The strategy of the monetary policy and the exchange
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
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
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.
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