Republic of Lithuania: Staff Report for the 2013 Article IV Consultation
Author: International Monetary Fund
Publication Date:
28 Mar 2013
eISBN:
9781484388358
Language:
English
Keywords:
ISCR; CR; growth; BoL website; credit growth; economic recovery; foreign currency; Gini coefficient; current account; exchange rate; Global
Download PDF (1 MB)

This 2013 Article IV Consultation IMF staff report focuses on measures that are being undertaken to rebalance macroeconomic growth in Lithuania. The IMF report discusses the requirement of fiscal consolidation to fully rebuild fiscal space. It highlights the important role played by the financial sector in enabling sound credit expansion to support economic growth. Reducing obstacles to the resolution of nonperforming loans could help ease constraints on credit supply. The current account deficit is projected to remain relatively contained over the medium term, reaching about 2 percent of GDP, and financed mostly by foreign direct investment.

Abstract

This 2013 Article IV Consultation IMF staff report focuses on measures that are being undertaken to rebalance macroeconomic growth in Lithuania. The IMF report discusses the requirement of fiscal consolidation to fully rebuild fiscal space. It highlights the important role played by the financial sector in enabling sound credit expansion to support economic growth. Reducing obstacles to the resolution of nonperforming loans could help ease constraints on credit supply. The current account deficit is projected to remain relatively contained over the medium term, reaching about 2 percent of GDP, and financed mostly by foreign direct investment.

Context

1. Lithuania has achieved significant macroeconomic rebalancing since the 2008–09 crisis, and vulnerabilities have diminished. The current account and fiscal deficits were substantially reduced, debt has fallen in most sectors of the economy, and wage compression quickly restored competitiveness. The latter laid the basis for a strong export-led recovery, which shifted the engine of growth to the tradable sector. Vulnerabilities have declined in the largely foreign-owned banking sector, as the loan-to-deposit (LTD) ratio has dropped markedly.

GDP per capita has recovered to its pre-crisis peak, although Lithuania’s shrinking population also contributed to this.

Lithuania: Macroeconomic Rebalancing

article image
Sources: BoL; MoF; Eurostat; and IMF staff estimates.

Latest available observation, except for fiscal balance projection.

2. The main policy challenge is to complete the adjustment to secure robust and sustainable growth. With the unemployment rate still high (albeit much lower than its peak level), sustaining growth will be essential for job creation, which would help stem outward migration, especially of young and highly skilled labor. Meanwhile, the fiscal deficit and public debt still need to be further reduced to create space for fiscal policy to play its countercyclical role going forward. In the banking sector, nonperforming loans (NPLs)—a legacy of the crisis—have contributed to cautious lending. Going forward, boosting credit growth will be especially important as a rebound in investment is needed to sustain the recovery and preserve competitiveness.

3. A new government took office in late 2012. The authorities are still in the process of fully articulating their policy agenda, but the government program stresses social inclusion, job creation, higher pensions and wages, and greater tax progressivity. The government has publicly announced its goal to adopt the euro in 2015. Lithuania will hold the EU presidency in the second half of 2013.

Recent Developments

A. An Ongoing Recovery

4. The recovery continued in 2012 with growth reaching 3.6 percent. Growth was supported by increased private consumption—reflecting improved labor markets conditions, some pent-up demand, and rising consumer confidence—and strong exports, which were further boosted by a bumper harvest (the harvest is estimated to have contributed about ¼ percentage point of GDP growth). Lingering uncertainty about the external and domestic environments kept investment low. As a result, capacity utilization is now above its long-term average.

A01ufig01

Industry capacity utilization

(percent, all NACE branches)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: National authorities; and IMF staff calculations.

5. Labor market conditions continued to improve. The unemployment rate fell to 13.2 percent in 2012, down from 15.3 a year before. Encouragingly, it fell across all segments, including for youth and the long-term unemployed, but remains high for both. Real wages are estimated to have increased moderately in 2012 for the first time in two years. After remaining frozen since early 2008, the minimum wage was increased in two steps, by 6.3 percent in July 2012 and by another 17.6 percent in January 2013, and is now in line with that of regional peers.

A01ufig02

Minimum Wage in Baltic States

(Euro per month)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Eurostat.

6. Inflation declined as the effects of rising global commodity prices moderated. The pass-through of higher food and energy prices continued in 2012, notably with a large increase in the heating price in July 2012. But this effect waned in the second half of the year, and energy prices even fell in late 2012. As a result, average inflation dropped from 4.1 percent in 2011 to 3.2 percent in 2012. Core inflation remained fairly subdued at 2 percent at end-2012.

7. The external position has improved, but debt remains high and reserve coverage low.

  • The trade balance turned positive and the current account improved. Strong exports, a bumper harvest, and an improvement in the terms of trade—lower oil prices and high cereals prices—turned the trade balance (goods and services) slightly positive in 2012, from a deficit of 2.6 percent of GDP in 2011. This reduced the current account deficit, which was broadly offset by lower FDI (the highly profitable manufacturing sector paid out dividends rather than fully reinvest profits), lower net portfolio inflows, and repayments of parent bank loans in the first half of 2012.1 The latter reflects the migration of deposits (about 3½ percent of GDP) from the intervened Snoras bank to foreign-owned banks, which used the extra funding to repay parent loans (Annex I, ¶10 and ¶22).

  • The real effective exchange rate is estimated to be broadly in line with fundamentals. The CGER results are based on the CPI, while manufacturing ULCs have risen more moderately.

CGER Results

article image
Source: Staff calculations.

  • External debt remains high and reserve coverage is low. Reserves at end-2012 (€6.5 billion) were about 3 months of imports, 60 percent of short term external debt, and about €1.9 billion below the new reserve adequacy metric. Gross external debt (72 percent of GDP) and net international investment liabilities (48 percent of GDP) are still high, reflecting still significant parent bank loans and foreign-held government debt, as well as the importance of net inward FDI. The debt sustainability analysis suggests that external debt is sensitive to current account and growth shocks.

8. Financial market conditions have been favorable. The government successfully issued about €1¾ billion in Eurobonds in 2012 and a 5-year €0.4 billion Eurobond at a yield of 2.6 percent in early 2013. Five year sovereign CDS spreads reached post-crisis lows, at about 100 bps.

B. The Banking System

9. The largely foreign-owned banking system is, overall, well capitalized and liquid. Banks’ capital was further strengthened in 2012 as dividends were not paid out: regulatory capital to risk-weighted assets improved from 13.9 percent at end-2011 to 14.2 percent at end-2012. The banking sector’s liquidity ratio stood at 40.4 percent, well above the regulatory minimum (30 percent). Preliminary calculations by the Bank of Lithuania (BoL) indicate that banks are compliant with future Basel III requirements, with the Tier 1 capital ratio at 11.5 percent, leverage ratio at 8.6 percent, liquidity coverage ratio at 192 percent, and net stable funding ratio at 161 percent. NPLs fell to 13.9 percent at end-2012, down from 16.3 percent a year before. At the same time, bank profitability declined amid excess liquidity, slow credit growth, and low net interest margins. Return on equity fell from 15.2 percent at end-2011 to 6.6 percent at end-2012.

10. But four credit institutions were intervened since the last Article IV Consultation amid rising loan losses. Snoras bank—at the time the largest domestically-owned bank, third largest bank by deposits, and fifth largest by assets (10 percent of system assets)—was liquidated in late 2011, as the bank became insolvent due to alleged fraud and misappropriation of assets (Annex I). The government financed the payout of insured deposits through a loan to the deposit insurance agency, but is expected to be largely reimbursed by Snoras’ bankruptcy estate. In late 2012/early 2013, two small credit unions were closed as rapid lending growth and some related-party lending had given rise to large loan losses and insolvency. On February 12, 2013, another domestically-owned bank (the largest after the liquidation of Snoras, with about 5 percent of system assets) was intervened and subsequently declared insolvent, after it was unable to raise sufficient capital to absorb losses and address problems of related-party lending. After an initial report by the temporary administrator, a domestically-owned bank with significant EBRD participation signed an agreement to take over a portion of the intervened bank’s assets (the “good” assets) and liabilities (insured deposits) and to resume banking services by March 5, 2013. The value of the assets that were taken over was based on an external auditor’s initial report. A more comprehensive asset valuation exercise will be undertaken, with results expected in three months. The government is expected to provide a loan to the deposit insurance agency to cover the shortfall between good assets and insured deposits, which could amount to ¾ percent of GDP. In all cases, confidence in the banking system was maintained, largely as a consequence of the authorities’ clear and careful communication to the public and swift action to provide depositors with access to their funds.

11. Credit continued to stagnate in 2012. The economic recovery has continued despite nearly four years of negative private sector credit growth. Uncertainty about growth prospects both in Lithuania and abroad have no doubt hampered the demand for credit. At the same time, lending standards have been tight, caused by banks’ continued risk aversion, which seems to partly reflect lingering NPLs. Outflows to parent banks, which were especially sizeable in the first half of 2012, were largely matched by deposit growth. As a result of these developments, banks’ liquid assets increased to 25 percent of total assets.

A01ufig03

Credit vs. Output

(percent of pre-crisis peak levels)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: National authorities.1/ Based on 2011Q3 data.2/ Based on end-2011 data.

Outlook and Risks

12. The economic recovery is expected to slow moderately in 2013. Growth is expected to reach 3 percent this year. Investment should be spurred by current high levels of capacity utilization, easing financial conditions, and dissipating uncertainty about the external environment. Exports would contribute less to growth in 2013 than in 2012, as the effects of last year’s very good harvest unwind. Inflation is projected to continue to decline to 2.1 percent in 2013, reflecting the lagged impact of lower global commodity prices and a moderate pass-through of higher wages to inflation, as high corporate profitability suggests there is room to absorb some increase in wage costs.

A01ufig04

Contribution to GDP Growth

(percentage points of GDP)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: National authorities; and IMF staff calculations.

13. Over the medium term, growth should gradually rise toward its potential of around 3¾ percent. This hinges on a recovery in investment and a modest pick-up in consumption (supported by falling unemployment and moderate real wage increases) in the coming years. The contribution of net exports is projected to turn negative in the near term, as stronger domestic demand boosts imports. However, as the payoff from investment bears fruit later on, export growth should rise. The output gap is expected to close in 2014, but structural unemployment is expected to remain high, reflecting skill mismatches. The current account deficit is projected to remain relatively contained over the medium term, reaching about 2 percent of GDP, and financed mostly by FDI.

A01ufig05

Investment

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: National authorities; and IMF staff calculations.
A01ufig06

Output and Potential Output

(logarithmic scale)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Haver; and IMF staff calculations.

14. Risks to the outlook have moderated, but remain tilted to the downside. Financial conditions—both globally and in Lithuania—have improved markedly in the past six months, but risks continue to emanate from both external and domestic sources. Renewed financial stress or weak growth in Europe, which accounts for about two thirds of Lithuanian exports, would adversely affect Lithuania through trade and financial channels. A growth slowdown in other trading partners, such as Russia, would also weigh on Lithuania’s exports. While risks of a renewed bout of parent bank funding withdrawal have moderated, Lithuania’s largely foreign-owned banking system still has a LTD ratio of 120 percent on average. Econometric analysis confirms that the impact of shocks to trading partner growth and parent bank funding is quite sizeable (Box 1). Continued strong policy implementation can help ensure that Lithuania is well-placed to deal with these risks should they materialize. On the domestic side, the projected pickup in investment could fail to occur (possibly because credit does not recover as anticipated under the baseline) or competitiveness gains could be eroded by wage growth outpacing productivity growth—both of which would hamper the recovery.

External Linkages and Spillovers From the Global Economy1

As a small open economy, Lithuania is highly exposed to external spillovers. Its export-to-GDP ratio was nearly 80 percent in 2011, making it vulnerable to changes in external demand. Lithuania is also susceptible to financial spillovers: its largely foreign-owned financial system continues to rely on funding from Nordic parent banks, which remain exposed to global wholesale markets. FDI (which is related to trade and financial linkages, given the countries of origin of Lithuania’s inward FDI) is yet a third spillover channel.

Lithuania: External Linkages with Major Partners, 2011

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Source: Statistics Lithuania, BIS and staff calculations

This box assesses the impact of shocks to trading partner growth and parent bank funding. A Bayesian Vector Autoregression (BVAR) (Villani, 2009) was used, with a sample covering 1998Q1-2012Q3. The BVAR has the advantage of improving the estimation efficiency and, given the short sample period, is particularly appropriate. First, we assess the impact of a shock to trading partner growth. As these trading partners also have the strongest FDI and financial sector links, we evaluate the spillover impact of an external growth shock through trade, FDI, financial and other (such as energy price) channels. Second, we focus specifically on spillovers from a financial sector shock.

A01ufig07

Impulse Responses to an External Growth Shock from Major Trading Partners

(percentage points)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Staff estimation.

Trading partner growth has a strong impact on Lithuania’s GDP, mainly through trade and financial channels. Econometric analysis suggests that a one percentage point adverse shock to trading partner growth would cause Lithuania’s growth to decline by 1¼ percentage points, with the spillover impact peaking after four quarters. Trade linkages explain a major part of the spillovers during the first four quarters immediately after the shock, with the financial (credit) channel playing a dominant role thereafter. FDI and fuel price channels have a more limited impact.

A01ufig08

Decomposition of Spillover Channels from External Growth Shock

(percentage points)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Staff estimation.

A shock to parent bank funding also has a strong impact on growth, mainly through financial and FDI channels. A one percent of GDP drop in quarterly parent bank funding flows causes GDP growth to drop by 0.8 percentage point, with the impact peaking after four quarters.

A01ufig09

Decomposition of Spillover Channels from a Parent Bank Funding Shock

(percentage points)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Staff estimation.

These econometric results need to be interpreted with some caution. Due to the short sample period, the econometric results here may also capture the boom and bust cycle and hence may overestimate the impact of spillovers.

1 Prepared by Nan Geng.

Lithuania: Risk Assessment Matrix2

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Authorities’ views

15. The authorities broadly agreed with staff’s assessment of the outlook and risks. They shared the view that growth and inflation would moderate this year. Their growth forecasts were similar to staff’s, and they agreed that investment would need to become the driver of growth. However, they viewed credit to be less of a constraint on investment, given the availability of EU funds and large liquidity buffers in the corporate sector. On inflation, the authorities’ projections were slightly higher than staff’s, given uncertainty over how fast falling global commodity prices would translate into lower inflation and how higher minimum wages would affect core inflation.

Policy Discussions

A. Securing Fiscal Space

16. The fiscal deficit is expected to decline to 3 percent of GDP in 2012, down from 9½ percent of GDP in 2009. This also represents a decline of some 2½ percentage points of GDP compared with 2011, mainly owing to the continued freeze of public sector wages and other cuts in primary expenditure. Large one-off dividend payments from state-owned enterprises (SOEs) also helped, and over-performance of CIT partly offset lower-than-expected VAT and excise duties (likely the result of tax administration weaknesses).

17. The authorities’ deficit target of 2½ percent of GDP in 2013 is appropriate, but staff underscored the need for high quality measures. Given that the recovery is slowing, the deficit target balances the need for further deficit reduction and support for the recovery. This translates into a structural adjustment of about ½ percent of GDP (taking into account the one-off measures on SOE dividends in 2012). However, the quality of fiscal measures has weakened over time and the consolidation in 2013 relies mainly on extensions of temporary measures (Box 2).

18. Fiscal consolidation should continue over the medium term to fully rebuild fiscal buffers. Lithuania is a small, open economy that is highly susceptible to external shocks. Moreover, it lacks monetary policy tools under its Currency Board Arrangement (CBA) and, thus, must rely on fiscal policy to provide support to the economy during downturns. It is, therefore, important that the structural fiscal deficit and public debt ratio continue to be reduced. This would bolster fiscal buffers and create space to allow automatic stabilizers to operate during future periods of weak growth. It will also help address external vulnerabilities by reducing reliance on foreign financing. The pace of consolidation going forward should balance supporting the recovery with the need to reach the authorities’ medium-term objective (MTO) of a small structural surplus.

19. Staff welcomed the authorities’ focus on tax reform, and emphasized that the composition of fiscal adjustment should shift to the revenue side. There is significant scope to implement high quality revenue measures to complete the fiscal adjustment in the medium term. The authorities have established working groups on tax policy and revenue administration to develop options for tax reform. The wide-ranging membership of the working groups, which include social partners and business representatives, could help achieve broad support for reforms. Staff supported the creation of the working groups, and underscored that the case for shifting the composition of adjustment to revenue side is strong, based on the following points.

  • There is scope to increase revenue in Lithuania. So far, most of the fiscal consolidation has taken place on the expenditure side. Partly as a result of this strategy, Lithuania’s revenue- and expenditure-to-GDP ratios were the lowest in the EU in 2011. Hence, future fiscal adjustment should aim to raise revenue.

  • Capital and wealth taxes and further base broadening can generate additional revenue. A comparison of Lithuania’s tax system with EU averages shows that the share of capital and wealth taxes in total tax revenue is very low in Lithuania (9 percent), compared with EU averages (20 percent). This suggests that Lithuania has significant room to expand these taxes in order to generate additional revenue. Also, within the current system, there is scope to broaden the bases for corporate and personal income tax by removing exemptions and closing loopholes.

  • Apart from raising revenue, these tax changes have added benefits, including their potential to better protect lower-income earners. Wealth and capital taxes are less distortionary, less cyclical, and can be designed to ensure that higher-wealth and higher-income individuals contribute most to revenue generation, hence improving the progressivity of the tax system. Staff analysis suggests that the social benefits system contributes far more to the reduction in inequality than the tax system. At the same time, Lithuania’s income inequality, as measured by the Gini coefficient, remains one of the highest in the EU, suggesting that it is possible to complement the progressivity in the social security system with added progressivity in the tax system (see Box 3).

  • To reap the benefits of this strategy, staff urged the authorities to improve tax administration. This would help ensure that any changes in taxation ultimately bear fruit in terms of revenue generation and boost tax compliance more broadly. Recent legislative amendments to allow faster collection of tax arrears and reduce the ability to pay taxes in cash are welcome, as are efforts to enforce the use of cash-registers and reduce border smuggling.

  • Expenditure growth should remain prudent. To ensure that the fiscal adjustment is completed, expenditure growth should be consistent with achieving the MTO after taking into account the impact of measures to increase revenue.

The Composition of Fiscal Consolidation in Lithuania1

Lithuania’s fiscal adjustment since 2009 has mainly relied on expenditure measures. Although the role of revenue measures has risen over time, expenditure cuts accounted for around 70 percent of the total adjustment. As a result, Lithuania has one of the lowest expenditure- and revenue-to-GDP ratios in the EU.

Figure 2.1.
Figure 2.1.

Composition of Cumulative Fiscal Adjustment after Crisis: Revenue vs. Expenditure - Based

(Excl. temporary measures on transfers to Pillar II)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Figure 2.2.
Figure 2.2.

Size of Public Sector, 2011

(General government revenue as percent of GDP)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Eurostat, and IMF staff estimates.

While expenditure measures have been broad based, this was not so for revenue measures. Spending cuts were roughly proportional to the importance of each spending category. However, on the revenue side, measures focused mainly on indirect taxes and one-off measures, while direct taxes, especially wealth taxes, were virtually untouched. The exceptions were a base broadening of social security contribution and a reduction of the PIT. The latter was partly offset by an increase in health insurance contributions, the burden of which is now shared between employee and employer.

The quality of measures also deteriorated somewhat over time. Less than one third of the measures undertaken since 2009 were permanent and about one fifth postponed deficits into the future.

Figure 2.3.
Figure 2.3.

Composition of Fiscal Adjustment since 2009: Permanent vs. Temporary 1/

(newly introduced measures in each year, in percent of GDP)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Authorites data and Staff analysis and estimates.1/ Temporary measures are reversed in next year’s budget. Semi-permanent measures have an explicit expiry date or are temporary measures that are repeatedly extended. Deficit postponing measures imply a future cost to the budget beyond their temporary nature.
1 Prepared by Nan Geng.

The Scope for Raising Revenue in Lithuania1

Given the need and desirability to shift the burden of fiscal adjustment to the revenue side, a key question is how to best raise revenue in Lithuania. This box takes a close look at Lithuania’s tax system, which suggests there is scope for raising revenue by increasing wealth taxation. At the same time, tax administration improvements should ensure that taxpayers cannot easily evade taxes and that tax collection is efficient.

Lithuania’s tax system relies heavily on labor and consumption taxes, with low wealth taxes. Compared to the EU average, the share of taxes from consumption in total tax revenue is very high (42 percent in Lithuania, vs. 29 percent in the EU), and that of capital and wealth low (9 percent in Lithuania, vs. 20 percent in the EU). The total share of taxes on labor income is close to the EU average (49 percent in Lithuania vs. 51 percent in the EU), but labor is also relatively more mobile in Lithuania and the grey economy is large.

Figure 3.1.
Figure 3.1.

Average Effective Rate of Income Tax and SSC by Income Decile of All Lithuanian Households

(Percent)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Income and Living Conditions Survey (2010); and IMF staff estimates.

Taxes on labor and consumption exhibit limited or no progressivity for higher incomes, and the limited taxation of wealth reinforces this trend. The personal income tax does not feature any strong progressivity beyond the lowest income deciles. This reflects tax exempt thresholds for low income earners and the uniform flat tax for all others. Similarly, social security contributions are a uniform tax rate on the wage. The near-absence of wealth taxation further reinforces the trend of an overall tax system with limited progressivity. At the same time, it is important to note that Lithuania’s social security contributions are not capped while benefits are capped, thus imparting progressivity to the overall security system.

Figure 3.2.
Figure 3.2.

Role of Taxes in Reducing Inequality, 2006

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Staff calculations based on data from Lithuania 2010 Survey of Income and Living Conditions and Zaidi (2008), “Main Drivers of Income Inequality in EU8 Countries: Some Insights from Recent Household Survey Data”.

Taxes in Lithuania appear to play a limited role in income redistribution, especially of late. This is apparent when comparing pre- and post-benefit and pre- and post-tax Gini coefficients. While social benefits helped reduce the Gini by about 50 percent in 2010, the tax system only reduced the Gini by 8 percent. Overall, the Gini after transfers (both taxes and benefits) remains among the highest in the EU. Recent Fund research suggests that societies with lower income inequality tend to experience more inclusive and sustainable growth.

Hence, tax policy changes should usefully focus on wealth and capital taxation. These taxes raise revenue, are less distortionary than other taxes, provide a stable source of revenue that is less subject to cyclical changes, and are more progressive than some other taxes. That said, tax administration improvements are important to ensure that tax changes yield their full potential.

Figure 3.3.
Figure 3.3.

Role of Social Benefits in Reducing Inequality, 2006

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Staff calculations based on data from Lithuania 2010 Survey of Income and Living Conditions and Zaidi (2008), “Main Drivers of Income Inequality in EU8 Countries: Some Insights from Recent Household Survey Data”.
1 Prepared by Nan Geng. See also the forthcoming Selected Issues Paper, “Toward a Sustainable and Inclusive Consolidation in Lithuania.”

Tax Policy Recommendations1

  • Wealth tax. Introduce an annual motor vehicle tax, graduated per engine capacity (or by weight) in line with international best practice (0.4 percent of GDP).

  • Property tax. Expand property taxes to include all residential properties (0.4 percent of GDP).

  • PIT base broadening. (i) Eliminate tax exemptions on interest income (0.1 percent of GDP). (ii) Restrict the exemption from capital gains tax on housing only for the sale of primary residences and subject all short-term gains on financial assets (realization within three years of acquisition date) to a withholding tax at a rate of 15 percent. (iii) Subject all pension payments to income tax (0.5 percent of GDP).

  • CIT base broadening. Consolidate reduced/preferential CIT rates on small companies and realized gains on security transactions up to three years into the standard 15 percent rate; remove CIT exemptions/preferential rates on investment incentives and tax holiday schemes in free economic zones (0.5 percent of GDP).

1 Prepared by Nan Geng.

20. Deepening fiscal reforms would be desirable. A simple, clear, and comprehensive fiscal rule, alongside a fiscal council, would strengthen the fiscal framework. The rule could usefully enhance the counter-cyclicality of the existing expenditure rule, while also ensuring that debt is reduced. Further reform of the pension system to ensure its long-term sustainability is also needed, especially in light of rapid population ageing. Parametric pension reforms could usefully link future benefits to demographic factors, separate basic pensions from other pensions (to de-link the redistributive role of basic pensions from the insurance role of other pensions), and means test qualification for basic pensions.

Authorities’ views

21. The authorities emphasized their commitment to continued fiscal prudence. They agreed that the composition of adjustment should shift to the revenue side, and stressed the importance of the working group on tax reform to provide options in this regard. They underscored, however, that job creation was a key priority and that they were still in the process of elaborating their policy agenda, including the future path for fiscal policy.

B. The Financial Sector—Playing its Supportive Role in Enabling Growth

22. Supervisory interventions have forcefully addressed weaknesses in some domestically-owned banks, thereby strengthening financial stability. The intervention of Snoras bank removed a major threat to financial stability, and the recent steps to rapidly address problems in two troubled credit unions and another domestically-owned bank underscore the importance of effective financial sector supervision. The BoL’s stepped-up onsite inspections, careful monitoring of banks’ loan loss provisions and ongoing efforts to strengthen the supervision of credit institutions are essential for the continued health of the banking system. In this context, steps to strengthen Lithuania’s AML/CFT regime are welcome, including additional dedicated supervisory staff at the BoL, more risk-based inspections, and new BoL guidelines for customer due diligence. In line with international standards, the operational independence and resources of the Financial Intelligence Unit should be strengthened.

23. The banking system as a whole appears resilient to shocks. BoL stress tests show that, under severe conditions—including large declines in exports (-20 percent) and output (-13 percent) and increases in interest rates (+370 bps)—aggregate capital adequacy would still remain at 11 percent, well above the regulatory minimum (8 percent). While provisions-to-NPL ratios are somewhat below regional peers, this partly reflects the BoL’s more stringent definition of NPLs.3

24. The financial sector has an essential role to play in enabling sound credit expansion to support the recovery. Econometric analysis suggests that credit demand and credit supply have been weak in recent years, although supply side factors dominate somewhat in 2012 (Box 5). Given available liquidity in banks, supply constraints seem to emanate mainly from NPLs and banks’ rebalancing of funding toward domestic sources, which have given rise to tight lending standards. While a balanced approach to risks and returns in new credit extension is clearly important to avoid the excesses of the boom years, sound credit growth is needed to support investment and the reallocation of resources to the tradable sector.

25. In this regard, staff urged the authorities to reduce obstacles to NPL resolution. A comprehensive review could usefully identify any legal, regulatory, or other obstacles to NPL resolution. In this context, the implementation of the new household insolvency regime in early 2013 is an important step. Recent changes to the corporate bankruptcy and restructuring regime have been helpful in simplifying procedures and allowing company’s boards to initiate restructurings. But these changes have not yet been able to speed up lengthy delays—anecdotal evidence suggests that bankruptcy proceedings take significantly longer in Lithuania than in regional peers. In this regard, new proposals for appointing bankruptcy administrators, an area where appeals are common, are a step in the right direction.

26. Staff welcomed the consolidation of competencies under the BoL. The unification of financial supervision, in place since early 2012, is paying off, and further steps to bring macro-prudential policy under the competency of the BoL is welcome. In this regard, the BoL is preparing draft amendments to the BoL law. Going forward, it will be important to monitor the resource implications of increased responsibilities for the BoL.

Authorities’ views

27. The authorities broadly agreed with staff’s assessment of the financial sector. They underscored that the interventions of the two banks and two credit unions were necessary to safeguard financial stability, and that confidence had been maintained. The BoL emphasized that it would continue its stepped-up monitoring of the financial sector to help ensure that risks were contained going forward. On NPLs, the authorities noted that improvements in the insolvency regime for households and corporations were important steps toward NPL resolution. On credit, they stressed that lending standards were too lax in the pre-crisis period and that some risk aversion by banks is welcome. In their view, ample liquidity suggested that banks did not face funding constraints.

C. Competitiveness—a Driver for Longer-Term Growth

28. Going forward, reaching potential growth requires that competitiveness gains are locked in. This will depend critically on boosting investment and addressing challenges in the labor market. It will also help avoid a resurfacing of large current account deficits and the related build-up of external debt.

  • Steps to improve the business environment can help spur investment. Administrative burdens and zoning restrictions make doing business more difficult. The authorities’ intention to review territorial planning regulations is welcome in this respect. Ongoing efforts to facilitate compliance with administrative regulations, allow waivers of fines for immaterial breaches on regulations for recently created companies, and coordinate inspections across several agencies are also valuable steps. Energy sector reforms continue to be important to reduce costs and improve efficiency in this sector.

  • Addressing high unemployment remains a key objective. There is a need to help reduce structural unemployment. According to the latest census, Lithuania’s population contracted by some 12 percent over the last decade, of which 75 percent was due to emigration (and over 60 percent of emigration is accounted for by 15–34 year olds). As a result, the average age of the population increased by four years. Outward migration is now slowing, but retaining young and highly skilled workers, further improving labor markets, and reducing unemployment continue to be essential. This implies addressing skill mismatches through training and active labor market policies (including by deploying EU funds in this area), reforming education, and removing obstacles in the benefits system that prevent workers from entering the formal labor force.

  • Wage growth should reflect productivity growth. While the recent large increase in the minimum wage can probably be accommodated given past productivity gains, there is a risk that it will feed into general wages and inflation, and erode competitiveness. More generally, it will be important that wage growth does not outpace productivity growth going forward.

A01ufig10

Lithuania: Net Migration

(Thousands)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Statistics Lithuania.

Does Low Credit Growth Reflect a Lack of Demand or Supply?1

While deleveraging and credit contraction have occurred in tandem in Lithuania, it is difficult to disentangle whether the observed credit contraction reflects credit demand or supply factors. Since early 2009, parent bank loans have fallen by nearly 50 percent while credit has contracted by almost 20 percent. On the one hand, the withdrawal of parent funding may have caused the credit contraction. On the other hand, a lack of demand for credit may have caused subsidiaries to use their excess liquidity to repay parent funding.

A disequilibrium model was used to identify whether demand or supply constraints drive low credit growth. A system of demand and supply equations for credit were estimated using maximum likelihood estimation, and actual credit is assumed to be the lesser of estimated demand or supply. Both price and non-price factors are allowed to play a role in the equations. Credit demand is modeled as a function of the cost of credit (interest rate), asset prices, future economic prospects (confidence, new orders, unemployment), economic and political uncertainty (variability of economic growth forecasts) and some proxies for borrowers’ financial and profitability situation (credit constraints reported in industry surveys and corporate profit margins). Credit supply is estimated as a function of return on credit, lending capacity (deposits and parent funding), the quality of banks’ loan portfolio (NPLs), status of the overall economic environment, future economic prospects and a Snoras dummy. Most explanatory variables are lagged by one period. Monthly data were used for the period 2006M10 – 2012M10. Quarterly available data were linearly interpolated. Credit is defined as the volume of new lending, expressed in real terms.

The model estimation intuitively captures the boom and deleveraging period, and suggests that credit supply may be constrained. Up to 2008Q4, there was strong excess demand, as supply could not keep pace with demand growth. The bust that started at end-2008 led to sharply falling demand. While some deleveraging took place in 2009, it was initially moderate, resulting in excess supply. Deleveraging subsequently accelerated in 2010 but demand was falling as well. For the recent period, the model identifies demand not to be the constraining factor, but rather supply. The lack of supply identified by the model coincides with ample liquidity in the banking sector, but since the model allows for non-price factors, this can be interpreted as tight lending standards or banks’ high risk aversion, possibly on account of high NPLs.

Figure 5.1.
Figure 5.1.

Demand and Supply of Credit

(million Litas)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Central Bank of Lithuania; Haver; and IMF staff estimates.
Figure 5.2.
Figure 5.2.

Predicted Lending and Excess Supply

(million Litas)

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Central Bank of Lithuania; Haver; and IMF staff estimates.
1 Prepared by Nan Geng.

Authorities’ views

29. The authorities shared the view that it was important to lock in competitiveness gains. They attached high priority to job creation and addressing high unemployment. They also saw a need to boost investment to sustain the recovery. On minimum wages, they stressed that an increase was warranted as inflation had increased by over 20 percent since the beginning of 2008 while the minimum wage had remained flat until mid-2012. They were confident that the increase could be accommodated, given past productivity gains.

D. Euro Adoption

30. Euro adoption remains an important goal. The CBA withstood the 2008–09 crisis and liquidity pressures have fallen with reduced vulnerabilities in both foreign and domestic banks. However, euro adoption remains desirable to complete the path toward full EU integration, ensure an orderly exit from the CBA in the light of high euroization, reap benefits of lower borrowing costs, and gain access to ECB liquidity. Therefore, macroeconomic policies should continue to align with the Maastricht criteria to afford Lithuania the best chance of meeting all criteria for euro membership, taking into account the limited room to directly influence inflation.

Authorities’ views

31. The authorities are firmly committed to the goal of euro adoption. They publicly stated their commitment to seek to join the euro area in 2015. A working group on euro adoption has been established to review potential impediments, highlight remaining issues, and prepare for a smooth transition.

Staff Appraisal

32. Much has been achieved in Lithuania since the crisis of 2008–09. Significant rebalancing has taken place: the current account and fiscal deficits have been substantially reduced and banks’ dependence on foreign funding has declined notably. A drop in unit labor costs led to quick competitiveness gains and laid the foundation for an export-led recovery. Debt has declined across most sectors of the economy.

33. Locking in these gains is essential for a robust and sustainable recovery. Despite a difficult external environment, the economy expanded strongly in the last two years, unemployment has fallen, and exports have grown rapidly. The recovery is expected to continue in 2013, but at a somewhat slower pace. Risks around this outlook have moderated but remain tilted to the downside, as renewed financial stress or weak growth in Europe would adversely affect Lithuania through trade and financial channels. Looking farther ahead, growth should gradually rise toward its potential of around 3¾ percent, but this requires that recent competitiveness gains are preserved and that investment continues to recover.

34. Completing the fiscal adjustment is important to rebuild Lithuania’s fiscal buffers. In light of the limited macroeconomic policy tools available under the CBA and Lithuania’s vulnerability to external shocks, the structural fiscal deficit and public debt ratio should be further reduced. The 2013 budget appropriately targets a further reduction in the deficit to 2½ percent of GDP. Looking ahead, further reductions in the structural fiscal deficit will be needed in the medium term. To bolster the fiscal framework, a simple, clear, and comprehensive fiscal rule, alongside a fiscal council, should be considered. Further reform of the pension system to ensure its long-term sustainability is also needed.

35. The composition of fiscal adjustment should shift to the revenue side. So far, most of the fiscal consolidation has taken place on the expenditure side, while Lithuania’s revenue-to-GDP ratio is the lowest in the EU. Therefore, taxation of wealth—notably real estate and motor vehicles—could be expanded to raise additional revenue. There is also scope to broaden the bases for corporate income tax and personal income tax by reducing exemptions. At the same time, it is essential that tax administration be improved to ensure that revenue collection does not continue to fall short.

36. Recent interventions have forcefully addressed weaknesses in domestic banks. The intervention of Snoras bank removed a major threat to financial stability, and the recent steps to rapidly address problems in two troubled credit unions and in another domestic bank underscore the importance of effective financial sector supervision. In this context, the BoL’s stepped-up onsite inspections, strict stress testing, and careful monitoring of banks’ loan loss provisions are essential for the continued health of the banking system. Ongoing efforts to strengthen the supervision of credit institutions are welcome.

37. The financial sector has an essential role to play in supporting a robust and sustainable recovery. The banking system as a whole is well-capitalized and liquid, but NPLs remain high. While Lithuania has so far been able to continue its economic recovery despite negative private sector credit growth for nearly four years, it is important that credit is not unduly constrained going forward. In this regard, a review of obstacles to timely NPL resolution would be a welcome step toward ensuring that credit supply is not constrained. The new household insolvency regime and recent proposals to modify the corporate insolvency regime are welcome.

38. Reducing unemployment and boosting investment are essential for medium-term growth. Job creation should be supported through training and active labor market policies, including by deploying EU funds in this area. While the recent large increase in the minimum wage can probably be accommodated given past productivity gains, it will be important that wage growth does not outpace productivity growth going forward. Efforts to improve the business climate by reducing administrative burdens and streamlining territorial planning procedures are essential to boosting investment. Energy sector reforms are needed to reduce costs and improve efficiency in this sector. The government’s announcement to seek euro adoption in the near future is welcome, but will require a well-articulated policy agenda aimed at preserving Lithuania’s competitiveness.

39. It is recommended that the next Article IV Consultation be held on the twelve month cycle.

Figure 1.
Figure 1.

Lithuania: Real Sector, 2010–12

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Haver; Lithuania Statistical Office; Bank of Lithuania.1/ The export and import data are measured in terms of F.O.B and C.I.F respectively.2/ Percent balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
Figure 2.
Figure 2.

Lithuania: Labor Market and Competitiveness, 2008–12

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Sources: Haver; Eurostat; Lithuania Statistical Office; and IMF staff estimates.
Figure 3.
Figure 3.

Lithuania: Banking Sector, 2009–12

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Dx Time; Bank of Lithuania; and IMF staff estimates.
Figure 4.
Figure 4.

Lithuania: Recent Fiscal Developments, 2009–12

Citation: IMF Staff Country Reports 2013, 081; 10.5089/9781484388358.002.A001

Source: Ministry of Finance.
Table 1.

Lithuania: Selected Economic Indicators, 2010–18

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

The latest population census has resulted in updated labor force survey (LFS) statistics for 2010-11 only. Further revisions for 2003-09 data are in progress.

Calculation takes into account standard cyclical adjustments as well as absorption gap and output composition effects (based on FAD Structural Fiscal Balance Template).

Short-term debt at remaining maturity.

Government external debt here includes guaranteed loans.

CPI-based, 2005 trade-weighted real effective exchange rate against 17 major trading partners.

Table 2.

Lithuania: General Government Operations, 2010–18

(ESA 95 aggregates, in percent of GDP)

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

The projections are based on the assumption that the returning of reduced salaries paid from state and local budgets back to the level of 2008 (as set out in the decision of the Constitutional Court on April 20, 2010) will start to happen gradually from 2014 onward.

General government deficit including payments not transferred by SODRA to private pension accounts.

Table 3.

Lithuania: Balance of Payments, 2010–18

(Billions of Euro, 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.

Government external debt here includes guaranteed loans.

Short-term debt at remaining maturity.

Data revisions for 2010 reflect methodological improvements.

Table 4.

Lithuania: Summary of Monetary Accounts, 2007–14

(Billions of Litai, unless otherwise indicated)

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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 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.