By Alan Wheatley and Aleks Tapinsh
RIGA (Reuters) - If Latvia gets the green light to become the 18th country to use the euro, the small Baltic state will be the poorest member of the single-currency area, with the highest inequality and a dismal demographic profile.
But Latvia is also the fastest-growing European Union state and its eagerness to join will be welcomed in euro zone capitals as a vote of confidence in a bloc suffering many agonies.
Indeed, Latvia's resolve to endure a deep recession rather than devalue its way back to economic balance will bolster the argument made by Germany and other northern euro countries that budget and wage discipline pays off in the end.
"Latvia will side with Germany. There's no doubt about that," said Morten Hansen, an economist with the Stockholm School of Economics in Riga, the Latvian capital. "This is a hard-currency country that has been operating by the book."
Officials are confident that Latvia meets the criteria for joining the euro laid out in the 1992 Maastricht Treaty. They formally asked the European Commission and European Central Bank last week to run the rule over the economy.
The decision in the teeth of the crisis to preserve the lat's peg to the euro enjoyed broad political backing even though the cost was a 21 percent plunge in output in 2008-2009.
Gross domestic product is still well below pre-crisis levels, but the government's debt is below 40 percent of GDP and it is budgeting a deficit this year of just 1.4 percent of GDP.
"Latvia did what nobody thought they'd be able to do," a senior European diplomat in Riga said. "I'd very surprised if they didn't meet the criteria."
A decision by EU finance ministers is expected in July. A thumbs up would see Latvia joining the euro next year.
NAGGING DOUBTS
Adopting the euro makes eminent sense for a small open economy of 2 million people: With almost 90 percent of loans and half of bank deposits already in euros, mass bankruptcies and defaults would ensue if the lat's peg were ever to snap.
However, the EU could argue that more time is needed to prepare public opinion, which is against giving up the lat, a cherished symbol of Latvia's independence from the Soviet Union.
Brussels and Frankfurt are also concerned that the Latvian banking system's big pool of non-resident deposits is a source of financial vulnerability, as it is in Cyprus.
In an interview with Reuters, Prime Minister Valdis Dombrovskis brushed aside the comparison with Cyprus and said Latvia had shown it meets the euro zone's economic criteria.
"As such we certainly do expect to receive a positive recommendation. We do hope that nobody will start inventing new Maastricht criteria especially for Latvia," he said pointedly.
MACRO OUTLOOK BRIGHT, MICRO CLOUDY
Local economists have few worries about Latvia's capacity to keep living within its means. A new law stipulates that government debt must remain below 60 percent of GDP and the structural budget deficit - when the economy is running at full potential - may not exceed 0.5 percent of GDP.
And after the painful bursting of a credit bubble - wages rose some 35 percent in 2007 - the economy has gone back to basics and refocused on exports.
With firms seeking out new markets and climbing the value ladder, exports of goods and services rose 15.2 percent in the fourth quarter of 2012 from a year earlier despite recession in Europe, the destination for 60 percent of Latvia's shipments.
"Any illusion that Latvia could be domestic demand-driven is gone and won't come back for a number of years at least," said Martins Kazaks, Swedbank's chief economist in Latvia. "Latvia is on a more sustainable footing and there's a good chance that we can maintain that for quite a long time."
A bigger risk is that politicians will become complacent and go easy on root-and-branch reforms needed to raise productivity and Latvia's low income level. Elections are due in October 2014, increasing the temptation for the government to avoid confronting vested interests after several years of austerity.
HIGH UNEMPLOYMENT, LOW EDUCATIONAL ATTAINMENT
Every country has a long structural reform agenda, but Latvia's needs are particularly pressing: the ?natural' unemployment rate, below which inflation accelerates as firms bid up wages to find the right workers, at 10-12 percent - worryingly close to the present rate of 14 percent.
Unemployment is structurally high because of a gross skills mismatch that is the legacy of half a century of Soviet rule, a sustained brain drain and an education system that by common consent is not fit for purpose.
Latvia spends less than any of its EU peers on tertiary education and has no university ranked in the world's top 500.
It comes bottom of the EU innovation league table. And no other EU country produces proportionately as many social science graduates even though it is computer programmers who are needed.
Arturs Ernstreits knows the problem better than most. He is an executive with FMS, a 150-strong business software firm in Riga, and cannot hire the skilled IT staff he needs even though he is raising salaries by 5-7 percent a year.
Ernstreits is also a part-time lecturer and is shocked sometimes by the quality of the work undergraduates produce in their final exams. "As a businessman, out of 20 students I might take one of them onto my team. That's the problem," he said.
It's a headache made worse by a sharp fall in Latvia's population from a peak of 2.67 million in 1989 to 2.2 million in 2000 and 2 million in 2011, according to census figures.
An ageing population, a low fertility rate and, increasingly, rising emigration are to blame. The result is that Latvia has far more universities and colleges than it needs.
NO EURO MIRACLES
In a January report, the International Monetary Fund called the higher education system potentially unsustainable.
The IMF, which bailed Latvia out in 2008, also identified a clogged-up legal system and poor oversight of state-owned enterprises as other pressing structural shortcomings.
"Where we point to an agenda for reform is more on the micro side, said David Moore, the IMF's representative in Riga. "It's a bit like saying, ?You're out of the hospital, now it's time to go to the gym'."
Joining the euro will not make that gym work any easier.
But potential foreign investors will view it as a valuable ?stamp of quality', said Andrejs Jakobsons with the Baltic International Centre for Economic Policy Studies, a research outfit. "It a necessary but not sufficient condition for attracting a lot of foreign investment," he said.
Toms Silins with the Foreign Investors' Council in Latvia agreed that removing residual exchange rate risk would appeal to companies attracted to Latvia mainly for its low labour costs.
But, by itself, it was not a game changer. "Look at what is happening in the south of Europe, Being part of Europe doesn't mean you're going to live happily ever after," Silins said.
(Editing by Jeremy Gaunt.)
