Republic of Lithuania
Staff Report for the 2009 Article IV Consultation
Author: International Monetary Fund
Publication Date:
04 Dec 2009
eISBN:
9781451824223
Language:
English
Keywords:
ISCR; CR; GDP; flash GDP estimate; estimate; report; credit; current account; private sector; short-term debt; foreign currency; banking system; Fiscal consolidation; Global; Baltics; market share
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This 2009 Article IV Consultation highlights that the Lithuanian economy is undergoing a severe adjustment, after years of rapid economic growth and financial integration. With the global financial crisis, the unwinding of the imbalances accumulated during the boom has led to a sharp economic contraction. Capital inflows came to a halt in late 2008 and reversed in 2009, and the current account deficit turned into a surplus. Executive Directors have recognized the authorities’ strong commitment to maintain the currency board arrangement, which has served as a useful macroeconomic anchor.

Abstract

This 2009 Article IV Consultation highlights that the Lithuanian economy is undergoing a severe adjustment, after years of rapid economic growth and financial integration. With the global financial crisis, the unwinding of the imbalances accumulated during the boom has led to a sharp economic contraction. Capital inflows came to a halt in late 2008 and reversed in 2009, and the current account deficit turned into a surplus. Executive Directors have recognized the authorities’ strong commitment to maintain the currency board arrangement, which has served as a useful macroeconomic anchor.

I. Staff Appraisal and Executive Summary

1. The economy grew rapidly over the past decade but the surge in capital inflows post-EU accession generated significant risks that have now materialized. Between 1998 and 2008, real per capita incomes rose from about 40 percent to two-thirds of the EU average reflecting the rebound from the 1998 crisis and rapidly rising productivity (Figure 1). However, the capital inflows that followed EU accession were mostly channeled to the non-tradable sector, stoking an asset and consumption boom that had its counterpart in growing external indebtedness (Figure 2). Rapid wage growth began to erode competitiveness while loose fiscal policy added to demand pressures (Figure 3).

Figure 1.
Figure 1.

Lithuania: The Upswing: Real Sector Indicators

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: Statistics Lithuania; Haver Analytics.
Figure 2.
Figure 2.

Lithuania: The Upswing: Financial and Balance Sheet Indicators

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: Statistics Lithuania; Haver Analytics.
Figure 3.
Figure 3.

Lithuania: The Upswing: Fiscal Indicators

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Sources: Statistics Lithuania; Ministry of Finance; and IMF staff estimates.

2. The Lithuanian economy is now undergoing a painful adjustment. The reversal in capital flows in the wake of the global financial crisis has triggered a hard landing starting in late 2008. The downturn in domestic activity–by far the most severe since Independence—is also being compounded by the global economic contraction.

3. The sizable adjustment in policies since the onset of the downturn will have to continue. The original and May supplementary budgets implemented substantial fiscal adjustment, and timely measures have been taken to stabilize the financial system. However, the fiscal adjustment roughly offsets the impact of past expansionary policies and more is needed to underpin the credibility of the CBA and the strategy of rapid euro adoption going forward. A clearly articulated plan that outlines the multi-year reform strategy will be key to galvanize public support for the still substantial adjustment ahead.

4. Fiscal consolidation should be guided by the need to:

  • sustainably bring spending to more affordable levels, primarily through savings in social benefits and public sector wage bill which have grown at an unsustainable pace in recent years;

  • broaden the tax base, improve compliance, and raise some tax rates, including personal income tax and VAT rates;

  • strengthen fiscal institutions including frameworks for monitoring fiscal developments and setting rules to enhance fiscal discipline;

  • protect the most vulnerable including through rationalization of generous benefit programs.

5. Efforts to enhance soundness of the banking system and crisis preparedness must continue including through:

  • Accelerating loan loss provisioning and raising banks’ capital, seeking more explicit commitments from parent banks to pledge the necessary liquidity and capital support to their subsidiaries, and increasing surveillance particularly of banks with shorter-term and high cost funding profiles;

  • Augmenting contingency planning frameworks through enhanced communication and drill exercises; and

  • Expanding the tool kit to deal with potential bank difficulties by allowing alternatives to its full acquisition by the government, such as a bridge bank, to help protect the taxpayer from potential hidden losses or contingencies.

6. The crisis only underscores the imperative for structural reforms to improve longer-term growth prospects where risks to the outlook are on the downside. Private sector wages have shown flexibility but steps to improve the business environment including reducing administrative burdens in business planning, land regulation, and public procurement could help attract FDI.

7. Despite the ongoing adjustment and the fact that the currency board has acted as a useful anchor, there are risks. The CBA places the burden of adjustment squarely on domestic policies. Further substantial fiscal consolidation is needed to secure euro adoption, which may prove challenging. Moreover, the large fiscal contraction could exacerbate the downturn and in turn increase the size of the needed adjustment, all compounded in a context of price deflation and deleveraging of the economy. Adverse shocks could, given the limited excess international reserves, add to risks. Finally, while wages in the private sector are adjusting, production costs will need to come down further for a switch to a more tradeables-based economy to be achieved and to improve growth prospects.

8. The authorities broadly shared staff’s diagnosis of the challenges ahead but emphasized the strong adjustment being implemented to safeguard macroeconomic stability. They underscored the importance of maintaining the currency board as the key anchor for external and domestic stability, particularly in the current difficult economic environment, and pointed to the strong adjustment in private and public sectors underway that support it. They see fiscal consolidation as necessary to complement the adjustment in the private sector and underpin the CBA and euro adoption strategy. They stressed the size and quality of fiscal measures already taken in 2009 and emphasized that their medium-term consolidation is to be driven by structural reforms. While acknowledging the usefulness of building preemptive capital buffers in the banking system, they noted the steps already taken to intensify oversight of banks, the relatively high capital adequacy ratio, the sizable role of foreign banks in the system, and the results of recent stress tests as also providing assurances that the deterioration in asset quality over the downturn is manageable. The also pointed to other measures taken to strengthen contingency planning frameworks including the increase in deposit insurance as well as a new law that strengthens the bank resolution framework.

II. Outlook and Key challenges

9. A long and painful recession is underway (Tables 1–3, Figures 4–6). The reversal in capital inflows has come at the cost of a domestic downturn that ranks amongst the most severe in the region. Quarterly GDP was 12 percent lower in 2009 Q1 than in 2008 Q2 (peak), and although lead indicators show tentative signs of bottoming out they remain very weak. Real GDP is forecast to decline by 16 percent in 2009 and 3¾ percent in 2010 driven by the contraction in domestic demand. Associated with this, unemployment is likely to average 16½ percent in 2010, up from 6 percent in 2008. The end-2009 closure of the Ignalina nuclear power plant contributes to the continued contraction in 2010.1

Table 1.

Lithuania: Selected Economic and Social Indicators, 2004–10

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Sources: Lithuanian authorities; and IMF staff estimates and projections.

Based on labor force data.

ESA 95 methodology. For 2009, including measures currently in Parliament expected to yield 0.6 percent of GDP in savings. For 2010, including the annual yield of the 2009 measures estimated at 1.8 percent of GDP, plus an additional 4 percent of GDP in yet to be identified savings.

Excluding guarantees.

FDI in 2009/10 includes funds for recapitalization of foreign banks’ subsidiaries.

Includes loans guaranteed by the government.

CPI-based, 2000 trade-weighted real effective exchange rate against 17 major trading partners.

Table 2.

Lithuania: Medium Term Framework, 2005–14

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Sources: Lithuanian authorities; and IMF staff estimates and projections.

Based on labor force data.

ESA 95 methodology. Including additional savings of 0.6 percent, 4 percent, and 3.1 percent of GDP in 2009, 2010, and 2011 respectively.

Includes staff estimates’ of bank recapitalization needs in 2009 and 2010 but excludes guarantees that been issued but not called.

Includes loans guaranteed by the government.

Table 3.

Lithuania: Summary of Monetary Accounts, 2007–10

(In billions of litai; unless otherwise specified)

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Sources: Bank of Lithuania; and Fund staff estimates and projections.

Excludes local government deposits; includes counterpart funds.

BOP basis. Differs from gross foreign assets as shown in the monetary authority’s balance sheet because of valuation effects (BOP-basis official reserves include accrued interest on deposits and securities but exclude investments in shares and other equity).

Bank of Lithuania’s gross foreign assets less reserve money, in percent of banking system deposits. Excess reserves available for lending to commercial banks are determined based on net foreign reserves, and represent the equivalent of 4 percent of bank deposits.

Figure 4.
Figure 4.

Lithuania: The Bust: Macroeconomic Indicators in the Recession

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Sources: Statistics Lithuania; and Bank of Lithuania.
Figure 5.
Figure 5.

Lithuania: Financial Indicators, 2004–09

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: Bloomberg.1/ JP Morgan Euro EMBI Global sovereign spreads. Data for Latvia are spreads of bond maturing on 4/2/14 versus comparable maturity of German Bunds.2/ Gaps signify that no transaction took place.
Figure 6.
Figure 6.

Lithuania’s Recession in a Regional Context 1/

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Sources: Statistics Lithuania; and Bank of Lithuania.1/ The data on CEE countries are of the average of Czech Rep., Hungary and Poland.

10. In this context, staff expect strong deflation. Core consumer prices—which account for just over half of total CPI—are expected to fall by a cumulative 20 percentage points over 2009–10. This is consistent with ongoing sharp declines in private sector wages—gross earnings in the private sector fell by 8 percent (q/q) non-annualized in the 2009Q1—as well as with past international experience with deep adjustment in flexible economies with pegged exchange rate regimes.2 Headline CPI is expected to fall by a more modest 5 percentage points over this period, partly on account of food prices moving in line with international trends, but also due to expected increases in energy costs following the decommissioning of Ignalina.

uA01fig01

Inflation Forecasts: CPI and Components 1/

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: IMF staff estimates.1/ 2009Q1 = 100

11. In the medium term, staff see a slow return to a more sustainable pace of growth. A recovery is expected to take hold in 2011 with growth returning to positive territory, and gradually rising to 4–4½ percent over the medium-term. Driving this recovery is the ongoing adjustment in factor costs, which together with recent and planned structural reforms would help improve competitiveness and allow the economy to become more export-driven. Even then, potential output growth is likely to be significantly lower going forward, reflecting weaker investment (Table 2)—with much of the decline in investment in the baseline reflecting the correction in the inflated construction sector—the destruction of potentially viable firms in the downturn, and the negative impact of Ignalina’s closure. As such, potential growth could decline by at least 1½–2 percentage points relative to its peak of 6 percent in 2004–06. All in all, potential output is expected to be around 15 percent lower by 2014 than it would have been absent the crisis, a larger loss in potential than experienced during the Asian crisis, including in Indonesia.

uA01fig02

Real and Potential GDP 1/

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: IMF staff estimates.1/ In log terms. Potential output for Lithuania estimated using a production function approach.2/ For Indonesia, HP filter estimate of potential for 1997-2003, normalized at Lithuania’s 2008 level. Indonesia is chosen as a benchmark as it was the country most severely impacted by the 1997 Asian Crisis.

12. Uncertainty around these medium-term forecasts is unusually large, but risks are on the downside. Forecasting medium-term headline and potential growth in a context of double digit contraction is fraught with difficulties. The outlook could also prove worse than staff’s baseline: (i) the global recovery could be delayed, (ii) factor costs still have a ways to adjust to fully regain competitiveness, and (iii) resolving the debt overhang in a deflationary context may take longer than expected, with the banking system impaired by rising non-performing loans (NPLs) acting as a drag on growth. If downside risks to medium-term growth were to materialize, other elements of the baseline such as the fiscal path would naturally be affected.

13. Against the backdrop of a sizeable economic contraction, the current account is expected to be in a temporary surplus (Table 4). The current account is forecast to be in surplus in 2009 (0.6 percent of GDP) as the reduction in imports (about 36 percent) outpaces that of exports (about 26 percent). Over the medium-term, the current account is expected to revert to a deficit as the economy recovers and electricity-related imports to replace Ignalina’s output rise. However, the forecast 9 percent improvement in the real effective exchange rate over the projection period, together with the economic recovery in trade partners, contributes to gradually increasing export volumes. Inflows are likely to remain at lower levels than the recent past which would help stabilize external debt after 2011 (Annex 1).

Table 4.

Lithuania: Balance of Payments, Baseline 2007–14

(In billions of euros, unless otherwise indicated)

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Sources: Data provided by the Lithuanian authorities; IMF International Financial and Trade Statistics; and Fund staff estimates and projections.

The 2009 projections assume rollover rates of 85 percent for foreign banks, 50 percent for domestic banks, and 75 percent for corporates; 5 percent deposit outflows for nonresidents; and FDI (excluding bank recapitalizations) declining 75 percent. The 2010 projections assume rollover rates of 95 percent for foreign banks, 75 percent for domestic banks, and 85 percent for corporates; 5 percent deposit outflows for nonresidents; and FDI (excluding bank recapitalizations) declining 75 percent with respect to 2008. The overall FDI figures include the recapitalization of subsidiaries by their parent bank in both 2009-10.

Short-term debt at remaining maturity.

14. However, the economy is left with significant debt and subject to a funding contraction (Box 1). External liabilities are not being fully rolled over. Net private capital outflows are forecast to reach 12 percent of GDP in 2009 reflecting declines in trade credit and rollover rates of 80 percent in banks (85 percent in foreign banks) and 75 percent in the corporate sector.3 These outflows are partly mitigated by capital inflows to the public sector reflecting the front-loading of EU structural funds, and the increase in EIB and eurobond funding. Capital injections by foreign banks into their subsidiaries is assumed to occur over the remainder of 2009–10 through FDI. All together, net inflows (estimated recapitalization needs net of repayments to parent banks) by foreign banks in 2009–10 are assumed to amount to 1.7 percent of GDP.

uA01fig03

New Loans to Individuals

(Millions of litas)

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: Association of Lithuanian Banks; and IMF staff estimates.

15. The economy is consequently in the midst of a credit contraction reflecting deteriorating asset quality, as well as lower funding and credit demand.

  • The depth of the ongoing credit crunch is evidenced by the lack of issuance of new loans. The stock of credit to the private sector has already declined by 3.3 percent in the first five months of 2009.

  • The capital adequacy ratio (CAR) of 13.9 percent is above the 8 percent regulatory minimum (Table 5). However, the stock of NPLs nearly doubled between Q4 2008 and Q1 2009 to 8.2 percent, with the overdue but not impaired component increasing at a much faster rate.4 Loan loss provisioning is not keeping pace, covering only about 20 percent of NPLs, and NPLs net of provisions account for 70 percent of bank equity. Capital buffers are likely to thin as the recession proceeds, already evidenced by negative profitability in 2009 Q1.5

Table 5:

Lithuania: Financial Soundness Indicators, 2005–09, banking system data

(In percent, unless otherwise specified)

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Source: Bank of Lithuania.

Without foreign bank branches.

Capital is the item in banks balance sheet under Shareholders’ Equity and Foreign Bank Branches Funds Received from the Head Office (the latter untill end-2007).

From end-2005 FSI is Nonperforming loans to capital.

Net income before taxes.

Large exposure - means loans granted to the borrower the net value of which equals to, or exceeds, 10 per cent of bank capital that is calculated having regard to the national Rules for Calculating Capital Adequacy. In this particular case Loan - means all bank’s monetary claims to the borrower, acquired shares (contributions or other portions of equity), reflected in the bank balance-sheet and off-balance sheet items, also monetary obligations of the bank recognised in the bank’s off-balance.

From June 2008, the data on loan portfolio quality is collected through FINREP tables (EU common reporting templates). By this, overdue non-impaired loans and the impaired loans are separated. The sum of these loans could be considered as non-performing loans, however the new series of non-performing loans are not comparable to the previous ones.

Composition of liquid assets is defined in the Liquidity Ratio Calculation Rules approved by Resolution No. 1 of the Board of the Bank of Lithuania of 29 January 2004.

Composition of current liabilities is defined in the Liquidity Ratio Calculation Rules approved by Resolution No. 1 of the Board of the Bank of Lithuania of 29 January 2004.

Information is based on interbank deals of all maturities (mostly overnight) made between resident banks in national currency Litas within the last quarter of the period.

From 2005, the major part of foreign currency loans and foreign currency liabilities are in euros.

From end-2005 to Q1-2008, NPLs are loans with payments on which are overdue more than 60 days. Untill 2004 NPLs are loans in Substandard, Doubtful and Loss loans categories.

Credit registry data from 2005, therefore, it is considered as estimate of actual sectoral distribution.

As defined in Rules for Calculation of Capital Adequacy approved by Bank of Lithuania Board Resolution No. 138 of 9 November 2006.

uA01fig04

Bank Asset Quality and Provisioning

(QOQ percentage change)

Citation: IMF Staff Country Reports 2009, 322; 10.5089/9781451824223.002.A001

Source: Bank of Lithuania; and IMF staff estimates.

  • Liquidity risk requires close monitoring. In October 2008, a deposit run drained 6½ percent of total deposits. While liquidity has since stabilized, deposits have shifted increasingly into foreign currencies (FX deposits account for about 31 of deposits compared to about 25 percent at end-2008). Funding and access to contingent sources in case of deposit stress remains a challenge. Parent bank funding of subsidiaries has declined, while domestic banks face pressure from the interbank market—where maturities have shortened, funding has decreased, and rates have increased sharply—as well as increased competition for deposits. Moreover, nonresident deposits, which represent a modest 7 percent of deposits of the system have contracted sharply by 41 percent since end 2007 as the economic situation deteriorated in neighboring countries.

16. The BoL has reacted swiftly to these challenges. Since October 2008 it reduced reserve requirements from 6 to 4 percent to help ease liquidity pressures, and has implemented 2008 FSAP Update recommendations to improve internal guidelines for lender of last resort operations (LoLR) and collateral valuation procedures, while monitoring daily bank-by-bank deposits and liquidity positions. The deposit insurance limit was raised to €100,000 and bank resolution tools are also being enhanced through the draft Financial Stability Law in Parliament. The new framework provides for government guarantees of interbank lending (Litas 3 billion, 3.4 percent of GDP), and public support for bank recapitalization and asset purchases. The government has also established a financial crisis preparedness committee to enhance coordination and contingency planning.

17. Government finances are also under considerable strain reflecting the legacy of the sizable structural deficit amassed in the boom (Tables 6–7):

Table 6:

Lithuania: General Government Operations, 2005–11

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Sources: Ministry of Finance, Ministry of Social Security and Fund staff estimates.

As presented in the 2008 Convergence Programme (approved in January 2009).

For 2009, including 600ml litai in yet to be approved savings measures, worth an annual yield of 1.5bn litai in 2010/11 and already distributed in the appropriate line items. For 2010/11, also including yet to be approved unidentified savings measures worth 3.35bn and 2.7bn litai, respectively

In the projection, unidentified financing.

General government deficit including 0.55 percent of GDP not transferred by SODRA to private pension accounts in 2009-2011.