Why Latvia Wants to Join the Euro Zone

Riga, Latvia
Ilmars Znotins | AFP | Getty Images
Riga, Latvia

The European Central Bank has given Latvia the green light to become the 18th member of the euro zone on Wednesday, but its admission has prompted questions over why the small Baltic nation surrounded by economically robust Scandinavia – and itself a model of economic success after a recovery from financial crisis - wants to join the troubled currency union.

The Prime Minister of Latvia, Valdis Dombrovskis, told CNBC that it made monetary sense to join the euro after Latvia's currency had undergone speculative "attacks".

"First of all it's worth noting that our currency, the lats, is pegged to the euro so whatever is happening to the euro is happening to the lats. Then if you look at the euro as a currency, no one is worried about the euro as a currency. If anything they're worried about the euro being too strong," he told CNBC Europe's "Squawk Box."

"So what we're having is financial and monetary crisis in certain euro zone countries, which need to be addressed – so the euro is not the key problem here," he added.

Latvia experienced strong growth until the financial crisis struck when it suffered a 17.7 percent drop in gross domestic product (GDP). The country has undertaken an aggressive drive to reduce its budget deficit, slashing public spending and raising taxes and undergoing the biggest fiscal adjustment in the European Union of 17 percent of GDP in three years.

(Read More: Role Model of European Austerity Turns to Stimulus)

Indeed, Latvia has been so zealous in its austerity policies that the International Monetary Fund (IMF) warned it not to go too far with austerity measures earlier this year.

Latvia is, however, a model for returning to growth. The European Commission and Latvia's finance ministry forecast growth in GDP of 3.7 percent in 2013 for Latvia, which would make it one of the strongest countries in the euro zone. Germany is expected to eke out 0.4 percent growth in 2013, according to the Commission, and the euro zone is expected to contract by 0.4 percent.

It's perhaps not surprising then that opinion polls suggest that 38 percent of Latvia's population does not want to join the euro zone with its high unemployment and burgeoning deficits.

(Read More: Europe's Leaders Must Rethink Austerity Strategy: Ex-IMF Chief)

"In our economic and financial crisis, not having the euro was part of the problem, not part of the solution. Apart from dealing with all of the structural problems in our economy, we also had to defend our currency against speculative attacks and it was costing the economy," Dombrovskis said.

"This is a euro zone crisis. If for three years people have heard that there is a crisis in the euro zone then certainly they are asking the question "Why join?" but then it's the government's task to explain the nature of the crisis and then to explain the economic benefits of joining the euro."

(Read More: Krugman Can't Admit He Was Wrong on Austerity: Latvia PM)

He added that he expected opinion polls to improve before Latvia adopted the single currency in January 2014.

"Moreover, our party 'Unity' campaigned on the introduction of the euro in January 2014 through two parliamentary elections and we were elected on this policy proposal, so in this sense we are doing exactly what we promised voters," Dombrovskis said.

But, Nicholas Spiro, head of Spiro Sovereign Strategy, told CNBC that there was widespread ambivalence in Latvia towards the euro zone.

"As last weekend's local elections showed, anti-euro sentiment in Latvia is running high, with the anti-euro party in Riga capturing nearly two-thirds of the vote."

"Make no mistake about it," Spiro added. "Latvia is very much in two minds about euro zone accession."

In a report the ECB said Latvia met all the criteria for membership of the euro, but it raised concerns about high foreign deposits in the country's banks, which could pose a risk to financial stability.

"The reliance by a significant part of the banking sector on non-resident deposits as a source of funding, while not a recent phenomenon, is again on the rise and represents an important risk to financial stability," the ECB said.

As the growth versus austerity debate continues in the euro zone, the Latvian leader said that austerity had worked well for his country.

"We were able to return to economic growth and job creation. Our production and export levels exceed pre-crisis levels so we are able to say that our strategy has worked."

According to Nicholas Spiro, however, the economy isn't yet secure.

"Latvia's economic reforms are often cited as a model for the euro zone's peripheral economies to follow. Yet the comparisons are misplaced on a number of fronts, not least the fact that Latvia's economy is still far from recovering all the output lost since the crisis hit in 2008," he said.

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt