Exchange Rate Policy
The strategy of the monetary policy and the exchange
rate policy
After joining the EU and by the time Latvia becomes a
participant in the Economic and Monetary Union (EMU), the Bank of
Latvia continues the implementation of its monetary policy, provided
that it is in agreement with the EU common interests, without prejudice
to the development of other EU Member States and facilitate economic
stability.
Accession to the EU implies preparation for the participation in the EMU and introduction of the euro, for the new Member States of the EU may not choose to stay outside the euro area. Hence, after joining the EU, Latvia will have to demonstrate its capability to meet the criteria for joining the EMU. One of the criteria implies participation in the Exchange Rate Mechanism II (ERM II) for two years. Latvia joined ERM II on May 2, 2005. ERM II means that, for at least two years prior to the introduction of the euro, the lats will have to be pegged to the euro, with the fluctuation margins of the lats exchange rate against the euro not exceeding +/-15% against the lats/euro peg rate. The Bank of Latvia plans to ensure narrower fluctuation margins against the euro than the prescribed maximum, thus maintaining higher stability of the lats against the euro.
In order to achieve the key objective as well as join the EMU successfully, the Bank of Latvia has chosen its exchange rate strategy for the implementation of monetary policy. Under this strategy, the Bank of Latvia's intermediate target is the external stability of the national currency, i.e. the peg of the lats to the euro (at the rate 1 EUR = 0.702804 LVL). The normal fluctuation margins around the fixed peg rate are +/-1%. The Bank of Latvia performs interventions when the exchange rate of the lats exceeds the normal fluctuation margins of +/-1%. The Bank of Latvia has been implementing the lats pegging policy since February 1994 when the lats was pegged to the SDR currency basket. As of January 1, 2005 the lats has been pegged to the euro.
It is essential to note that the Bank of Latvia ensures the external stability of the lats under free capital movement and unlimited convertibility of the national currency: Latvia has established one of the most liberal foreign exchange and capital movement regimes in the world. Both foreign currency and the lats can freely enter and leave the country; accounts can be opened in lats and foreign currencies without any restrictions, and lats can be purchased and sold freely in exchange for foreign currencies. Foreign investors can repatriate their profits in any currency without restriction.
Why was a fixed
exchange rate strategy chosen?
A fixed exchange rate strategy is one of the most effective instruments
for reducing inflation, stabilising the macroeconomic environment and
strengthening the public's confidence in the national economic policy
during the initial phase of the economic reforms in transition
economies. Therefore Latvia, like many countries, chose a fixed
exchange rate strategy at the initial stage of the economic reforms.
A fixed exchange rate strategy is appropriate for the Latvian economy for other reasons as well which are not related to the prospective participation in the EMU, therefore Latvia has maintained the above strategy.
Firstly, a fixed exchange rate policy is appropriate for small countries with an open economy, where foreign trade plays a very important role. A smaller economy is dependent on changes in the global financial and commodity markets, and its chances to influence them are limited. In such countries, single major transactions (capital inflow or outflow) may cause considerable short-term exchange rate fluctuations, increasing foreign exchange expenditure and risks. The more open the economy, the more important it is to ensure the conditions (including the exchange rate stability) necessary for successful growth of foreign trade and foreign investment, as the development of foreign trade has a more significant impact on the country's overall economic growth in an open economy.
Secondly, in Latvia's monetary transmission mechanism, the exchange rate channel affects the consumer price dynamics considerably. That can be largely attributed to quite a high imports component both in Latvia's consumption, as well as manufacturing.
Having implemented the fixed exchange rate policy for several years, it is evident that it was the right choice, and this policy is still appropriate for the Latvian economy.
Operational target
Under the fixed exchange rate, the Bank of Latvia's operational
target coincides with the interim target – ensuring the lats'
peg to the euro.
The Bank of Latvia's foreign exchange reserves back every lats in circulation (the monetary base), therefore it is capable of maintaining a stable lats exchange rate even in case of any external disorders.
