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Bank of Latvia

The Bank of Latvia » FAQ » The lats exchange rate and its peg

The lats exchange rate and its peg


Is the lats a convertible currency? What does that mean?
The lats is a convertible currency. Thus, individuals making payments in other countries acknowledge the lats to be a convertible currency and use it in transactions. The lats exchange rate is globally known. The price of the lats is set in other currencies. The lats is the currency used in international settlements and transactions. 

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Is the lats stable? What proof of its stability is there?
The lats is stable both in Latvia (domestic or price stability) and against other currencies (external stability). 

In recent years, robust economic growth has contributed to a rise in inflation. This, however, is a cyclical process and the lats is a relatively stable long term measure of the value of goods and services. 

The lats has been pegged to the euro with a fluctuation band of ±1% as of 1 January 2005, and covered with the Bank of Latvia's foreign reserves. Latvia has joined the Exchange Rate Mechanism II, where its participation will cease when the changeover to the euro has been implemented (has been anticipated in 2012 or 2013). 

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Why is the lats worth more than the euro, the US dollar, the British pound sterling and many other currencies?
The decision on fixing the lats exchange rate adopted by the Monetary Reform Committee in 1993 does not necessarily imply that Latvia's money is better or worse than other freely convertible foreign currencies. This is similar to the unit of weight or length. For example, the length of the shortest sprint distance of track and field events is 100 metres or 109.36 yards, and it does not imply that the quality of a metre exceeds that of a yard. 

When making payments, one should be aware of the exchange rate of the respective country's currency against the mutually accepted benchmark (the euro is used as a benchmark in Latvia). 

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Why was the exchange rate of the lats against the Latvian ruble set at 1:200 in 1993?
This ratio supported projections that the already minted santims with the smallest nominal value would be a necessary coin with a purchasing power i.e. an appropriate measure of value for the very smallest of purchases. In fact, the dividing number is not a matter of great importance. For example, had the ratio been set at 1:100, salaries and bank balances would be twice as high, but so would the prices in the shops and elsewhere. 

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Why can't the lats be bought in banks and currency exchange offices abroad?
It is possible to buy lats in the countries and cities whose inhabitants visit Latvia as tourists. The lats can be bought in Stockholm (Sweden), the Baltic States, etc. It should be noted though that money is a product and that a seller will not purchase it for sale unless there are buyers. A reply to this question really implies another question: is Latvia a country attractive to travel and business trips? 

The lats cannot always be bought abroad also because of the growing number of ATMs and cash registers in Latvia suitable for electronic settlements. Foreigners can settle payments in a way they are used to in all major cities and district centres of Latvia. 

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What is the current lats peg?
The lats is pegged to the single European currency, the euro. On 30 December 2004, the Bank of Latvia fixed the peg rate of the lats and the euro at 1 EUR = 0.702804 LVL. The peg rate took effect on 1 January 2005 in accordance with the plan for Latvia's preparation for a full-fledged membership in the Economic and Monetary Union approved by the government. 

The repegging of the lats to the euro is the first step towards the euro as Latvia's future currency: one of the criteria for the euro implementation specifies that for at least two years prior to the euro changeover the national currency is to be pegged to the euro, with the fluctuation of the lats exchange rate against the euro not exceeding the fixed fluctuation band. 

As we know, upon acceding to the EU Latvia, similar to other new EU Member States, agreed to adopt the single European currency. The above commitment was stipulated by the Treaty on European Union. 

Since their EU accession the new Member States have also joined the Economic and Monetary Union (EMU), which is the supreme stage of the economic integration of the EU Member States that have adopted the single currency. These countries, including Latvia, have been granted the country with derogation status until their euro changeover. Latvia will become a full-fledged member of the EMU upon its changeover to the euro. That can be attained in accordance with the prescribed procedure, after the economy has complied with a number of criteria. No deadline has been specified for the euro changeover - it is, however, anticipated in 2012 or 2013. 

The repegging of the lats to the euro is a logical step, with the overall Latvia's trade and economy increasingly integrating with the EU. The containment of the lats and the euro exchange rate fluctuations will mitigate the risks related to the exchange rate and reduce transaction costs with these countries as well as facilitate the attainment of the price stability objective. 

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Why is the lats/euro exchange rate quoted by commercial banks different from the central parity rate set by the Bank of Latvia?
For the purposes of currency exchange transactions, the exchange rate for one or another currency - in fact, the price of the currency - depends on the actual demand or supply -- so, the larger the demand for the euro, the higher the price. As of January 2005, the Bank of Latvia has been ensuring the lats exchange rate fluctuations against the euro within the band of  ±1% of central or parity rate. This means that, in the interbank market, the Bank of Latvia automatically buys or sells the euro when the exchange rate  is 1% above or 1% below the peg of 1 EUR = Ls 0.702804. As to banks, if the euro price in the interbank market is more than 1% above central parity, because of a better price, they would prefer to buy the euro from the Bank of Latvia, instead of another bank or a retail client. Alternatively, when on the sell side, banks would opt for selling the euro to the Bank of Latvia when the interbank rate is 1% below the central parity. 

Thus the peg of 0.702804 is market-regulated, rather than administered and mandatory for everybody in whatever transactions. Unlimited amount of lats or euro is offered to banks in a situation when the exchange rate for these currencies has stepped over a certain threshold. Within the band of ±1% itself, the exchange rate of the euro against the lats depends on the demand and supply of the currencies in question. 

Commercial banks, when dealing with retail clients, price the euro depending on their own needs for the euro, i.e., how much euro currency they need to settle other transactions. Also, they are likely to lock in commissions, meaning that they would buy a currency at a price below the selling price. Thus, the euro exchange rate for identical transactions may differ across the commercial banks. 

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What is the backing for the lats with foreign currency and gold?
The entire supply of the Latvian national currency in circulation is backed with foreign currency and gold reserves. The Bank of Latvia foreign reserves have been constantly growing. They are worth about 3 billion lats and sufficient to fully cover the Latvian imports over a four-month period. The backing of the monetary base (currency in circulation and bank deposits with the Bank of Latvia) with foreign reserves exceeds 100%. 

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What is devaluation of currency?
Devaluation is a reduction in the value of a currency with respect to other monetary units. An economy having substantial exports of goods produced from domestic resources might benefit from devaluation. The competitiveness in export markets would increase along with the price decline in foreign currencies. However, devaluation may trigger inflation hikes, increase the cost of foreign debt services, and lead to an economic crisis. 

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Is there any chance that the devaluation of the lats might be supportive of economic growth in Latvia?
The task of the central bank is to ensure the stability of the exchange rate. Devaluation of the lats, allegedly to increase the competitiveness in export markets, ultimately would fail to have an overall positive effect on the economic growth in Latvia, since the surge of import costs (e.g., energy resources and raw materials) may bring far more sizeable losses. 

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What is revaluation of currency?
Revaluation is opposite to devaluation - an increase in the value of a currency with respect to other currencies. Revaluation promotes imports and hampers exports, and this is the reason why developed economies would rather refrain from revaluation. 

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Does Latvia impose any restrictions on free movement of capital?
There are no barriers to free movement of money and capital in and out of Latvia. 

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What financial instruments would the Bank of Latvia recommend for preventing potential losses from exchange rate fluctuations?
To mitigate the risks arising from the volatility of the exchange rates, the Bank of Latvia would suggest forwards, which means buying or selling a currency at a fixed rate on a fixed date in future. This service is offered by commercial banks. 

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Why are the interest rates on loans in lats, and also on government bonds, not the same as for foreign currencies?
Right now, in the Latvian credit market loans in foreign currencies are charged lower interest than loans in lats. There are several reasons for that. 

First, banks get most of funds in foreign currencies - mainly from non-resident credit institutions, and parent banks in particular. Typically, these funds are less expensive. 

Second, the ever-changing liquidity conditions in the interbank market are the reason why the amounts and price of banks' lats resources tend to fluctuate. 

Third, some of loans are extended at a floating rate, meaning that the end rate is directly linked to base rates. As to loans in lats, the interest rate usually is linked to 3-month RIGIBOR (a money market index), while the interest rates on loans in foreign currencies (as a rule, in US dollars or euro) are linked to 6-month  LIBOR or EURIBOR, both lower than the rate on borrowings in lats. 

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Where does the Bank of Latvia keep its gold? How much gold does the Bank of Latvia have altogether? How much is it worth?
Bank of Latvia's gold is under safekeeping with the UK bank. The total amount is 7.7 tons. In lats terms, the value of the gold changes depending on the price of gold in the global markets and the exchange rate of the lats against the US dollars. For example, in October 2008 the Bank of Latvia's gold was worth about 100 million lats at market price. The price of gold on global financial markets is volatile; therefore, in order to contain risks, the Bank of Latvia enters into futures and forward contracts. 

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Can't Latvia change over to the euro on its own?
No, it can not. This is contradictory to the core principles underlying the Economic and Monetary Union. Both the European Central Bank and the European Commission would disapprove of such an exercise. This, apart from making the process of the euro changeover more complicated, might bar Latvia from joining the euro area for the unforeseeable future. 

Also, this would be of no benefit to the country and the stakeholders in the national economy. As to businesses and public institutions, two parallel currencies in circulation would involve introducing and maintaining parallel accounting, settlement etc. systems, hence a cost increase. The country then would be responsible for ensuring due circulation of the euro in Latvia, albeit denied of issuing rights. The Bank of Latvia is not in charge of the euro cash circulation: it has neither the right to issue the currency nor the capacity to supply euro notes and coins or to ensure their circulation in Latvia. The banks would be hardly able to respond quickly to the demand for euros. Moreover, replacing lats notes and coins with those of euros would likely increase commissions and transportation costs, because the printing and minting of the euros is to be outsourced to foreign suppliers.

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