My Lithuanian authorities thank staff for the frank and constructive discussions as well as valuable policy advice. The authorities broadly agree with staff’s findings and analysis in the report and thoroughly consider the recommendations.

The GDP growth remains strong

Lithuania’s economy has, after the vibrant recovery in 2011, returned to a more sustainable growth path. Nevertheless, the real GDP growth rate at 3.6 percent in 2012 remained the second highest in the EU. The solid economic growth has been led by the export sector supported by improving competitiveness and adjusting unit labour costs. Lithuania’s relative advantage is its diversified export base. Two thirds of Lithuanian exports go to the EU partners, mostly more robust economies, such as Germany, Poland, the Netherlands, and the Baltic peers; about one third of trade is with the CIS countries.

The contribution of investment to economic growth was moderate in 2012, but it is expected to strengthen with increasing manufacturing capacity utilization and stabilising expectations. The industry survey shows that the industrial companies now use a historically large share – about three quarters – of their production capacity and some businesses are starting to face shortage of inventories. However, the non-financial corporate sector still remains cautious about making new investments and follows news regarding global financial uncertainties.

The growth in 2013 is expected to slow down, but will remain among the strongest in the EU. In line with IMF and other international financial institutions, the Ministry of Finance (MoF) and the Bank of Lithuania (BoL) projects that the real GDP growth will be at about 3 percent in 2013. The deteriorating export growth prospects are behind the expected deceleration of economic growth.

Inflation is slowing down

The average annual inflation rate declined from 4.1 percent in 2011 to 3.2 percent in 2012. The decrease in inflation was driven by external factors, foremost by slower growth of food and fuel prices in international markets. The prices of industrial goods and market services, which mostly depend on domestic factors, slightly increased but had an insignificant influence on inflation. For 2013, the forecast is for headline inflation to decline to 2.4 percent, though subject to developments in global commodity prices.

The Government expects that the minimum wage increase will have a minimal effect on inflation and competitiveness due to a substantial increase in productivity over the past years. The decision to raise the minimum wage was made only after extensive consultations with employers, who did not see major difficulties for the increase. Only SMEs were more concerned, therefore, the Government has foreseen support measures for SMEs at the initial stage.

External sector balances improved

Lithuania’s export development has positively affected the current account balance. As export growth outpaced import growth, the trade balance has become positive in 2012. Only larger reinvested earnings of the foreign capital enterprises led to an income account and subsequently to a current account deficit.

Gross foreign reserves increased by 1.4 percent in 2012 and accumulated by more than 40 percent since the 2008 crisis. Foreign reserves (in absolute terms) are currently at their highest historical level. In 2012, the reserve coverage in percent of short-term debt increased by 9 percentage points, surpassing 60 percent.

The unemployment and business environment has been improving

Strong growth in the domestic economy in the past two years led to an improvement of the labor market. In 2012, the unemployment rate stood at 13.2 percent or 2.1 percentage points lower than a year earlier. Employment has been growing mainly due to a rise in the number of employed persons in the private and, in particular, the tradable sector. Public sector employment remains almost unchanged. Long-term unemployment has been decreasing for more than a year, however, about half of the unemployed are long-term and this ratio has not changed since the end of 2010.

The reduction in unemployment, with a particular focus on youth unemployment, remains the Government’s top priority. For this reason, the Government has started a revival of the housing renovation program. The expected benefits of the housing renovation program are not only a reduction of imported energy consumption, but also creation of jobs and at the same time stimulation of the construction sector, which suffered the most during the crisis. The longer-term measures aimed at reducing unemployment and youth unemployment, in particular, focus on improving the balance between the specialist supply and labor market demands, increasing vocational training, providing support for self-employed and start-ups, as well as increasing flexibility in labor regulation.

In addition, the Government is revising the rules for registering business and territorial planning, as well as insolvency procedures to improve the business environment. The initiated energy sector reforms also play an important role here. Therefore, it is expected that these measures, alongside with continuing economic growth, will gradually improve the situation in the labor market.

Responsible fiscal policies are oriented towards growth

During the last three years Lithuania has undertaken substantial fiscal consolidation measures, bringing the general government deficit from 9.4 percent of GDP in 2009 to the expected 3 percent of GDP in 2012. The 2013 budget aims to reduce the deficit to 2.5 percent. Fiscal consolidation was focused on the expenditure side, including sizable cuts in wages. These measures were necessary to restore market confidence, regain competitiveness, and to put the public finances on the sustainable path.

The Government remains committed to strictly adhering to the Law on fiscal discipline adopted in 2007 and observing medium-term fiscal targets as set in the 2012 Convergence Program. However, the Government’s key priorities now are to encourage economic growth, reduce unemployment and to put the economy on a strong and sustainable growth path. To achieve these goals, the Government intends to pursue active investment policies. For this reason, in addition to improving the business environment, the Government intends to intensify the use of available EU funding and financing provided by the international financial institutions as well as to devote more budget funds for investments.

The Government agrees that further fiscal consolidation should shift from the expenditure to the revenue side. In this regard, the authorities are determined to improve the tax administration and compliance measures as well as to revise the tax system. A working group for this purpose has been established with the task to prepare recommendations on the tax system reform by June of this year. The Fund’s suggestions will be considered.

The resilience of the financial sector has been tested and strengthened

The resilience of the banking system continued to improve. The NPLs have been decreasing and the quality of the loan portfolio has improved. The capital adequacy and liquidity ratios have strengthened and are above the Basel III requirements. The loan-to-deposit ratio is gradually approaching 100 percent due to a considerably faster growth in deposits, compared to a subdued rebound of the loan portfolio. Low interest rates and an improving financial position of the private sector are expected to strengthen credit demand. The recent bank lending survey shows that the demand for credit is expected to increase and banks do not plan on tightening their lending conditions.

The depositors’ confidence was maintained during the authorities’ interventions in two smaller size banks. The interventions addressed the residual risks, strengthened the financial sector going forwards, and testified to the authorities’ supervisory vigilance. The effects on confidence indicators were only very limited. The interbank rates continued to decrease and the CDS rates stand at the pre-crisis levels. There was no impact on the real economy. SNORAS bank was announced insolvent and liquidated, whereas the healthy share of UKIO bank assets with matching liabilities was transferred to another bank operating in Lithuania.

During the last three years, the authorities have carried a complete overhaul of the institutional set-up for micro- and macro- prudential supervision. Both tasks are planned to be assigned to the BoL. Microprudential supervision of banking, insurance and financial markets have already been consolidated and enhanced by customers’ rights protection. To strengthen the macroprudential supervision, a new Financial Stability Department, with more analytical capacities, has been established at the central bank and has been in operation since May 2012. To entitle legal powers to the BoL for macroprudential supervision, an amendment to the Law of the BoL is foreseen for 2013. With that, the reforms to the micro- and macro- prudential institutional set-up will be fully completed.

The authorities continue to enhance micro- and macroprudential policies in order to strengthen financial stability. At the end of 2011, the BoL adopted the Responsible Lending regulations and defined the mandatory limit on loan-to-value and debt-to-income ratios. Currently, a number of measures, such as requirements for the qualification of the heads of credit unions, limitations on maximum loan per borrower, tightening the liquidity and the capital adequacy ratios, were introduced to strengthen the credit union sector.

Preparations for euro adoption are ongoing

The authorities remain committed to introduce the euro from a strong and sustainable base after the convergence criteria are fulfilled. The newly elected Government has reconfirmed the euro introduction target and re-launched the necessary preparatory work.