The Lithuanian authorities extend high appreciation to Ms. Purfield and her team for their distinguished cooperation and well-written report. The authorities highly value staff’s assessment of the country’s economic and financial policies and their professional advice, which they take into account when considering policy options.
Lithuania experienced sharp output contraction in 2009 as the global financial and economic crisis deepened the cyclical economic downturn. Domestic demand plunged due to undergoing internal adjustment after a period of excessive growth in the non-tradable sector, whereas exports were negatively affected by the global recession. Private consumption shrank reflecting reduced economic sentiment, tighter credit conditions, and lower household disposable income. Investment fell on account of the increased economic uncertainty, changed financial conditions, and deterioration in the real estate market.
The economy started to show clear signs of stabilization in the second half of 2009 and modest recovery is on the way in 2010. Positive quarterly output growth was recorded for the last two quarters of 2009. Although this welcomed trend was temporarily interrupted in the first quarter of 2010, in large part due to the impact of the closure of the Ignalina Nuclear Power Plant (INPP), it is expected to resume as early as from the next quarter. Exports staged a strong recovery, as the external demand has improved, and were 17.2 percent higher for the first four months of 2010, compared with the same period a year ago. Confidence indicators strengthened markedly, retail sales stabilized and lately started to increase, housing prices are bottoming-out as well. Increased absorption of the EU structural funds shall further support economic recovery and re-orientation towards the tradable sector. The authorities project the economy to expand by 0.5–1.6 percent this year, with more pronounced real GDP growth (about 3 percent) expected in 2011.
Substantial external adjustment occurred in 2009 and the current account reversed from a large deficit into surplus. Changes in the current account were mostly driven by considerably lower trade deficit and higher EU related current transfers. The authorities project the current account balance to remain positive (1.5 percent of GDP) in 2010 and turn slightly negative in 2011–12 to -0.6 and -1.3 percent of GDP, respectively.
Lithuania maintained external competitiveness, which is best illustrated by the developments in export market shares. Export market shares temporary contracted in the first half of 2009 as currencies in some of the export markets experienced steep depreciation, but fully recovered later on and reached, or even exceeded, the level of 2007–08. The Lithuanian industries reacted to changed internal and external economic conditions by re-orientating from domestic demand and successfully finding new export markets. The fastest recovery has been observed in the manufacturing sectors, having higher intensity to modern technologies. Lithuania more than doubled its share in global exports over the last decade and its tradable sector already comprises a high share of GDP (about 40 percent).
Fiscal consolidation and structural expenditure reforms
In response to the worsening revenue outlook and increasing expenditure pressures, the authorities implemented ambitious fiscal consolidation in 2009–10. Forceful policy measures, amounting to 12 percent of GDP, helped to contain deterioration in public finances and limited accumulation of debt. By facilitating orderly adjustment in the economy it also provided necessary support to the credibility of the currency board. Convincing consolidation measures helped to enhance market confidence, as has been demonstrated by the successful issuance of government bonds during periods of heightened market uncertainty, also by general narrowing of spreads, CDS risk premiums and improved outlook for sovereign credit ratings in early 2010.
The authorities carefully considered the design of measures being implemented, with particular emphasis given to their quality and social sensitiveness. Approximately 1/5 of the measures undertaken were revenue increasing, with the rest falling on expenditures. Most important revenue measures were the abolishment of reduced VAT rates and a general rate increase, also changes to excises. These measures have lower impact on the tradable sector and therefore could be seen as contributing to economic reorientation. After initial cuts more targeted and progressive cuts in the public sector wages, pensions, and social benefits followed. Some of the cuts, for example in parental benefits, were reversing previous unsustainable increases in the level of benefits. While part of the measures implemented are considered to be temporary, such as reduced transfers to private pension funds (Pillar II) and, to some extent, wage and pension cuts, they will be extended until permanent solutions are found.
Increased absorption of the EU structural funds plays an important non-deficit increasing role in stimulating the Lithuanian economy. The absorption of EU funds was almost 5 times higher in 2009, compared with 2008, and is expected to reach its peak in 2010–11. A signed loan agreement with the European Investment Bank provides additional EUR 1.1 billion available for national co-financing of the EU supported investment projects in the public sector, thereby reducing domestic financing constrains.
The authorities are fully aware that despite substantial measures already implemented, further consolidation efforts will be needed to meet their 3 percent of GDP fiscal deficit target by 2012 and to stabilize debt at a sustainable low level. The authorities are strongly committed to undertake further measures to tackle the remaining challenges and recognize that the most important challenges are in the social sector. The authorities are already well advanced in implementing comprehensive efficiency-enhancing structural expenditure reforms in education and health care sectors, whereas the reform of the social security and pension system is under way. Initial guidelines of the public administration reform were also introduced to society. The authorities are confident that successful implementation of these reform plans will put the economy on a stronger footing and will contribute to its competitiveness.
In June, the government approved the concept of comprehensive social security and pension system reform, which discusses proposals to enhance efficiency and long term sustainability of the social security and pension system, while maintaining an adequate level of benefits. It is expected to reach an agreement on the key reform measures through 2010. Proposals for the pension system reform seek to address aging related challenges, increase transparency and predictability of the system, reduce its vulnerability, and provide better incentives for the participants. The most important measures include strengthening the link between contributions and benefits, amending indexation rules and simplifying the pension formula, eliminating duplicate payments, and making clearer delineation between funded part of the system and basic social pension, with the latter being financed from the budget.
The first phase of the reform has already started as the government submitted a package of proposals to the parliament that foresee gradual increase in the retirement age starting from 2012, elimination of some duplicate payments, further extension of previously introduced cuts in the public sector wages and reduction in the level of sickness benefit. It is also proposed to cap generous parental benefits, while providing more flexibility to choose the duration of the benefit. Reduced transfers to Pillar II will remain in place as an interim measure until a generally improving economic situation and implemented reform measures will reduce tensions in the pension system to an acceptable level.
The authorities are also considering revenue enhancing measures proposed by staff and measures to strengthen the fiscal framework. Based on the guidelines prepared by the Ministry of Finance, the authorities started public discussions with social partners on the feasibility and timing of the possible broad-based real estate tax to natural persons. The authorities also stepped up efforts to enhance tax administration and compliance. Conceptual proposals to strengthen the budget planning and execution framework have been drafted by the authorities. It is proposed to introduce fiscal stance and impulse indicators in the budgetary planning process, also binding rules for anti-inflationary fiscal policy, taking into account the assessment of the output gap. Expenditure execution framework should be enhanced by more stringent expenditure evaluation criteria, improved cost-benefit analysis, and strategic planning.
Monetary and financial sector issues
Lithuania’s financial system weathered the impact from the global financial crisis and is well positioned to withstand further potential shocks. Lithuania benefited from deep financial integration in the Nordic-Baltic region, with strong presence of reputable Scandinavian banks, holding 80 percent of the total banking system assets, contributing to systemic stability. Banks operating in Lithuania follow a more conservative retail-banking business model and supervision of credit institutions is in line with international standards, as has been so noted in the 2007 FSAP update. The risk of debt overhang as an impediment to economic recovery and reorientation towards the tradable sector is comparably lower in Lithuania, given, by regional standards, low private sector indebtedness (68 percent of GDP). The currency board arrangement provided an additional source of stability during the times of heightened global uncertainty and remains an important monetary anchor. The authorities see an eventual introduction of the euro as the most credible exit strategy from the currency board and plan their policies in accordance with this objective.
Deterioration of asset quality in the financial institutions mirrors sizeable output contraction and ongoing restructuring in the economy, however despite rapid increase in NPLs all financial institutions were able to absorb incurring losses and none have requested support from the state. The largest shock to the banking system has already been absorbed and the level of NPLs is expected to start stabilizing in the second half of 2010 as the economic growth strengthens. Although the 2010 data indicate that the quality of loan portfolio has been still slightly decreasing, stabilization is getting noticeable. The level of NPLs itself to a large extent could be explained by the structure of the loan portfolio and stricter definition of the non-performing loan category in Lithuania, compared with other countries.
Stability in the banking system as a whole and in individual institutions has improved, since banks have strengthened their capital base and risk management. Last year, the loan portfolio in the banking sector was reassessed conservatively and historically large provisions were made by banks. Notwithstanding large credit losses incurred by banks, the compliance with prudential requirements as well as the resilience to shocks has been improving. Capital adequacy and liquidity ratios of the banking system has reached one of the highest levels in recent years, respectively 15.1 and 45.1 percent (compared with 8 and 30 percent prudential requirements). Developments in deposits also reflect confidence in the banking system. Despite substantially lower interest rates, deposits increased to previously unseen highs, allowing banks to reduce dependence on parent bank funding and increasing liquidity in domestic banks.
The Bank of Lithuania has been monitoring the situation in the banking system closely, with particular emphasis given to the developments in asset quality and banks’ shock absorption capacity. Stress-testing has been enhanced and its frequency increased. Banks were asked to update stress-tests semi-annually, with unified stress-testing scenarios being prepared. The contingency and business plans of banks are carefully evaluated based on the stress-testing results and banks will be asked to adjust their business plans if the results of a unified stress-testing will so require. The results of stress-tests carried out this May showed that the capital buffers in the banking system are sufficient to absorb credit losses even under the worst-case scenarios. However, in the worst-case scenario some individual banks would require additional capital injection. The banks plan to increase their capital already this year. The authorities will continue to monitor liquidity, capital adequacy and credit risks closely and will request banks to inject additional capital if needed. Based on the capital strengthening measures currently being implemented and planned for the nearest future, banks will manage to ensure sufficient level of capital without the need for support from the state.
Going forward supervisors will further concentrate their efforts on strengthening the risk management processes in credit institutions. The Bank of Lithuania paid particular attention to risk management and strengthening of capital basis. The Bank of Lithuania has already approved the legal act based on which banks will have to additionally assess their liquidity situation and to ensure sufficient liquidity buffers as well as to evaluate the liquidity counterbalance capacity in order to withstand a liquidity stress in a short, medium and long timeframe. In 2010, new requirements for calculating capital adequacy ratio will enter into effect, which should ensure better assessment of banks capital for covering the risks. New legal acts have been drafted to supplement limitations and management of the concentration risk. Every year, the Supervisory Review and Evaluation Process (SREP) is carried out, and a close assessment is made to evaluate whether banks properly ensure risk management and have sufficient capital to cover it. An SREP for banks that belong to foreign banking groups is performed in cooperation with the foreign supervisory authorities, what allows to assess risks and management methods for the overall banking group.
Additional efforts were undertaken by the authorities to enhance operational preparedness for crisis prevention and management. Contingency planning has been strengthened by adopting the Financial Crises Prevention and Management Plan, which has clarified the role of relevant institutions in crisis prevention and management, enhanced information exchange and established a Crisis Management and Prevention Commission. The crisis resolution framework was further improved by the acceptance of the Financial Stability Law, which defined measures for possible state support and intervention in the financial institutions. More recently, operational by-laws were drafted to support the implementation of the Financial Stability Law and await approval by the European Commission. Cross-border cooperation with the home supervisors of foreign banks operating in Lithuania has been strengthened by signing multiple Memorandums of Understanding, enhancing cooperation in information exchange, jointly participating in the supervisory colleges, and carrying out joint on-site inspections.
The authorities are also putting efforts to facilitate orderly debt restructuring in the private sector. The existing legal framework for corporate restructuring and bankruptcy shall be strengthened, with the aim to provide more flexibility, while strengthening prevention of fraudulent bankruptcies and securing creditors’ rights. Based on the technical assistance provided by the Fund, the framework for natural persons’ bankruptcy is also under preparation.