From Russia to labour shortages, Latvia faces stern tests in euro

Reuters

By Alistair Scrutton and Aija Krutaine

VALKA, Latvia, Oct 29 (Reuters) - From his office nearLatvia's border, Valka deputy major Viesturs Zarins can see thefuture. It's down the road, right at the supermarket and pastthe derelict house.

Across a disused border post lies Estonia, a euro currencynation that Latvia will next year emulate. From a quirk ofhistory this town is split between the two countries, where somestreet vendors deal in euros and others in Latvian lats.

Latvia's adoption of the euro on January 1 may encourageinvestment and lower borrowing costs. The country's entry intoEurope's single currency is also symbolic. It heralds anotherstep by a former Soviet republic, still heavily dependent onRussia for energy, into the West.

But two months from Latvia's euro entry, locals like Zarinsare unimpressed. Officials on both sides of the border are moreconcerned about uniting separate water, lighting and seweragesystems. There are few shops, some so bare and non-descript theyappear to be stuck in a Soviet-era time warp.

Loyal to the Latvian maiden of their notes and coins,Latvians suspect the euro will raise prices - as they did up theroad in Estonia. They fear the problems Latvia faces areintractable.

"I'm not that optimistic," said Zarins, referring to a localunemployment rate of around 12 percent. "The main issue isunemployment. I don't see that the euro will solve this issue."

On the ground, touted benefits of the single currency fallon deaf ears. Unemployment on both sides of Valka is roughly thesame. Estonia attracts more Latvians, but mainly because theirside of the town is larger, has a better hospital and holds morerock concerts.

"It's our own currency, different from other countries, morebeautiful," Laura Cera, a 23-year-old mother of two, said on theedge of a windswept housing estate. "Jobs? I don't think it willchange."

Prices in the few shops are already being printed in euros.Because of the exchange rate, the euro figure is higher,reinforcing fears of inflation.

Problems of unemployment and emigration remain. Polls showvoters of what will be one of the euro zone's poorest membersstill oppose membership. The potential destabilising influenceof Russia has surfaced - Moscow has stepped up trade anddiplomatic pressure on the Baltics.

The European Union is generally happy Latvia is joining thecurrency bloc, bringing another voice in favour of fiscalprudence. But some say the euro zone is bringing in a problemchild - a playground for Russian oligarchs and where foreignmoney, much of it Russian, accounts for half of bank deposits.

"Certainly there will be some quick gains," said MartinsKazaks, chief economist for Swedbank in Latvia. "But there aresome risks. We should not fall asleep while driving."

"What happens with the education system, regionaldevelopment or the business environment? What happens withinfrastructure ... labour markets?"

AN INSURANCE POLICY

With Russia assertive on the border, the government is keento emphasise the gains of tying itself close to the West. Thegovernment is mainly Latvian-speaking, while the opposition ismostly supported by a large Russian-speaking minority.

The split is reflected in attitudes towards the euro. Someethnic Latvians say Russian-speaking communities are hostile tothe euro because of a reliance on Russian media for the news.

Moscow appears frustrated at its lost influence and is usingremaining leverage to pressure them to stay close. Russiasuspended dairy products imports from Lithuania this month,weeks before it hosts an EU summit. Russia and Belarus held oneof their largest military exercises near Latvia this year.

"This (euro entry) is certainly another insurance policy forsome of the risks that we sometimes see when it comes tosometimes very changing relations with Russia," said LatvianForeign Minister Edgars Rinkevics.

This year, NATO has scrambled jets 37 times to check onRussian jets approaching Latvia's border. That compares to oncein 2004 when NATO first began patrolling here.

"It is important that countries like Latvia and Estonia,given their geopolitical situations, are in the eurozone," saidDefence Minister Artis Pabriks.

Latvia is viewed by many EU policymakers as a poster childof austerity, an example of what southern Europe could achieve.Latvia's government has signalled it will side with northernEurope over economic policy.

Refusing to devalue its currency after the 2008 globalfinancial crisis, Latvia pursued a policy of spending cutscoupled with redundancies and wage cuts that wiped out a fifthof its GDP.

Its public debt is now around 41 percent of GDP, below theEU ceiling of 60 percent, and its currency was pegged to theeuro in 2005 after it joined the EU. Latvia is now the EU'sfastest growing economy, expanding by 5.5 percent in 2012.

"We certainly want to work and closely cooperate in theNordic-Baltic-Polish-German kind of league," Rinkevics said. "Iwant to see that this group of countries is really leadingEurope with sounder policies."

But on the ground there are concerns European enthusiasmbelies problems for an economy that has been bleeding workers toits richer neighbours. The population has fallen from a peak of2.67 million in 1989 to 2 million in 2012.

There are also concerns, echoed in Estonia, that a poorcountry may find itself contributing to future euro zonebailouts. "(This is) one of the things being debated and seen asa negative consequence," said Latvian Prime Minister ValdisDombrovskis.

DOUBTS

Scepticism is felt a short drive outside Riga, where anhistoric centre is quickly replaced by drab Soviet-erabuildings. On one such complex lies Olainfarm, Latvia's secondlargest drug manufacturer.

Board member Salvis Lapins hopes the company will benefitfrom lower foreign exchange costs. But he fears a rise ininflation - seen in Estonia. The last currency switch, from aSoviet rouble to the Latvian rouble and then to the lat - sawinflation explode and eat into savings. The memory lingers.

"Whatever the government says, there will be price rises,"Lapins said. "This will inevitably lead to salary pressures."

A labour shortage is complicating life for the firm, whichhad sales of around 70 million euros last year and employs over1,000 workers. Half of senior research positions have come fromabroad - mainly Russia and Belarus. There are difficulties infinding mid-level staff like equipment operators.

"Ten years ago they were talking about some huge Coca Colafactory for the whole of Eastern Europe. That is simply notpossible," Lapins said. "If you need to hire a thousand peopleyou don't have those people. I don't see any big companydeveloping in Latvia in the next 50 years."

But growth in companies like Olainfarm will be essential forthe wider economy. OECD senior economist Andreas Woergoettersays Latvia will need to grow 4-5 percent annually to avoid moreemigration.

"They live in a rich neighbourhood. They don't have a lot oftime for income convergence. Major reforms will be necessary toachieve growth rates of that magnitude," said Woergoetter.

One of Latvia's hardest tasks will be to ensure growth doesnot produce bubbles. House prices in Riga are rising, boosted bya policy that has allowed mostly wealthy Russians to gainresidency - and access to the Schengen area of unimpeded travelacross Europe - by investing around 140,000 euros in property.

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