The Eurozone is now 18 Nations Strong

The Eurozone is making a U-turn.

For the last few years, the Greek government’s debt crisis has driven talk about downsizing the the Eurozone. It has instead gone the opposite direction by adding a new member to its elite club.

On January 1st, the Baltic nation of Latvia officially became the Eurozone’s 18th member.

“It’s a big opportunity for Latvia’s economic development,” Latvia’s prime minister, Valdis Dombrovskis announced in a press conference.

“Latvia will enter the euro area stronger than ever, sending an encouraging message to other countries undergoing a difficult economic adjustment,” European Commission President José Manuel Barroso expressed his optimism.

And a difficult adjustment it has been for Latvia, the fourth-smallest economy of the now 18 member Euro currency zone. After stellar GDP growth topping 10% in each of 2006 and 2007, foreign investments during the global crisis of 2008 dried up, widening the nation’s deficit and severely cutting its GDP by 18% in 2009 alone.

Yet its government has been hard at work since then, reducing Latvia’s fiscal deficit from 7.7% of GDP in 2010 to 2.7% of GDP in 2012, with 16 consecutive quarters of GDP growth since early 2010 averaging 4.6% annual growth throughout.

But will entry into the Eurozone work out for the small nation of 2.8 million people, over 50% of which are opposed to membership? And will this former satellite state of the ex-Soviet Union face reprisals from Russia for shifting its allegiance from east to west – which it began by joining NATO and the European Union in 2004, and has finally completed by formally adopting the Euro and all the other Eurozone ties that go along with it?

Russia has already managed to strong-arm the Ukraine back into its economic family. Might Latvia be next? Russia’s tactics can be very persuasive.

Russia Makes its Disfavor Known

With over 27% of its population being of Russian heritage, and with 18% of its exports being purchased by Russia as its largest trading partner, Latvia may face economic opposition in the marketplace and political opposition at the poles.

Still a predominantly resource-based economy, Latvia’s chief exports of food products, wood and wood products, metals, machinery and textiles are already subject to stiff competition from other Eurozone members, heightening its reliance on Russian purchases. Recent economic sanctions by Russia on Estonia which joined the Eurozone in 2011 and Lithuania which is due to join in 2015, plus its recent pressure on the Ukraine when it started cozying-up with the E.U. must have Latvia concerned.

In September, Russia stiffened border checks and tariffs on Lithuanian freight, and in October banned imports of its dairy. The Latvian government has openly criticized Russia’s tactics as politically motivated. “Latvia fully supports Lithuania against unfounded trade sanctions by Russia. EU must act in unity,” Latvia’s Foreign Minister Edgars Rinkēvičs tweeted.

Then last week Russia imposed a ban on eleven Estonian dairy and fish exporters effective January 9th, citing failed inspections of their products in October. The head of the Estonian Veterinary and Food Board, Ago Pärtel, revealed to Estonian Public Broadcasting that “the ban follows a previous pattern whereby Rosselkhoznadzor [the Russian veterinary and phytosanitary surveillance office] bans products, then negotiations open, and the bans are alleviated or dropped”.

It’s an effort to “remind” the small Baltic states of their continued dependence on Russia.

The European Central Bank is also quite aware of such a heavy economic dependency on Russia among all Baltic states and Latvia in particular, going as far as to warn its newest member that its high levels of Russian foreign deposits are a serious “risk factor”. Should Russia cut Latvia off completely, the small country with the population of an average American city whose $38 billion GDP is smaller than the annual income of many corporations could once again relapse into crisis.

The EU vs. Russia

Further heightening the urgency for Latvia to build new ties with other economies is Russia’s program of increased self-sufficiency in food production – especially in meats, targeting 85% home-grown production by 2020. From 2009-12, Russia has devoted over $2 billion to just pork production alone.

This has been one of the key drivers behind the recent bans and increased tariffs on food entering Russia, including last year’s ban on pork from the U.S. and other European states. It also explains Russia’s keen interest in securing the Ukraine’s allegiance, it being one of the world’s largest grain producers. Russia’s mind is on its nation’s future food needs.

Thus, Russia’s shifting import priorities seem to be giving Latvia little choice but to turn to the west. If its largest buyer is ramping up self-sufficiency and cutting back on imports, Latvia’s snuggling up to the west can only intensify.

“It’s inevitable,” Janis Urbanovich, leader of the country’s Social Democratic Party announced at a press conference yesterday. “We took the responsibility to join the eurozone when we entered the EU. It doesn’t matter how much money there is in our pockets, it matters how much money we have.”

The distinction between citizens’ depleting “pocket” money and the nation’s growing “revenue” money is an important one to make.

While continuing increased economic activity with Europe will generate more revenues for the nation, the lowering of tariffs will make imports cheaper. This results in more consumer cash exiting the country as foreign products compete with locally produced consumer goods.

Andris Orols, chairman of the Anti-Globalist Association, warns that Latvia will import “other goods at a cheaper rate which means [the country] will produce less”, which will “ruin the economy.”

Tough austerity measures imposed by Eurozone membership will also continue to shift more wealth from citizens to the state. But Martin Gravitis, a spokesman for the Bank of Latvia, believes the net economic effect of Eurozone membership will be positive for Latvians, whose citizens will now enjoy “higher [credit] ratings and lower interest rates on their loans.”

One More Vote for the Euro

The addition of Latvia into the Eurozone gives the Euro another place to transact, albeit a relatively small one. But with Lithuania due to join next year, and six other ex-Soviet satellite nations being courted by the E.U.’s Eastern Partnership program, the multi-nation currency’s prospects look stronger than they have been in years.

Denounced as a dying currency and a “failed experiment” as recently as last year, the Eurozone and its currency look to have bottomed. “The euro crisis has gone into remission,” Market Watch remarked last week.

“There are increasing signs that the European economy has reached a turning point,” EU Economic and Monetary Affairs Commissioner Olli Rehn informed in a November statement. “The fiscal consolidation and structural reforms undertaken in Europe have created the basis for recovery.”

But Nicholas Spiro, managing director at Spiro Sovereign Strategy, informed his clients that “while the euro zone may have technically emerged from a recession in the second quarter of this year, it’s still knee-deep in a protracted economic downturn with scant prospect of meaningful growth any time soon. The [E.U.] Commission’s downward revision to its GDP forecasts for 2014 show how brittle the underpinnings of the euro zone’s so-called ‘recovery’ are.”

While the addition of new members from the ex-Soviet block does help in providing E.U. members with access to cheap labor and resources which go a long way toward helping their recovery, the added influx of workers only worsens the already dismal employment rate through Europe, which is expected to remain near 12.2% unemployed for 2014 before dropping to 11.8% in 2015 averaged across the zone.

Investors may find some rock-bottom opportunities in Europe this year, which may make 2014 a good entry point. Just don’t expect returns from such investments for a few years yet, as the European Commission recently edged down its GDP growth forecast slightly from 1.2% to 1.1% annual growth for 2014.

Joseph Cafariello