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WorldFebruary 2 2015

Lithuania: the new kid on the euro bloc

Lithuania became the 19th country to adopt the euro as its currency in January, joining Baltic neighbours Latvia and Estonia. But what benefits can the country expect to see from this move?
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Lithuania: the new kid on the euro bloc

A new year has commenced and the eurozone has grown by another member country – Lithuania. The last of the three Baltic states to enter the eurozone, Lithuania is the 19th country to adopt the common European currency.

And for Lithuania, the decision to join the eurozone appears to have been a simple one. In 2002, Lithuania pegged the litas, its currency from 1993 until the end of 2014, to the euro – two years before even becoming a member of the EU – making the transition easier than many other countries have experienced. Added to this, Estonia’s eurozone entry in 2011 and the 2014 addition of Latvia harnessed a number of benefits that Lithuania is hoping to emulate.

'An asset to the eurozone'

Lithuania suffered from the impact of the global financial crisis early. Its downturn in 2008/09 forced the country's government to rescue its own economy through internal devaluation. This meant a downward adjustment of local wages and prices, as well as social benefits and pensions. Through these strict steps, the government was successful in decreasing its deficit and realigning the country's budget to meet the Maastricht criteria for euro-accession.

“Lithuania is an asset for the eurozone,” says Alexander Lehmann, lead economist for central Europe at the European Bank for Reconstruction and Development (EBRD). “Like Latvia and Estonia, Lithuania adjusted [to the crisis] through internal devaluation – through the adjustment of local wages and prices – and Europe needs that [kind of] flexibility. [The eurozone] should be proud to take [on] such economies.”

Today, Lithuania is a country with low public debt-to-gross domestic product (GDP) ratio of 39%, and boasts healthy GDP growth – despite the impact on its economy caused by trade restrictions in Russia.

While Russia accounted for about 12% of Lithuania’s exports in 2013, the Baltic country managed to find ways to accommodate for 2014’s shortfall in trade by redirecting its exports, especially to Europe. Indeed, 2014 was a strong year for Lithuania, with GDP growth forecasts coming in at 2.9%, according to the Bank of Lithuania, while optimism is high that membership of the eurozone will bring with it additional benefits.

Lower cost of funding

One of the key advantages of being a member of the eurozone is a reduction in the cost of funding. When it became evident that Lithuania would join the eurozone at the beginning of 2015, credit rating agencies Moody’s, Standard & Poor’s and Fitch reacted positively. In 2014, both S&P and Fitch upgraded Lithuania’s ratings by two notches to A-, while Moody’s kept its Baa1 rating but changed the country's outlook to 'positive'.

Since March 2014, the difference between German 10-year sovereign debt and Lithuania’s has also decreased. The spread development between the respective bonds show a tightening from a difference of about 150 basis points (bps) at the end of March to below 70bps at the beginning of 2015, according to data collated by East Capital.

Lithuania’s central bank, the Bank of Lithuania, expects further improvements in the interest rates on sovereign and private sector debt of 80bps and about 50bps, respectively, after the government issued €1bn of 12-year bonds in October 2014 at the country’s lowest ever coupon.

“The euro introduction will lead to lower interest rates and will also eliminate the exchange rate risk, which during the crisis caused our economy a lot of headaches because there was a lot of speculation around it,” says Vitas Vasiliauskas, governor at the Bank of Lithuania.

A fluctuating exchange rate is also the main risk related to the country’s foreign currency debt, which with the euro entry was reduced from about 75% at the end of 2013 to about 40%, according to Moody’s.

Furthermore, even with the euro trading at weak levels, this presents an opportunity for its exporting businesses to look for new customers in dollar-based markets such as the US, Asia and the Middle East, according to Eglé Fredriksson, a senior advisor at emerging market asset management specialist East Capital.

Trade impact

“Better conditions for exporting our production is what we really expect to see, with better conditions for payments between [Lithuania and] the eurozone countries... making full use of the SEPA [Single Euro Payments Area] system of payments,” says Rimantas Šadžius, finance minister of Lithuania. “All these things should help us to be more successful in [our export markets].”

Forecasts by Bank of Lithuania predict a 5% to 10% increase in foreign trade as a result of the country's euro membership. Overall, Bank of Lithuania estimates that adopting the euro will boost Lithuanian GDP growth by an average of 1.8% to 1.9% each year until 2022, and by an average of 1.3% a year for the foreseeable future thereafter. The eurozone is expected to have grown by 0.8% in 2014, with 1.1% growth predicted for 2015.

“Lower transaction costs and higher price transparency should further facilitate exports and should make the country a more attractive target for foreign direct investments,” says Ms Fredriksson.

“The main advantage of joining the eurozone is a huge step in the improvement of the investment climate,” adds Mr Šadžius. “In our region, there are three small countries – Lithuania, Latvia and Estonia – two of which are already in the eurozone. So, to be competitive in attracting investment, we had to join the eurozone as well.”

Although there were global downturns in FDI flows in 2011 and 2012 and flows into European countries have continued to decline, Lithuania is hoping to increase its investments from 2013’s $68.7m-worth of greenfield projects and 2014’s $104.3m, according to data from investment tracker fDi Markets.

Confidence boost

For Lithuania’s banks, the introduction of the euro is bringing significant changes. With the eurozone’s new single supervisory mechanism (SSM) and single resolution mechanism coming into effect, the zone looks to be heading towards a banking union.

“I see the benefit [of euro membership] primarily in the quality of bank supervision that Lithuania will now have to comply with by being part of the SSM,” says Mr Lehmann. “[Now we are] a eurozone country, [Lithuanian banks] have become part of the banking union project that may reassure some investors and may bring down the bank refinancing costs.

“There have been two failures of smaller, local banks, in the past few years that were related to governance issues. The regulator has already beefed up its standards, through adopting the uniform standards that will apply within the banking union.”

In 2011, Snoras Bank, the then third largest bank by deposits in Lithuania and the fifth largest by assets, was declared bankrupt, while some of Ukio Bankas, which failed in 2013, was able to be rescued through a good bank/bad bank split. Ukio saw its assets transferred to Siauliu Bankas.

In preparation for euro entry, the foreign-owned subsidiaries of SEB, Swedbank and DNB in Lithuania – the country's three largest banks with a combined market share of about 70% – had to take part in the European Central Bank’s asset quality review (AQR) and the European Banking Authority’s stress tests in 2014.

“The results demonstrated the strength of our capitalisation and provisioning practices,” says Dovile Grigiene, CEO at Swedbank Lithuania.

“The participation in a single supervisory system is of great benefit, not just for Lithuania,” says Mr Vasiliauskas. “We went through the AQR exercise and what we see is that Lithuania’s banks are healthy, comply with supervisory requirements and have large capital reserves.”

Lithuanian banks’ non-performing loans have also decreased from an 11% average at the end of 2013 to about 9% at the end of 2014.

Cheaper funding

According to Mr Lehmann, bank refinancing costs in Lithuania are likely to fall as a result of its eurozone entry, partly due to the removal of the residual currency risk and also thanks to additional confidence in the banking sector following SSM implementation.

Ms Grigiene also hopes that Lithuania's adoption of the euro will encourage a reduction in the reliance on cash transactions within the country. This reliance was measurable through the amount of litas handed in by Lithuanians by the end of December. According to Ms Fredriksson, this amount was substantially higher than expected, particularly when compared with the levels in Estonia and Latvia, which suggests that the size of the shadow economy had previously been underestimated.

“A positive outcome is that the currency change exercise is serving partially as an economy clean up too,” she says. “Out of pure convenience, part of those exchanged cash funds will probably stay in banks, disregarding the high preference of Lithuanians to own cash.”

One Baltic market?

Still, one question remains. With both Estonia and Latvia already members of the eurozone, to what extent will the common currency be a means of facilitating greater integration between the three Baltic financial markets?

For a start, cross-border bond issues by large corporates or banks in the Baltic market could become more commonplace.

Latvenergo, the Latvian state-owned energy provider, was the first wholly state-owned company from the country to successfully issue public bonds on the Nasdaq OMX Baltic Bond list, a co-operation of the bond lists of Nasdaq OMX Tallinn, Nasdaq OMX Riga and Nasdaq OMX Vilnius which has used the euro as single trading and clearing currency since 2014. Latvenergo raised €20m from investors in Latvia, Lithuania and Estonia in 2012 and listed them in 2013, and it has plans to continue using the platform, as several other companies have also since – a development the EBRD supports.

“To what extent will we see an integration of issuance and investors, now that all three Baltic states are in the euro, interests us,” says Mr Lehmann. “It is the idea of the European capital markets union that we need to overcome the divisions of local bond markets, and allow a common issuer and investor base to benefit from economies of scale.”

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