On 1 January 2014, Latvia became the 18th member of the euro area, three years after its Baltic neighbour Estonia and, if everything goes according to plan, one year before its other Baltic neighbour Lithuania.

Impact on country risk

One of Latvia’s main sources of vulnerability is its high level of external debt. A third of it is composed of short-term debt, mainly non-resident deposits (NRD). Actually, about half of deposits in the banking system come from non-residents, mainly directly or indirectly from CIS countries. The NRD are by nature more volatile than domestic ones and their large share in the banking liabilities up to now constituted a significant potential source of pressure on the foreign-exchange reserves in case of outflows and given the currency peg, as was demonstrated during the 2008-09 crises. With a number of risk-mitigating factors having been already in place since then (such as rapid growth of liquid foreign assets by the banks concerned and more stringent capital and liquidity requirements for banks dealing with NRD), euro area membership is an additional powerful factor for moderating the political risk. In fact, liquidity stress arising from a sudden massive outflow of NRD would be supported by the European Central Bank, to which the monetary policy is now delegated. In addition, the remaining exchange rate risk associated with the largely euroised share of loans has disappeared with the accession to the euro, improving financial stability.

Analyst: Florence Thiéry, f.thiery@credendogroup.com