Some implications of EU membership on Baltic monetary and exchange rate policies

Abstract

This paper examines possible effects of EU membership and the shift to the euro on the monetary and exchange rate policies of Estonia, Latvia, and Lithuania.The Baltics, which have extensive economic integration with euro-area states, all apply monetary policies based on fixed exchange rates.Estonia s kroon is pegged directly to the euro.The external value of the Latvian lats is determined by a currency basket with a heavy euro weighting.Lithuania is currently shifting its peg of the litas from the US-dollar to a euro-dominated basket.The switch to the euro as the Baltics anchor currency has compelling practical reasons.Euro-area countries now provide a significant share of foreign direct investment into the Baltics and they collectively comprise the Baltics largest trading partner.The Baltic financial sectors are also extensively integrated with the euro area.Finally, the Baltic economies are natural candidates for fixed exchange rates, due to their small size and openness.Nevertheless, fixed exchange rate regimes always involve risks.Two of the biggest challenges facing the Baltic states are finding ways to keep productivity growth in line with real wage growth and increasing the flexibility of labor markets.