s inflation indicators have been diverging sharply from the EMU entry inflation target in recent months. The consumer price index (CPI) rose by 7.8% year-on-year in August 2004, and remained as high as 7.2% in November.
To qualify for full EMU membership on Jan. 1, 2008, Latvia will need to be assessed for compliance with the Maastricht requirements by the third quarter of 2007. Latvia’s average inflation rate in the 12 months leading up to assessment must not exceed the average of the three lowest-inflation EU member states by more than 1.5 percentage points. In October 2004, this equated to a reference rate of just 2.1% year-on-year, leaving Latvian inflation increasingly adrift of its target.
Although Standard & Poor’s sees inflation in the EU trending higher in the medium term, a number of countries are still expected to record inflation of little more than 1.5% in 2007, giving a reference rate of about 3.0% for the point at which Latvia plans to be assessed for EMU entry.
In practice, there are reasons to believe that the pace of Latvian inflation will henceforth slow down, peaking at an annual average of less than 7.0% in 2005, and falling below 3.0% by mid-2007.
The realistic worst-case scenario would be a brief postponement of full EMU entry, to January 2009, with inflation still overshooting marginally by year-end 2007,” said Mr. Salters. “We believe, however, that if inflation does not abate significantly, the Latvian government is likely to adopt whatever measures are needed to bring the headline rate into compliance for a 2008 entry, if necessary by tightening fiscal policy.”