Strong GDP growth continues on a healthy and balanced path

Since 2011, Lithuania has remained one of the fastest growing economies in the European Union, and last year was no exception. GDP, which at the end of 2013 was 2 percent below the pre-crisis level, is expected to reach that pre-crisis level this year, on a more robust footing. At the beginning of this year, high-frequency economic indicators show that strong growth continues as expected. More importantly, economic growth has become more balanced and sustainable, with the tradable sector obtaining higher weight in overall economic activity. The composition of GDP is also becoming more broad-based. While exports remained traditionally strong, private consumption picked up significantly and was the main driver for economic growth in 2013.

Our authorities broadly share staff’s view of the economic outlook and expect a strong and balanced economic growth this year and in the medium term. Strengthened domestic demand is expected to be the main factor driving future growth, since the private consumption is supported by an improving situation in the labor market and low inflation. Investments are also set to increase in view of capacity utilization being at a record high. However, moderate economic growth for Lithuania’s trading partners and a fluid geopolitical situation in the region create elevated risks for exports.

Positive impulse is expected from the prospective Euro adoption

Lithuania aims at sustainable fulfillment of the Maastricht criteria with a target date to adopt the euro on January 1, 2015. The goal to introduce the euro is based on a legal obligation under the EU Treaty, policy consistency, proven economic flexibility and capacity to operate under the fixed exchange rate regime, as well as the high level trade and financial integration with the euro area.

The economy is on a solid and sustainable recovery path. The crisis response proved to be efficient and imbalances have been corrected. With the lack of clear pressure in the labor market and with commodity prices continuing to drop, consumer prices are rising only slightly and less than expected. Fiscal policy has been put on a sustainable path. The authorities have learned their lessons from the past and have been focused on building a balanced and competitive economy. To ensure stable economic growth and further convergence, the authorities have introduced new and more powerful macro-policy tools. The Fiscal Discipline Law was enacted to ensure fiscal discipline. To increase the resilience of the financial sector, macro-prudential instruments (85 percent loan-to-value ratio (LTV) and 40 percent debt service-to-income ratio (DSTI)) were introduced by the Bank of Lithuania (BoL).

At the same time, the authorities are fully aware that policy prudence, especially on the fiscal side, will remain a key prerequisite for successful functioning in the euro area, helping to avoid the emergence of macroeconomic imbalance.

Adoption of the euro is expected to have a significant positive effect on Lithuania’s economy through the enhancement of economic integration. A quantitative assessment of the likely impact of the adoption of the euro shows that the positive effect of introducing the euro will be felt by citizens, businesses, and government finances. In the medium term, a successful integration into the euro zone is expected to boost Lithuania’s real GDP on average by 1.8 percent.

The level of public debt has stabilized

A prudent fiscal policy underpinned by the law on Fiscal Discipline and the Stability and Growth pact is at the core of Lithuania’s policy framework to ensure macroeconomic stability. Lithuania continues to strengthen its fiscal framework through transposing the provisions of the Treaty on Stability, Coordination and Governance in EMU (“Fiscal Compact”) into its national legal system, including the constitutional law on the implementation of the fiscal treaty that lays down commitment to sustainability of general government finances.

Last year the fiscal budget deficit turned out to be markedly smaller than expected (2.2 percent instead of the planned 2.5 percent of GDP). This improvement in the country’s fiscal position was driven by accelerating revenues from corporate and household income taxes. A steadily decreasing budget deficit since the crisis firmly stabilized the ratio of public debt to GDP just below 40 percent of GDP and is expected to start decreasing after 2014.

The authorities are committed to continuing a growth-friendly fiscal consolidation at a pace aiming to reach a structural budget surplus of 0.9 percent of GDP in 2017. According to the government’s program, a further budget consolidation will be based on strengthening tax administration and rising revenues through initiatives that support economic growth and create new jobs. There are a number of major legal initiatives and conventional measures coming to tackle the shadow economy and improve tax administration. The government has already proposed amendments to the laws regulating tax administration and the value added tax (VAT). Besides, the consolidated view is being applied and specific measures are envisaged with a focus on ensuring the VAT, excise duty obligation compliance, as well as on strengthening collection of taxes on personal income. In addition, discussions on a comprehensive review of the tax system will continue, with particular emphasis on reviewing taxation on labor and the application of reduced VAT rates.

On the expenditure side, particular attention is paid to the efficient use of resources and prioritization. No cuts to productive, job-creating expenditures, such as investment and expenditures on research and development, are foreseen.

The authorities share staff’s concerns about the deficiencies in the control framework of local government finances and are ready to address them. The government is considering asking the Fund to provide technical assistance to improve the accountability and control framework of local government finances. The initial talks with the Fund on such assistance have already started.

The financial sector is stable and resilient

Lithuania’s financial system remains stable and resilient. The banking sector is well capitalized and liquid. In 2013 the capital adequacy ratio improved by 2 percentage points and reached 17.6 percent. This higher capital adequacy ratio was achieved by retaining profits. The liquidity ratio at 41.2 percent was well above the required level of 30 percent. The continuously improving quality of loan portfolios as well as measures undertaken by the authorities to improve the legal and regulatory framework for NPL resolutions are also yielding results. In 2013, NPLs decreased to 11 percent.

Although the stock of outstanding credit has not been increasing, credit flows to the economy continue at a steady pace. In 2013, new loans to non-financial corporations and households amounted to 15.9 billion litas (16.0 billion litas in 2012) or 13.3 percent of GDP, of which 70 percent was lent to non-financial corporations. Commercial banks in Lithuania expect a 2–3 percent growth in their loan portfolio this year.

The financial sector supervision is focused on identification of risks and decision making at an early stage. The BoL has shifted to a risk-based supervisory process by concentrating on systemically important and high risk financial market participants.

The government together with the BoL devotes substantial efforts to strengthen and reform credit union regulation. The current reform aims to make the credit union sector strong, sustainable, and able to effectively complement the existing banking sector. To reform this sector, an inter-institutional working group (comprised of representatives from the Ministry of Finance, the BoL, the Central Credit Union of Lithuania, and credit union associations) has prepared draft laws for the regulation of credit union activities. This draft legislation has been submitted to parliament for discussion and subsequent approval.

Alongside these efforts, the BoL has prepared a document for public discussion on how to reform the credit union sector. Particular attention is given to eliminating the moral hazard problem and aligning shareholders’ incentives with prudent risk taking. The reform proposals draw extensively upon Lithuania’s own experience and international best practice. The document also incorporates recommendations provided by the Fund’s technical assistance, which is highly appreciated by the authorities.

On other supervisory matters, the authorities are working on the implementation of CRD IV into national laws. The preliminary assessment shows that, due to the high quality of Tier I capital of the banks, reduced capital requirements for FX positions (if the euro is adopted), decreasing of risk weights for small and medium enterprises exposures, the introduction of releasing regime for exposures secured by mortgages on residential property and other measures, the implementation of the new requirements would contribute to increasing the capital adequacy ratio.

The government and the BoL are also preparing for changes to the financial sector’s supervisory framework related to the prospective euro area membership, including the asset quality review (AQR) exercise and necessary adjustments of legal acts. In December 2013, the Board of the BoL approved the position of the BoL on participation in the Banking Union. The base case scenario is that Lithuania joins the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) in 2015, together with the accession in the euro area. It is expected that after joining the SSM, the ECB would take supervision of the 3 largest banks (71 percent of the market share), while other banks would remain under the direct supervision of the BoL.

The process of broadening the BoL’s mandate to include macro-prudential policy is nearly complete. The relevant amendments to the Law of the Bank of Lithuania granting the macro-prudential mandate is expected to be adopted during the Spring parliamentary session ending in June 2014. Currently, the BoL indirectly pursues macro-prudential policy by empowering the Responsible Lending Regulations approved in 2011. In addition to LTV and DSTI, a wide macroprudential toolkit specified in the EU level legislation is envisaged to apply once CRD IV is transposed into the national legislation. It is expected that countercyclical capital buffer application will become fully operational in the end of 2014, whereas an interim decision has been made to apply a 2.5 percent capital conservation buffer starting in 2015.

Structural reforms aim to create more jobs

The government is continuing its policies of promoting pro-growth structural policy measures, such as improving the business environment and reducing high unemployment.

Despite significant improvement in employment trends over the recent years, unemployment remains high, especially for the youth and the long-term unemployed. This is a priority area for the authorities. To address this situation, the government is taking measures on both the labor demand and supply sides. On the labor demand side, the authorities continue to support a number of investment projects expected to raise the supply side potential of the economy. The housing renovation project has advanced considerably since its start in 2012. The energy sector reforms are also very high on the agenda. The Liquid Gas Terminal (LNG) in Klaipėda is expected to be completed by the end of this year.

On the labor supply side, the government is taking active measures to realign worker skills with employer needs. Active labor market policies, training and dialogue with educational institutions has been enhanced. To reduce the administrative burden of labor market regulations, a number of amendments to the Labor Code have been submitted to parliament for approval. Also, a working group has been established for a comprehensive review of the Labor Code.

Lithuania has further improved its business environment. In 2013 Lithuania moved to the 17^th position among all countries and the 6^th position among EU countries in the World Bank “Ease of doing business report 2014”. The adopted new territorial planning laws, together with labor market flexibility, technological innovations, and high participation of women in the workforce, have all contributed to these high rankings.