Currency pegs are turning into stumbling blocks in the euro adoption path for Latvia, Estonia and Lithuania, but the three are unlikely either to abandon the regimes or to devalue as they struggle with economic imbalances. Pegging their currencies to the euro helped the Baltic EU states overcome once rampant post-Soviet inflation and survive an emerging markets meltdown.
But questions remain over how these countries will bring inflation down to the levels required for euro adoption when currency pegs restrict their central banks' use of interest rates to influence consumer demand and inflationary pressures.
The answer is more likely to be found in fiscal policy than in changes such as dropping the euro pegs or devaluing. "A devaluation at the moment is not likely at all," said Morten Hansen, the head of economics at Riga's Stockholm School of Economics, adding such a move would feed inflation.
"But to completely avoid all this talk of devaluation Latvors, and here fiscal policy has quite frankly not delivered," he said. Of the eastern and central European states which have joined the EU in the last four years, Bulgaria, Latvia, Lithuania and Estonia use a currency board system linked to the euro.
Devaluation speculation has persisted in the region since Latvia's lat currency weakened sharply in February, leaving a cloud of worry over Estonia and Lithuania too.
While a devaluation is not round the corner, it could become the only way to avoid an economic crash landing from a rapid growth rate. Even though they are small nations, a devaluation would likely have a wide impact on investor sentiment towards other emerging markets.
With wages surging due to labour shortages, and rapid credit growth, booming house prices and high consumption boosting current account deficits, European central bankers have questioned if countries such as the Baltics could avoid a move.
"In principle, (this) could be seen as an indication that, for some of these countries, the current situation might not be sustainable," ECB Executive Board member Juergen Stark said in a speech last month.
Lithuania narrowly missed entering the euro zone in 2006 because its inflation was just a whisker too high. It has since accelerated to 7 percent in September year-on-year, the same as in Estonia. In Latvia the rate has hit 11 percent.
Euro zone inflation was running at 2.6 percent in October. The ceiling for entry to the bloc is set at 1.5 percentage points above the average of the three lowest national inflation rates in EU countries.
This has meant that none of the Baltic three can aspire to enter the eurozone before 2011. Latvia is eyeing 2012-2013. Danske Bank's Lars Christensen, one of the most bearish analysts on the Baltic, said he did not recommend abandoning the pegs because whatever the authorities do, pain awaits.
"The risk of devaluation has significantly increased in all three countries," he said. "They can easily avoid (a devaluation), but what I think is unavoidable is that you will have a severe slowdown in growth. The question is how do you get on from there." Worries over the pegs have persisted despite unanimous rejection of the idea of devaluation from Baltic central bankers, government officials and local analysts.
The lat peg is one euro equals 0.7028 lats, the Estonian kroon at 15.6466/euro and the Lithuanian litas at 3.4528/euro. But doubts remain because of the economic imbalances generated by strong growth, such as wide current account deficits and high inflation. Growth is now beginning to slow, most notably in Estonia, where the cycle is generally considered to be about 18 months ahead of its southern neighbours. The central bank sees growth this year at 7.3 percent, slowing to 4.3 percent in 2008.
But even in Estonia the government's commitment to fiscal rectitude is being questioned. Some economists say its planned budget surplus of 1.3 percent of gross domestic product (GDP) underestimates the extent of the slowdown.
Similar criticisms are made of Latvia, where the government is planning a 2008 surplus of 1 percent of GDP. Fiscal policy is the only way to cool growth and reduce domestic demand as the pegs mean there are no monetary levers.
"The costs would be larger than the benefits," said Latvian central bank chief economist Uldis Rutkaste when asked why he thought a devaluation or end to the currency peg was unlikely.
In a small, open economy, exchange rate stability and predictability was important for businesses, he said. A devaluation would also make it more expensive for people to service their housing loans, 80 percent of which in Latvia are in euros, while incomes are in lats.
Mindaugas Leika, head of the Lithanian central bank's financial stability division, said the litas currency could be devalued either by a political decision or by financial market pressure, but neither was likely.