Republic of Lithuania
2011 Article IV Consultation
Author: International Monetary Fund
Publication Date:
21 Nov 2011
eISBN:
9781463925246
Language:
English
Keywords:
ISCR; CR; deficit; authority; financing; debt; foreign currency; core inflation; current liabilities; energy price inflation; consumer confidence; Commercial banks; Baltics; Global
Download PDF (683.6 KB)

The 2011 Article IV Consultation reports that the economy in the Republic of Lithuania has staged an impressive recovery based on a supportive global environment and determined policy adjustment. The main driver of the recovery was export growth. Executive Directors commended the authorities for Lithuania’s impressive economic recovery, noting in particular the sizable fiscal consolidation and the maintenance of confidence in the banking system. Directors also supported the authorities’ goal of reducing further the fiscal deficit, thereby putting government debt on a downward path.

Abstract

The 2011 Article IV Consultation reports that the economy in the Republic of Lithuania has staged an impressive recovery based on a supportive global environment and determined policy adjustment. The main driver of the recovery was export growth. Executive Directors commended the authorities for Lithuania’s impressive economic recovery, noting in particular the sizable fiscal consolidation and the maintenance of confidence in the banking system. Directors also supported the authorities’ goal of reducing further the fiscal deficit, thereby putting government debt on a downward path.

CONTEXT

A. Recent Developments

1. Following a sharp output decline in 2008 and 2009, Lithuania has staged one of the strongest recoveries in Europe. The economy contracted by a cumulative 18 percent between the second quarter of 2008 and the last quarter of 2009, the fourth largest peak to trough contraction in the world after Latvia, Ukraine, and Estonia. But the revival in exports that started in mid-2009 lifted the economy out of its slump, with GDP expanding by 1.4 percent in 2010 and by 6.3 percent in the first half of 2011.

2. Export growth has been the main driver of the recovery. Exports were underpinned by strong economic growth in Lithuania’s main trading partners, including Germany, Poland, and Russia. Sharp nominal wage declines helped restore competitiveness, leaving Lithuania well positioned to take full advantage of higher external demand. Staff estimates that the real exchange rate is now broadly in line with fundamentals (Box 1). Finally, prices for some of Lithuania’s key agricultural exports have soared.

A01ufig03

REER, Manufacturing ULC-based

(peak = 100)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: EU Commission; and IMF staff calculations.

3. Booming exports raised corporate profitability and improved the labor market. Higher sales revenue boosted corporate profitability, with the aggregate operating surplus and mixed income up by some 60 percent since early 2010, and almost back to pre-crisis levels. The unemployment rate, which rose sharply from mid-2008 until mid-2010, has started to fall. The ratio of vacancies to unemployed has risen. As a result, private sector average gross earnings, which had fallen by some 12 percent from late 2008 (substantially more in some sectors like construction), have picked up again, rising by a cumulative 2.5 percent in the last three quarters, more than offset by strong labor productivity growth.

4. As a result, the recovery has broadened to domestic demand. Improvements in the labor market and rising consumer confidence have fed into private consumption. Car sales have been especially strong, reflecting pent-up demand. On the corporate side, improved profitability and rising capacity utilization rates led to higher fixed investment. Gross fixed capital formation, which contracted sharply until mid-2010, has risen vigorously. The rebuilding of inventories also contributed strongly to growth in 2010.

5. Rebounding domestic demand, import-intensive exports, and higher energy prices have boosted imports. With oil-related products constituting a third of total imports, the rise in global energy prices that lasted until mid-2011 was an important factor. But non-oil imports have also been strong, including consumer durables and capital goods. As a result, the current account swung from a 1.5 percent of GDP surplus in 2010 to a 1 percent of full-year GDP deficit in the first half of 2011.

6. The surge in food and energy prices raised headline inflation, but pressures are now abating. With food and energy accounting for 40 percent of the CPI basket, higher heating costs stemming from the closure of the Ignalina nuclear plant in January 2010 and the run-up in food prices quickly translated into higher headline inflation, which peaked at 5.0 percent in May 2011. Since then, food and energy prices have been falling on a m/m basis, in line with global trends, bringing headline inflation down to 4.7 percent in September. After more than a year of deflation, core prices started rising y/y in April 2011. Core inflation was 1.2 percent in September, led by items such as clothing and hotels, cafes, and restaurants.

A01ufig04

HICP Inflation

(YoY percent change)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Haver; and IMF staff calculations.

B. Near-Term Outlook and Risks

7. Growth is expected to slow sharply. Given slowing external demand and uncertainty about prospects, q/q growth (s.a.) is projected to be only about 0.5 percent (annualized) in the second half of 2011. For the year as a whole, this implies growth of 6.3 percent, given the very strong first half. In 2012, the economy is expected to gradually regain momentum, in line with the baseline view in the Fall 2011 WEO that tensions in the global economy will be resolved. Annual growth in 2012 is projected to be 3½ percent. As a result, the estimated negative output gap should narrow from 2.7 percent in 2011 to 1.4 percent in 2012 (compared to 6.1 percent in 2010).

8. The external current account deficit should remain manageable. The current account deficit is expected to widen a little in 2012, as the slowdown in domestic demand is projected to be less sharp than that of exports. In both 2011 and 2012, the modest current account deficits will be more than financed by EU capital transfers. In the financial account, net FDI is expected to be strong, and repayments of liabilities by domestic bank subsidiaries to their Scandinavian parents are expected to decline, in line with recent trends.

9. The labor market should continue to improve. The unemployment rate is projected to fall from 15.5 percent in 2011 (yearly average) to 14 percent in 2012. Staff expects average nominal gross earnings to grow by 3.3 percent this year and 4.1 percent next year.

10. Headline inflation is expected to moderate going forward. Consumer price inflation is projected to fall to 3.8 percent at end-2011, reflecting the easing of food and energy price inflation, in line with recent declines in international commodity prices. Core inflation is expected to rise only modestly, given still-high unemployment and a negative output gap. The projected continuation of these trends (low non-core inflation, core inflation rising slowly up to 2 percent) would result in 2.7 percent inflation at end-2012 (and an annual average rate of 3.1 percent). While the uncertainties surrounding inflation forecasts are large, it appears at this stage that Lithuania may not meet the Maastricht inflation criterion in 2012, given the inflation forecasts for other EU countries.

11. Risks to growth are clearly on the downside. Turmoil in the global economy presents two major risks for Lithuania:

  • Heightened uncertainty. Both in Lithuania and elsewhere, heightened uncertainty could push consumers and firms to defer investment spending, firms to defer hiring, and banks to defer extending credit. Lithuania is particularly exposed as 30 percent of its exports go to the euro area.

  • Global financial markets freeze. While external debt has fallen since 2009 as foreign-owned banks have reduced liabilities to their parents, it remains relatively high. The government has fully financed current year needs, but increases in external borrowing costs would weigh on the country given some 8 percent of GDP in gross financing needs for next year. In the banking system, subsidiaries or branches of Scandinavian banks account for three quarters of total assets. The parent banks rely on wholesale markets to cover about half of their total funding. However, the Scandinavian authorities are well prepared to deal with liquidity pressures on their banks, given their sizeable reserves, their preparedness to extend the range of acceptable collateral, and the possibility of re-activating swap lines with major central banks.

Authorities’ views

12. The authorities broadly agreed with staff’s assessment of the outlook and risks. They shared the view that growth and inflation are likely to slow going forward, and that risks are firmly on the downside. They underlined Lithuania’s small size and high degree of integration into the European economy. At the same time, they considered that the impact of any global crisis would be smaller than in 2008–09, as large imbalances have been corrected. The authorities concurred with staff that there is no remaining competitiveness gap in the real exchange rate.

POLICY CHALLENGES

A. Reducing Government Debt and Financing Needs

13. The fiscal deficit has narrowed substantially since 2009, reflecting mainly expenditure restraint. The general government deficit (ESA basis) declined from 9.2 percent of GDP in 2009 to 7.1 percent of GDP in 2010. In the first half of 2011, it fell by 1 percentage point of GDP compared to the first half of 2010 (Figure 2). Staff projects a fiscal deficit of 5.1 percent of GDP for 2011 as a whole, compared to the government’s original target of 5.8 percent of GDP (set in the 2011 budget) and the revised target of 5.3 percent of GDP (set in the Convergence Program). In particular:

  • Expenditure. Wage cuts instituted in 2009 resulted in a substantial decline in the wage bill from 2009 to 2010, and these gains are being preserved in 2011. Similarly, social benefit payments—notably pensions and parental benefits—were reduced. All in all, staff expects total expenditure to fall by 3 percentage points of GDP in 2011, despite higher debt service costs.

  • Revenue. VAT and excise duties are growing fast, consistent with staff analysis that suggests that VAT yields are pro-cyclical (Box 2). However, direct taxes and social contributions lagged behind, as wages and employment have grown less quickly than nominal GDP.

Figure 1.
Figure 1.

Real and External Developments

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Figure 2.
Figure 2.

Fiscal Developments

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

14. Looking ahead, the government’s 2012 deficit target of 2.8 percent of GDP and medium-term objective of a small surplus are appropriate. In addition to preserving euro adoption aspirations, a further reduction in the fiscal deficit is needed to reduce financing needs, put debt firmly on a downward path, and prepare for population aging:

  • Financing needs. The government has fully financed 2011 needs. However, the government has some 8 percent of GDP in gross financing needs next year, including refinancing the euro bonds that were issued in 2002 and 2006. As buffers, the government has several months of cash reserves. There may also be scope for greater domestic financing, given significant liquidity in the banking system and limited private demand for credit.

  • Regaining fiscal space. Given its high exposure to external shocks and currency board arrangement, Lithuania needs room for automatic stabilizers to operate in downturns. With government debt now approaching 40 percent of GDP (up from 15.5 percent of GDP in 2008), such room is limited. A small medium-term surplus would put debt firmly on a declining path, regaining some of the fiscal space lost in the recent crisis.

  • Population aging. Lithuania’s population is projected to fall by 20 percent between 2010 and 2060, with the dependency ratio rising from 1-to-4 to 1-to-2. The most recent EC Sustainability Report projects that, as a result of aging, government spending could rise by as much as 6 percent of GDP over the long term. In addition, rising health care costs could add a further 4 percent of GDP to spending.

A01ufig05

General Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Statistics Lithuania; and IMF staff projections.

15. While staff and the authorities agreed that measures worth 1–1¼ percent of GDP are needed to reach the 2012 target, staff emphasized that consolidation be sustainable (Table 5). One option would be to expand wealth taxation, given that such taxes are less distortive than other taxes, are progressive, and are relatively low in Lithuania. Specifically, the taxation of property and motor vehicles could be expanded to include non-commercial usage, with appropriate thresholds to protect poorer owners. Another option would be to broaden tax bases. For example, the base of social contributions could be broadened to include all earnings categories, CIT exemptions (such as the investment incentive) could be eliminated, and pensions could be taxed as regular personal income. In addition, staff recommended that any further spending cuts should aim to protect the most vulnerable, as well as preserve investment levels.

Table 1.

Lithuania: Selected Economic and Social Indicators, 2009–2009

Population (2010): 3.293 million

GDP per capita (2010): U$D 11,004

Life expectancy at birth (2009): 78.3 years (women), 67.5 years (men)

At-risk-of-poverty, share of population (2010): 33.4 percent

article image
Sources: Lithuanian authorities; World Bank; Eurostat; and IMF staff estimates and projections.

For 2011, second quarter data.

Government external debt here includes guaranteed loans.

CPI-based, 2005 trade-weighted real effective exchange rate against 17 major trading partners. For 2011, average January-August.

Table 2.

Lithuania: Medium Term Framework, 2009–16

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

Based on labor force survey data.

Government external debt here includes guaranteed loans.

CPI-based, 2005 trade-weighted real effective exchange rate against 17 major trading partners. For 2011, average January-August.

Table 3.

Lithuania: Balance of Payments, 2009–16

(In billions of euros, unless otherwise indicated)

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

Government external debt here includes guaranteed loans.

Short-term debt at remaining maturity.

Table 4.

Lithuania: General Government Operations, 2009–2009

(ESA 95 aggregates, in percent of GDP)

article image
Sources: Ministry of Finance; Ministry of Social Security; and IMF staff estimates.

General government deficit including payments not transferred by SODRA to private pension accounts. For 2012 and beyond, the forecast assumes the planned restoration of pensions to pre-crisis levels.

Table 5.

Lithuania: Possible Revenue Measures

article image
Source: IMF Staff estimates.

Estimated yields for the proposed measures are mutually exclusive.

16. If downside risks to revenue materialize, further fiscal measures would be needed. While additional fiscal adjustment would be procyclical, the scope for a wider fiscal deficit is limited, as it would be more difficult to finance, could shake investor confidence, and would undermine euro adoption aspirations. Therefore, the government should draw up a list of saving measures that could be implemented quickly if revenue growth is weaker than expected.

17. Over the medium term, additional adjustment will be needed to achieve the government’s medium-term objective. Based on announced policies and staff’s medium-term outlook, cumulative adjustment of about 2 percentage points of GDP is required in addition to the 2012 effort. In this context, structural reforms are important:

  • Pension reform. In June, Parliament approved a gradual increase in the pension age to 65 for both men and women, from 62.5 and 60 in the current system, respectively. This is an important step that is expected to deliver at least 1 percent of GDP in annual savings over the long run, but is insufficient in itself. Because of the size of demographic changes, and because benefits are indexed to wages, the system will not be sustainable without further reform. Staff thus supports recent guidelines on pension reform approved by Parliament which call for linking future benefits to demographic factors. In tandem with these reforms, the basic social pension could be separated out and financed from the general budget.

  • Health care reform. The government is consolidating hospitals, given the relatively high number of hospital beds per capita, and concentrating medical procedures in fewer, higher-volume centers, so as to benefit from economies of scale.

  • State-owned enterprises (SOEs). With SOE assets accounting for some 25 percent of GDP, efficiency gains could yield substantial transfers to the government as well as benefit the economy as a whole. With this in mind, the government completed a major inventory of SOE assets last year, which has been published. There is also ongoing work to assess the social functions of SOEs. Rigorous cost-benefit analysis should be expanded, as some operations may be too costly given the social benefit they provide. Governance reform is also needed, particularly with respect to the independence and professional experience of boards of directors.

  • Tax compliance. The government has launched an ambitious compliance strategy, supported by Fund technical assistance. A Commission for Coordination of Cooperation among State Economic and Financial Control Authorities has been set up to provide strategic guidance and monitor the implementation process. Following Fund advice, the State Tax Inspectorate (STI) has improved the allocation of resources earmarked for tax inspection, now focusing the majority of its efforts on a relatively small number of large and medium-size businesses representing about half of total turnover in the country. In addition, STI has put in place new training programs for tax inspectors, and legislative changes have been introduced allowing the government to collect unpaid taxes from enterprises facing bankruptcy proceedings. Going forward, staff supports the authorities’ plans to tighten tax compliance further by expanding the use of cash registers, reducing loopholes through which business licenses can be used for tax avoidance, and stepping up the fight against border smuggling.

18. Improvements to the fiscal framework would help underpin medium-term consolidation efforts. Currently under consideration are amendments to the fiscal framework which would tighten rules on the use of Treasury reserves, strengthen the role of independent evaluation in budget planning and execution, and introduce an additional fiscal rule requiring a decline in the headline deficit of at least 0.6 percent of GDP whenever the projected output gap is positive. Tighter access to fiscal reserves would be an important step, as it would help discipline spending. At the same time, independent evaluation should be entrusted to a new body such as a fiscal council. Also, while the proposed additional rule provides a welcome focus on counter-cyclicality, it would be difficult to implement: linking it to the sign of the projected output gap is hard to manage effectively, and the setting of a 0.6 percent of GDP fiscal adjustment whenever the output gap is positive would seem arbitrary. Instead, it would be better to complement the existing expenditure rule, which provides sensible targets for the forecast horizon, with a “debt brake,” in line with the objective of bringing debt down to well below 40 percent of GDP.

Authorities’ views

19. The authorities underlined their commitment to the 2012 fiscal deficit target of 2.8 percent of GDP. However, they pointed to the difficulty of introducing new taxes in an election year. Instead, they said they would meet the target by increasing non-tax revenue and reducing spending. Given the strong financial performance of SOEs in 2011, they saw scope for higher dividend receipts of about ½ percent point of GDP in 2012. In addition, land sales could yield ¼ percent of GDP, and a change in the valuation method for the land tax (administered by local governments) could yield ¼ percent of GDP. They also planned to reduce ministries’ spending allocations by 2 percent across the board, which would save another ¼ percent of GDP. Should downside risks to revenues materialize, they would consider a supplementary budget to achieve the 2012 fiscal target. Finally, they said that work on the fiscal rule is still ongoing and that they would take into account staff’s suggestions.

B. Ensuring Banking System Resilience

20. The strong recovery has boosted banking system performance (Figure 3). Nonperforming loans, which rose sharply from mid-2008 to end-2009, have stabilized. Several banks, which provisioned aggressively for NPLs when they were rising, have recently reduced loan loss provisions. Lower loan loss provisions and higher net interest margins have supported an improvement in banking system profitability. Cumulative profits in the four quarters to 2011Q2 reached €188 million, compared with €1 billion in losses in previous four quarters. Return on assets improved from negative 4.8 percent at end-2009 to positive 1.3 percent in the most recent four quarters, close to ROA during the boom.

Figure 3.
Figure 3.

Money and Banking

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

21. The banking system as a whole is liquid and well capitalized. Increases in capital, which in 2009–2009 amounted to 3 percent of GDP or 40 percent of bank capital measured at end 2008, played a key role in preserving financial stability. Banking system prudential ratios are now well above regulatory minima: the average capital adequacy ratio was at 14.8 percent in 2011Q2, while the Tier 1 and core Tier 1 ratios were 11.4 percent and 10.3 percent respectively, above future Basel III requirements. Similarly, the average ratio of liquid assets to current liabilities was slightly above 40 percent (compared to the regulatory minimum of 30 percent); the central bank’s preliminary calculations suggest that the liquidity coverage ratio was close to 200 percent, and the net stable funding ratio was slightly below 100 percent (the Basel III requirements for the latter two are minima of 100 percent).

22. The banking system’s strong capital position suggests that supply factors are not the main reason behind low credit growth. Both stock and flow indicators of credit remain weak, but in staff’s view this mostly reflects lack of demand as corporations and households continue to repair their balance sheets. Recently, greater uncertainty about global economic developments has dampened appetite for investment. On the supply side, it is reassuring that banks have tightened lending standards on construction and real estate related sectors (where excess capacity is large) but not on export sectors (which are growing rapidly). Anecdotal evidence suggests that there is competition among banks to provide credit to good corporate borrowers.

23. Most banks are well-positioned to withstand further shocks. While no Lithuanian bank was included in the EBA stress tests, recent stress tests by the Bank of Lithuania (BOL) show that, under a large decline (13 percentage points) in export volumes and a sharp spike (260–440 basis points) in interest rates, aggregate and median CARs would still remain above 10 percent. Similarly, the aggregate liquidity ratio would remain above 30 percent even with a 10 percent deposit drain, and would fall only marginally below 30 percent with a 15 percent deposit drain. While foreign-owned banks are dependent on funding from their parents (their average loan-to-deposit ratio is still about 150 percent), parents did not curtail funding abruptly in 2009–10.

24. Despite generally encouraging developments, remaining pockets of weakness should be addressed without delay. A few banks, which account for 15–15 percent of deposits and do not have liquidity backstops from foreign parents, have set aside lower provisions for losses than others despite having higher NPL ratios. Under the adverse scenarios in the BOL stress tests, these banks did not meet minimum capital requirements. Prompt corrective action is needed to address these weaknesses before they get bigger and to minimize any potential costs. Supervisors should enforce conservative assessment of risks in these banks, require adequate loan loss provisions, and demand capital increases when this is warranted. If the need arises, the law provides the necessary authority to take adequate measures. In line with European and global initiatives, as well as earlier Fund technical assistance, it is urgent to broaden the range of resolution tools, for example to include a purchase and assumption option.

25. Plans to unify financial supervision should lead to better identification of risks and trouble spots. At present, the central bank is responsible for bank supervision, while insurance and securities companies are supervised by an insurance commission and a securities commission, respectively. A draft law currently in parliament would unify supervision (as well as a newly created consumer protection agency) under the BOL. Unification of supervision makes sense in Lithuania given economies of scope, with many insurance and securities companies owned by banks. Preparations to implement the new organizational structure in early 2012 are well under way. However, the draft law is silent about the reporting responsibilities of the head of supervision. It will be important that this function report directly to the highest governing body of the BOL. In addition, the imminent introduction of responsible lending guidelines (which include limits on loan-to-value and debt service-to-income ratios) should help contain systemic risk in the future.

26. More effective insolvency regimes are needed. A corporate insolvency regime exists, but is widely regarded as too slow, in part because the law does not provide adequate guidance to judges. A new law on a personal insolvency regime is currently in parliament. The proposed law is broadly in line with Fund advice. However, there is room for improvement in a few areas, notably to allow creditors (and not only debtors) to initiate bankruptcy proceedings. The draft law also lacks collective enforcement mechanisms when no plan has been submitted to or approved by the courts, or when proceedings have been declared terminated. It will also be important to ensure the availability of advisory services to debtors on their rights under the new regime.

Authorities’ views

27. The authorities broadly agreed with staff’s assessment of financial sector stability and risks. They said that they are determined to be proactive in assessing credit quality and requiring remedial action where necessary. They do not plan to allow creditors to initiate personal bankruptcy proceedings, as they consider that civil courts provide enough recourse.

C. Sustaining Growth over the Medium Term

28. Sustaining the recovery over the medium term will require balanced growth. During the economic expansion that preceded the crisis, resources were increasingly allocated to nontradable sectors, which have little room for productivity enhancements. Looking forward, it will be important that resources go to tradable sectors, which will also help minimize external imbalances. Early signs are encouraging (Box 3). The contribution of tradable sectors to Lithuania’s strong recovery has been about 50 percent, much higher than during the pre-crisis boom. In addition, the sharp depreciation of Lithuania’s ULC-based REER suggests that international price competitiveness is not a problem. However, there is not yet evidence of stronger employment growth in tradables compared to nontradables.

29. Sustained growth also requires strong investment (Box 4). The investment to GDP ratio fell sharply during the crisis. Under staff’s central medium-term scenario, lower investment will lead to lower labor productivity growth, at precisely the time when the labor force is projected to shrink due to population aging and migration. Altogether, staff estimates potential growth of 3½–4 percent, which implies slower convergence of living standards to the EU average than before.

A01ufig06

Baltic Countries: Fixed Investment to GDP Ratio

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Haver; and IMF staff calculations.

30. Boosting employment participation and reallocating labor towards tradable sectors will be key. Sustaining even 4 percent potential output growth in the face of lower investment and a shrinking labor force will require large increases in the employment ratio, from around 60 percent currently to some 65 percent in the medium-term in the staff baseline forecasts. For this to happen, the labor market will have to reallocate resources towards growing sectors in the face of skill mismatches. To facilitate this process, staff support plans to make permanent changes to the Labor Code that allow greater use of fixed term contracts for new vacancies. Given that fixed term contracts are imperfect substitutes for permanent ones, temporary crisis measures which reduced firing costs on the latter could also be extended. In parallel, full use should be made of EU funds to support job schemes, expand training programs, and enhance the efficiency of labor bureaus. Finally, proposals to raise the minimum wage should be evaluated carefully, as they might slow job creation, reverse recent competitiveness gains, and increase government spending at this difficult time (as wages and benefits are tied to the minimum wage).

31. Efforts to improve the business environment are also important. Requirements for starting a business (including registration processes) have been commendably streamlined, though it will be important to ensure that the shorter timetable for obtaining a construction permit is implemented. The new law on business inspections is also welcome, as it separates policy making from policy implementation, increases transparency, and strengthens coordination among inspection agencies. Staff also supports the proposed law on strengthening the role of the Competition Council, as it would grant the council authority to more proactively investigate breaches of competition rules.

Authorities’ views

32. The authorities shared the view that potential output growth has fallen since the crisis, with their estimate close to 4 percent. They agreed that sustaining growth will require reallocating resources towards tradable sectors despite skill mismatches. They pointed to initiatives to make the labor code more flexible, improve the business environment, and enhance efficiency in SOEs. Regarding EU funds, they noted that Lithuania has one of the highest absorption rates in the EU. Finally, the authorities noted that raising the minimum wage could enhance labor supply incentives (as it is currently barely above the level of unemployment benefits), improve the reporting of wages for tax purposes, and help to reduce income inequality.

D. Euro Adoption

33. Staff supports the authorities’ intention to meet the Maastricht criteria in 2012. The exchange rate arrangement (both de facto and de jure) is a currency board pegged to the euro. Meeting the fiscal deficit target for 2012 of 2.8 percent of GDP is an important step towards the MTO, as well as necessary to preserve euro adoption aspirations. With regard to the inflation criterion, price controls should not be used to reduce inflation.

Authorities’ views

34. The authorities expressed their determination to meet the Maastricht criteria as soon as possible. They acknowledged that inflation could be above the criterion in 2012, but said that they had no intention of taking unorthodox measures to reduce inflation.

STAFF APPRAISAL

35. The economy has staged an impressive recovery, based on a supportive global environment and determined policy adjustment. Policy action included sizeable fiscal consolidation, the maintenance of confidence in the banking system, and significant wage adjustment that underpinned gains in competitiveness. After contracting sharply in 2008–2008, economic activity grew modestly in 2010 and robustly in the first half of 2011. The export-led recovery broadened to domestic demand and employment growth accelerated.

36. With the worsening of external conditions, a further strengthening of policies is needed. As weaker demand from the euro area dampens export growth, and higher external financing costs are passed on to bank lending in Lithuania, economic growth will slow sharply in 2012. Risks to the economic outlook are clearly on the downside. An intensification of financial strains in Europe could lead to even weaker external demand and jeopardize funding.

37. Further fiscal consolidation is needed to preserve Lithuania’s good fiscal record. The authorities’ commitment to reducing the fiscal deficit to 2.8 percent of GDP in 2012 is welcome, though some of the proposed measures (such as extraordinary SOE dividends and land sales) do not appear to be sustainable. Also, in implementing spending cuts, it will be important to protect the most vulnerable people and preserve the level of public investment. Looking forward, expanding wealth taxation and broadening tax bases remain important options. Given the upside risk to the fiscal deficit stemming from the downside risk to economic growth, a contingency plan consisting of further measures should be prepared.

38. Important fiscal reforms already underway should be deepened. Given population aging, further reform of the pension system to ensure long-term sustainability is needed. The cost-benefit analysis of state-owned enterprises’ social functions should be enhanced and governance reforms should be developed. Plans to further improve tax compliance are welcome. The role of independent evaluation in budget planning and execution could be expanded, and a strengthening of the existing expenditure rule could be considered.

39. The banking system as a whole appears well-positioned to withstand adverse shocks, but remaining pockets of weakness should be addressed without delay. The strong recovery has boosted banking system profitability; substantial increases in capital have raised the average capital adequacy ratio; and the average liquidity ratio is well above the regulatory minimum. Recent stress tests by the central bank show that the banking system as a whole is resilient to substantial shocks to capital and liquidity. However, some banks have made lower loan loss provisions than other banks, despite having higher NPL ratios. In these banks, it will be necessary to assess risks conservatively, to make appropriate loan loss provisions, and to increase capital if necessary. If the need arises, existing law provides the necessary authority to take adequate measures. In line with European and global initiatives, it is urgent to broaden the range of resolution tools.

40. The planned unification of financial supervision under the BOL will strengthen the authorities’ ability to identify and address risks to the financial system. The head of supervision should report directly to the highest governing body of the central bank. In addition, the imminent introduction of responsible lending guidelines to contain systemic risk is welcome. To ensure that viable individual borrowers can recover and that creditors have adequate protection, an effective personal insolvency regime is needed.

41. Sustainable growth over the medium term depends on increased labor participation, labor reallocation to tradable sectors, and strong investment. Greater use of fixed-term contracts could stimulate job creation. By contrast, raising the minimum wage at this juncture could slow job creation, reverse recent competitiveness gains, and increase government spending. Full use should be made of EU structural funds to overcome skill mismatches. To encourage investment, further efforts are needed to improve the business environment. The new law on business inspections and the proposed law on strengthening the role of the Competition Council are welcome.

42. It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

Real Exchange Rate Assessment

The depreciation of the real exchange rate since 2008–09 has mostly reflected significant nominal wage declines. Since the peak, the whole-economy ULC-based REER has depreciated by 12 percent, and the manufacturing ULC-based REER by 19 percent. The latter is now back to its 2000 level and some 11 percent below its 2005 level. The CPI-based REER has depreciated by less, as consumer prices declined less sharply than wages.

A01ufig07

REER Index

(2000Q1 = 100)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: EU Commission; and IMF staff calculations.

The real exchange rate is now assessed to be broadly in line with fundamentals. The average misalignment across the three CGER methods is not significantly different from zero. In the 2010 Article IV consultation, the CGER methods had found modest overvaluation, while a broader analysis (including unit labor costs) had suggested no competitiveness gap. As various measures of the real exchange rate have been broadly stable over the past year, this year’s assessment is broadly consistent with last year’s. Regarding the CGER methods, it is important to note that this year’s computations of the current account norm and equilibrium exchange rate are based on a wider data set, and the estimates now impose multilateral consistency.

CGER-type Estimates of Misalignment

(Percent)

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Source: IMF staff calculations.

The assessment that there is no competitiveness gap at present is consistent with Lithuania’s strong export performance. The share of Lithuania’s exports in total EU exports has increased sharply over the past year and a half. Going forward, it will be important to avoid real exchange rate appreciation in order to maintain competitiveness in the face of significant challenges to medium-term sustainable growth.

A01ufig08

Lithuania: Share of EU Exports 1/

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Source: Haver.1/ Lithuania non-fuel exports as a percent of total EU exports.

Time-Varying Tax Elasticities1

Historical, cross-country evidence suggests that tax revenues grow more quickly than their underlying bases during expansions and contract more sharply during recessions. The deviation of short-run tax elasticities from their long-run equilibriums can be driven by short-changes in the composition of tax bases and cyclical variations in tax compliance. In Lithuania, the VAT elasticity is especially important, as VAT revenue accounts for about half of total tax revenue. Staff analysis finds that the elasticity of VAT has fluctuated between 0.5 and 1.5 over the past decade.

The recent strong growth of VAT revenue is consistent with an increasing short-run elasticity. Using a panel of 10 new EU member countries, staff analysis finds robust evidence of the long-run neutrality (i.e. unit elasticity) of VAT revenue with respect to private consumption (tax base). At the same time, the analysis finds that VAT revenue can and does deviate from its long-run value, with the deviation falling by about 10 percent each quarter (or 60 percent each year). According to the analysis, VAT revenues in Baltic countries deviated from their long-run levels during the recent boom and bust. At the peak of the boom, VAT collections exceeded their long-run equilibrium by about 20 percent in Latvia and 10 percent in Lithuania and Estonia. The gap turned negative in the aftermath of the crisis, particularly in Latvia and Lithuania, but is now closing again. In Lithuania, VAT revenue is estimated to have been about 5 percent below its long-run value at end-2010.

A01ufig09

Estonia: Cyclical VAT Gap

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Ministry of Finance; and IMF staff calculations.
A01ufig10

Latvia: Cyclical VAT Gap

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Ministry of Finance; and IMF staff calculations.
A01ufig11

Lithuania: Cyclical VAT Gap

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Ministry of Finance; and IMF staff calculations.
1 See Selected Issues Paper, “Assessing the Variability of Tax elasticities in Lithuania”.

Rebalancing Growth1

After the boom in non-tradables ended in a crisis, will the economy rebalance towards export sectors? The post-crisis recovery has been very much export driven, and the contribution of tradable sectors to total growth, at some 50 percent, has been much higher than in the past. The impressive export performance has helped Lithuania achieve the second strongest recovery in central and eastern Europe after Estonia.

Is the export revival a product of temporary factors, or does it signal a more permanent reallocation of resources in the economy? Lithuanian exports have benefitted from temporary factors, including increases in the global prices of key exports (especially food products and fertilizers) that could easily reverse. Signs of a more sustained reallocation are mixed:

A01ufig12

Contributions to Cumulative GDP Growth since Trough

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: Haver; and IMF staff calculations.

  • Labor: with the exception of the transportation sector, tradable sectors have generally not contributed more to employment growth than non-tradable sectors. It may be that exporting firms are uncertain about prospects, so are delaying hiring new workers.

  • FDI: while net FDI as a percent of GDP is lower than before the crisis, the composition of FDI has shifted towards tradable sectors. FDI flows into real estate or financial intermediation have fallen by some 2½ percentage points of GDP relative to pre-crisis levels, but flows into manufacturing have stayed constant.

In short, there are early signs of a reallocation of resources towards tradable sectors, but this is not yet firmly entrenched. Going forward, it will be important to ensure that competitiveness is not eroded.

A01ufig13

Contribution to Total Employment by Sector

(Percent)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Source: Eurostat; and IMF staff calculations.
A01ufig14

FDI Allocation, 2007 and 2010

(percent of GDP)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Source: Central Banks and national statistical officies
1 See Selected Issues Paper, “The Strength and Sustainability of the Recovery”.

Medium-Term Growth Prospects1

Medium-term growth rates in the Baltic countries will likely be lower than before the 2008–09 crisis. Empirical specifications based on the growth literature, which link economic growth to variables such as initial income, investment, education, institutional quality, and quality of macroeconomic policies, suggest that medium-term growth rates in the Baltic countries will be in the range of 3¼–4¼ percent. This is 4–5 percentage points lower than during the 2002–07 boom, a decline which is due to the following factors:

A01ufig15

Medium-term Growth: Model Predictions

(Percent per year)

Citation: IMF Staff Country Reports 2011, 326; 10.5089/9781463925246.002.A001

Sources: WEO; and IMF staff calculations.

  • Growth during the boom was unsustainably high. Estimating the same models in 2002 would have predicted growth rates about 2–2½ percentage points below actual growth during the boom.

  • Baltic countries are wealthier today than they were in the early 2000s. In all three Baltic countries, income per capita was higher in 2010 than in the early 2000s, despite the collapse in output over 2008–2008. Given conditional convergence (the phenomenon that ceteris paribus poorer countries tend to grow faster than richer countries), the Baltic countries should be expected to grow more slowly going forward. Econometric estimates suggest that the convergence effect accounts for about ¾ percentage point of the projected decline in growth.

  • Investment has fallen. In the Baltics, investment ratios were artificially boosted during the boom, but these gains were more than fully wiped out by the crisis. The decline in investment has not been limited to construction: non-construction investment also plummeted and is now about half the level seen over much of the last 15 years. Experience from countries with similar boom-bust cycles suggests investment could be slow to recover. If investment today was at 1998 levels, ceteris paribus, yearly predicted growth would be 1 percentage point higher in Latvia and Lithuania, and 1¾ percentage points in Estonia.

Lower investment will imply slower growth of labor productivity and hence a slower catch-up of living standards with the EU average. Labor productivity is projected to grow between 3¼–3¾ percentage points more slowly than during the boom years. And the slowdown in labor productivity will come at a time when the labor force is expected to shrink due to population aging and emigration. Sustaining even 4 percent GDP growth will thus require large increases in employment ratios.

1 See Selected Issues Paper, “How Fast Can the Baltics Grow in the Medium Term?”
Table 6.

Lithuania: Summary of Monetary Accounts, 2009–12

(In billions of litai; unless otherwise specified)

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

Excludes local government deposits; includes counterpart funds.

Loans to households and non-financial corporations.

BOP basis. Differs from gross foreign assets as shown in the monetary authority’s balance sheet because of (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.