Republic of Lithuania: Staff Report for the 2016 Article IV Consultation

Thanks to sound macroeconomic management and an overall favorable business climate, income convergence with Western Europe is advancing. In 2015, sharply contracting exports to Russia temporarily dragged down growth. Ensuring good economic progress over the medium term requires continued productivity improvements, safeguarding competitiveness in a tightening labor market, and beginning to address high income inequality.

Abstract

Thanks to sound macroeconomic management and an overall favorable business climate, income convergence with Western Europe is advancing. In 2015, sharply contracting exports to Russia temporarily dragged down growth. Ensuring good economic progress over the medium term requires continued productivity improvements, safeguarding competitiveness in a tightening labor market, and beginning to address high income inequality.

Context

1. Good policies and favorable business conditions have helped put Lithuania back on the convergence path with Western European living standards. After the setback from the 2008/09 crisis, Lithuania’s per capita income is advancing solidly again, reaching 75 percent of the EU average in PPP terms. But the income gap narrowed within a context of slower GDP growth in both Lithuania and the EU, breeding some discontent amongst low-wage earners and spurring emigration. Years of fiscal consolidation, financial deleveraging, and policy upgrades led to strong public and private balance sheets, and underpin internal and external balance. The financial sector is comfortably capitalized, debt servicing burdens of households, and companies are low, and public debt is relatively small (42.7 percent of GDP). Unemployment is close to its historical average (9.1 percent), core inflation is low (1.9 percent), and the current account deficit is moderate (1.7 percent of GDP). Euro area membership since 2015 has reinforced stability further.

A01ufig1

Real GDP per Capita and Real GDP, 1995-2015

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat and IMF staff calculations.
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Household and Nonfinancial Corporate Balance Sheet Indicators, 2014

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Source: Eurostat.*Denotes 2013 data for net debt to income for NFCs.

2. The main policy challenge remains to step up the advancement of living standards, while ensuring that benefits are broadly shared throughout society. In addition to maintaining sound macroeconomic conditions, this requires pushing ahead with a comprehensive supply-side reform agenda to support productivity, protecting competitiveness in the face of mounting wage pressures, and improving economic opportunities and outcomes for all.

3. Many reform elements are in train or under consideration, but the definition and implementation of a comprehensive package of measures will likely have to await the appointment of a new government after the elections in October. The current administration led by the Social Democrats is focused on getting new labor legislation, along with adjustments to social benefits and pensions, through Parliament and containing populist pressures. Many of the required reforms will be multi-year endeavors and will thus more likely need to be considered by the government that will take office in December.

Recent Developments

4. Last year, growth took a temporary hit from the difficult external environment. It fell to 1.6 percent, less than half its 2010–14 average. Exports to Russia contracted by some 40 percent, due to ruble depreciation, recession, and sanctions on selected EU exports—a shock of over 1½ percent of GDP, which was somewhat alleviated by export reorientation, primarily in the transport sector. Economic growth was driven by a 4.9 percent expansion of private consumption on the back of favorable wage developments and 10 percent higher investment, reflecting elevated capacity utilization, and a spike in EU-funds utilization. The labor market tightened, with unemployment falling nearly to its structural level and real wages advancing by 5.5 percent.

Impact of Lower Exports to Russia on GDP

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Sources: Statistics Lithuania; Bank of Lithuania; and IMF staff calculations.

Impact of efforts to reoriented the exports of transport services and goods of Lithuania origin to countries other than Russia are estimated from the difference between the actual growth rate in such exports and the expected growth rate implied by the decline of exports to Russia.

The projected growth rates of Lithuanian exports to Russia are based on projections of Russian’s import growth in 2016.

5. External factors caused the price level to fall in 2015, but deflation is unlikely to take root. The fall in global energy prices pushed down fuel and heating prices. And food prices, which had modestly contributed to inflation in 2014, were flat, partly due to excess supply related to Russia’s embargo on many food imports. This improved consumers’ purchasing power by an estimated 2 percent. While headline inflation fell to -0.7 percent, core inflation picked up to 1.9 percent as strong wage growth drove up services prices. With no signs of wages decelerating and balance sheets strong, the emergence of entrenched domestic deflationary dynamics remains only a remote possibility.

A01ufig3

Inflation and Major Inflation Components

(Year-on-year change in percent)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Haver; and IMF staff calculations.1/ Core excludes energy, food, alcohol, and tobacco.

6. The external current account moved into moderate deficit in 2015 due to weak export markets and strong domestic demand. Plummeting exports to Russia, as well as to the CIS more generally, and imports buoyed by strong machinery and equipment investment made for the first trade deficit in several years despite improving terms of trade. The income account also deteriorated because of higher profits of foreign-owned companies and lower remittances. But thanks to the inflow of EU-funds, the capital account surplus more than fully covered the deficit in the current account. Accordingly, the Net International Investment Position improved somewhat to -45 percent of GDP.1 The external balance assessment finds Lithuania’s current account and exchange rate to be broadly aligned with fundamentals (Box 1).

7. The fiscal deficit declined further last year, reaching structural balance and undershooting for the first time the level of ½ percent of GDP for the structural deficit long advocated by staff. Despite the economic slowdown, the headline fiscal deficit declined from 0.7 percent of GDP in 2014 to 0.2 percent of GDP, about one percentage point of GDP less than planned in the budget. The revenue-friendly growth composition—key tax bases such as wage income and retail sales grew much faster than GDP—together with incipient results from better tax administration were chiefly responsible. Correcting for one-off and cyclical effects suggests a negative fiscal impulse of ¾ percent of GDP. But, on the other hand, the government’s prefinancing of European Structural and Investment Funds for the private sector provided a sizable boost to the economy, which is not captured by fiscal stance and impulse calculations. Financing conditions continued to be favorable with spreads on long-term government bonds vis-à-vis Germany narrowing to less than 50 bps.

8. Lithuania’s largely Nordic-owned financial system is stable. The CAR rose to 24.8 percent, the NPL ratio declined to 5.5 percent, the loan-to-deposit ratio has been halved since its 2008 peak, falling to 100 percent, and net parent bank funding is down to less than 4 percent of GDP. Thanks to cost-cutting measures, bank profitability has so far proven resilient despite revenue losses from euro adoption and negative interest rates, although performance varies across financial institutions. Recent capital injections into smaller domestic banks are welcome, but close monitoring of these institutions remains important. Measures to contain weaknesses in the small credit union sector are in place, but more fundamental reform still awaits parliamentary approval.

9. Credit growth is resuming at a moderate pace. For the first time since the 2008/09 crisis, private-sector credit growth moved convincingly back into positive territory, reaching 4.1 percent last year. A pickup in credit demand and strong borrower balance sheets rather than a material loosening of credit standards were responsible. Higher credit growth in support of investment is welcome, but lending is not typically reaching SMEs, where forays of banks remain exploratory. Continued support through government sponsored schemes using EU funds to improve SMEs’ access to financing, remains therefore important. With credit growth moderate, real housing prices some 30 percent below their 2008 peak, and low financial depth, there is no evidence of imminent financial risks emerging. Were they to do so, a comprehensive macroprudential toolkit in now in place to address them. To maximize its traction, cooperation with banks’ home-country authorities needs to be strong. It might take coordinated moral suasion to address run-away consumer loans when banks are overcapitalized. Support from home-country authorities is also critical in the case of cross-border loans to corporates.

External Sector Assessment

A moderate current account deficit of around 2½ percent of GDP seems appropriate for the medium term. After registering mostly surpluses during the adjustment period following the 2008/09 crisis, the current account moved to a deficit of 1.7 percent of GDP last year, as a result of collapsing Russian import demand. While ongoing trade diversification should erase most of this effect over time, other forces point to a widening of the external deficit. In particular, investment should rise as the recovery from the compressed post-crisis levels fully unwinds. However, current account deterioration must not go too far. Reasonable savings are required ahead of demographic aging and large EU funds will eventually run out. Elevated external debt (75 percent of GDP) and a sizable negative Net International Investment Position (-45 percent of GDP) also need to be taken into account, even though relatively large FDI and inter-company loan components mean that there are no immediate external stability concerns.

The exchange rate appears to be broadly in line with fundamentals. Direct estimation of the REER, through the Equilibrium Real Exchange Rate approach (ERER) indicates that Lithuania’s REER is close to equilibrium, marginally overvalued at 3 percent. The External Sustainability Approach (ES) shows that compared to the current account that would stabilize Lithuania’s net foreign asset position (-3.3 percent of GDP), the actual current account is somewhat better and the exchange rate is slightly undervalued by 2.6 percent.

The EBA-lite methodology indicates that Lithuania’s policies are broadly appropriate, but finds a moderate real exchange rate undervaluation. The current account norm is estimated as -4.3 percent of GDP—a larger deficit than the -1.7 percent of GDP recorded for 2015. This result should be interpreted with caution. The estimation does not take into account the current period of relatively low investment to compensate for the excesses of the boom years up to 2008 and the need to save ahead of one of the largest demographic challenges in Europe.

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Outlook and Risks

10. With external drag diminishing, the near term outlook is favorable. Growth is projected to be domestic demand driven again and to rise to 2.7 percent this year. Consumption should benefit from solid wage growth and declining energy prices. Pent-up demand, high capacity utilization, and low interest rates should spur investment. In contrast to last year, the drag from weak exports to Russia is set to be smaller, with Russia’s recession projected to ease and its importance as an export market already diminished. High frequency indicators for the first few months of 2016 also point to a growth pickup. Consumer inflation is projected to rise to 0.6 percent as the decline of import prices lessens. With imports growing faster than exports, the external current account will deteriorate somewhat.

11. Growth could climb to some 3½ percent over the medium run.2 This would still be about 1 percentage point below the historical trend on account of worsening demographics and the narrower income gap relative to the global economic frontier. Still, these medium-term projections assume continued structural reforms supporting productivity and human capital development, as well as measures to safeguard competitiveness. As the output gap narrows and commodity prices begin to recover, inflation should rise and run again at a small premium over the euro area target of 2 percent, reflecting Balassa-Samuelson effects.3 As a catching-up country, Lithuania is expected to run a moderate current account deficit.

12. Downside risks to the outlook dominate and mostly relate to external factors. Adverse developments in the global economy would spill over primarily through trade channels. Volatile financial conditions abroad could reach Lithuania indirectly via the foreign banks that dominate its financial system, curtailing credit supply. Regarding home grown risks, wage growth in excess of productivity gains could undermine external competitiveness going forward. On the upside, improving domestic prospects could trigger increased reverse migration, setting a virtuous circle of demand, productivity, and employment growth in motion.

13. The authorities broadly shared staff’s views on the outlook and risks. The authorities were marginally more cautious about the prospects for a quick recovery this year. Like staff, they saw medium-term growth somewhat above 3 percent. As downside risks they highlighted developments in the euro area and Russia, as well as in China, which could affect Lithuania through third countries. But they also saw a fair amount of upside risk, including faster progress on trade diversification, bigger payoffs from current reforms, a jolt from the Juncker plan, and still lower energy prices. Because of energy prices, inflation could undershoot projections. Neither European supervisors nor the national competent authorities saw immediate risks to financial stability from spillovers of potential financial volatility abroad through the cross-border banks, pointing to healthy capitalization, ample liquidity, and much reduced parent bank funding. Potential risks to competitiveness are on the authorities’ radar screen, but to some extent high wage growth is the natural outcome of labor market tightness, underscoring the need to boost productivity.

Republic of Lithuania: Risk Assessment Matrix

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Policy Discussions

The overriding objective for Lithuania is to raise living standards through income convergence with Western Europe. In this context, the discussions focused on three main issues: (i) raising productivity growth through structural reforms; (ii) securing continued competitiveness as the labor market tightens; and (iii) going beyond structural policies to reduce income inequality through fiscal measures while maintaining a prudent policy stance. The authorities carefully consider all Fund analysis and advice at the highest political level, and have implemented many past recommendations (Box 2).

Implementation of Past Fund Advice

  • Fiscal policy. Fund advice focused on repairing public finances following the setback from the 2008/09 crisis. The authorities successfully reduced the deficit to a level consistent with the gradual restoration of fiscal buffers. They are increasingly pushing ahead with recommended tax administration reform. Calls for rebalancing taxation from labor to capital and improved spending quality have resonated, but action is still at an early stage due to the complexity of such reforms.

  • Structural reforms. The authorities implemented a comprehensive list of recommended improvements to the business environment over the years. The long advocated overhaul of labor legislation is now underway. The authorities appreciated the Fund highlighting deficiencies in education, health care, and innovation policies, but related reforms are longer term in nature and mostly still at an early stage.

  • Financial sector policy. The authorities and the Fund saw eye to eye regarding the need to improve oversight and macroprudential policies after the crisis. Related reforms have been implemented. There is also consensus on credit union reform, which is now under discussion in parliament.

A. Raising Productivity through Structural Reforms

14. Boosting productivity is a key to sustainably raise living standards, and policies should be framed in a coherent package to leverage impact. Total factor productivity growth averaged 3½ percent per year since 1995, but has been much slower recently. The authorities have rightly earmarked a large share of EU funds for corrective policies—equivalent to over 5 percent of GDP over seven years. Reforms fall into three broad categories, but should be assembled into a credible reform package to clearly communicate the way forward.

A01ufig4

EU Countries: Pro-growth ESIF Spending, 2014-201/

(Percent of 2014 GDP)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

1/ Spending on thematic objectives 1 (research and innovation), 3 (SME competitiveness), and 10 (eductaion and training).Sources: European Commission (https://cohesiondata.ec.europa.eu/); and IMF staff calculations.

15. There is room to improve the employability of labor. Upgrading skills, right grading skills, and lowering the tax wedge would help reduce still high structural unemployment, foster efficient use of talent, and combat the shadow economy.4,5 Productivity would rise and economic opportunities would improve, especially for currently disadvantage parts of society.

  • Upgrading skills. Resources devoted to active labor market programs (ALMPs) are less than half the EU average and seven times less than in leading Denmark. There is accordingly ample scope to ramp up spending while ensuring quality, and coverage should be extended to include those at risk of job loss. A program for life-long learning would be a valuable preventative complement.

  • Right grading skills. Lithuania’s tertiary education attainment rate (56 percent) is the highest in the EU, yet skill shortages are a key concern for employers. Chosen fields of study do not accord well with labor market needs and vocational training is underdeveloped. Building on the recently launched “job barometer,” mandatory orientation for students that are provided government-paid study places could be considered. Government should also review the mix of the study places that it pays for to ensure value-for-money. The profile of vocational training should be raised and made less school-based.

  • Reducing the tax wedge. The personal income tax rate of 15 percent seems low, but applies to all income above the basic allowance rather than being phased in. More importantly, social security contributions run at some 40 percent and apply from the first euro earned. Incentives for low-wage earners to go informal are accordingly high. There is also a risk of benefit traps even at modest benefit levels. A basic allowance for social security contributions could be considered. Phasing it out as incomes rise would contain its fiscal costs.

16. Company upgrading is instrumental for improved productivity. Lithuania ranks poorly on innovation indicators, occupying the forth place from the bottom on the European Innovation Score Board. The fragmentation of the innovation system and excessive emphasis on physical infrastructure needs addressing. More cross-border clusters and competence centers promise efficiency gains. Above all, more focus should be put on the promotion of more sophisticated products, better processes, better branding and marketing, new markets, etc. rather than on scientific breakthroughs that are difficult to commercialize. While supporting programs are already in place, these remain limited in size and scope.

17. Lithuania’s favorable business climate can be further improved. Lithuania ranks 20 out of 189 countries in the Doing Business Report’s assessment of regulatory quality and efficiency—second only to Estonia in Central and Eastern Europe (CEE). An important remaining shortcoming is the outmoded labor code, which deters job creation and FDI. The new labor code proposed as part of the “New Social Model” currently before parliament is welcome. It would modernize labor relations. Key features include an up-to-date set of contracts; shorter notice periods and less severance pay; more wage transparency; better labor representation in firms; and more training opportunities. But the original proposal should not be unduly diluted—the establishment of a payroll tax financed severance pay fund would be counterproductive, considering Lithuania’s already high labor tax wedge. Other areas for improvement in the business environment are bankruptcy procedures, which are lengthy with low recovery rates, and tight restrictions on immigration from non-EU countries. Government proposals for accelerated procedures to grant temporary resident permits for applicants with desirable occupations are welcome. “Labor market tests” could be dropped altogether for those with pertinent skills.

18. The authorities strongly agreed with staff’s diagnoses and the thrust of the proposed reforms, but also underscored the complexity of the task. They were keenly aware that the education system must be better geared toward labor market needs. Some reforms are already in train, such as new curriculums in vocational training and initiation of apprentice programs, and, in higher education, better connected universities and streamlined study programs. But the reform process is complex because of the multitude of stakeholders that need to be brought on board. Passage of the new labor code is a key priority. The authorities took note with interest of the idea to introduce a basic social security contribution allowance, although a recent constitutional court ruling to make social security more insurance-based complicated matters. They saw the economic merits of streamlined bankruptcy procedures and more liberal rules for immigration from non-EU countries, but both issues were politically and socially sensitive.

B. Securing Continued Competitiveness in a Tightening Labor Market

19. Price competitiveness remains intact for now, but will come under pressure on current wage and productivity trends. Because of fast wage growth and modest productivity gains in recent years, unit labor costs (ULCs) have risen much faster than in the EU. In the tradable sector, a cushion had built up in the post-crisis adjustment period when wages fell and productivity soared. Moreover, company profits recently received a windfall from lower input prices for raw materials, helping offset sharply higher wage costs. But these cushions now appear to have been largely exhausted, putting future price competitiveness at risk unless wage growth decelerates and productivity growth picks up substantially.

A01ufig5

Manufacturing: Unit Labor Costs (2005Q1=100)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat and IMF staff calculations.
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Manufacturing Sector: Profits, Sales and Costs of Companies

(Percent change)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Statistics Lithuania and IMF staff calculations. Manufacruring sector excludes petrolum products.
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Population and Working Age Population, 1990-2025

(Index, 1990=100)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Source: Eurostat. Reduced migration scenario assumes 28,000 net emigrations per year through 2025. This is close to the historical average of 25,000.

20. Wage pressures could persist over the medium term. With much smaller cohorts born in the post-Soviet period entering the labor market, competition among employers for suitable workers is bound to remain intense, pushing up wages. On the other hand, recent fast real wage growth could also to some extent be the result of downward inflation surprises, meaning that real wages would decelerate when inflation picks up. Fortunately, Lithuania’s labor market appears historically to have worked well, with wage and productivity developments aligned over longer periods, self-correcting transitory deviations.6

21. At this juncture, minimum wage increases should be paused following their sharp hikes in the past few years so as not to further fuel broader wage growth. Successive hikes since August 2012 have lifted the minimum wage by over 50 percent and it now stands at 47 percent of the average wage. A further increase for mid-2016 is under discussion. While wages in Lithuania are largely market determined, the government sets the minimum wage after non-binding tripartite consultations. Historically, a minimum wage hike of 10 percent has tended to push up overall wages by 3 percent. With the minimum wage incidence now significantly higher than in the past, this pass-through has likely increased. With wage growth already problematic from a competitiveness point of view, this is not the time for forceful minimum wage policies. Moreover, the level of the minimum wage relative to average wages is now unusually high by international standards. Adverse effects on job opportunities, especially for marginal workers, are likely much stronger than historical experience would suggest. In general, economic considerations need to come into starker focus in minimum wage setting, while the limitations of minimum wages in addressing income inequality concerns need to be recognized. This could be achieved by depoliticizing the process and giving independent experts a formal role.

22. Developments in non-price competitiveness warrant more attention. Despite ULC-based price competitiveness remaining intact thus far, Lithuania’s export market shares have started to stagnate in recent years, even excluding the Russian market. While exporters have demonstrated nimbleness in maneuvering a difficult external environment, stagnating market shares suggest that the prices that Lithuania’s exports command are no longer rising faster than those of competitors. This in turn could well be an indication of stalled catching up with the frontier as far as product quality, mix, and sophistication is concerned. This underscores the urgency of the productivity enhancing agenda laid out above.

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Exports Market Shares, 2000:Q1-2015:Q3

(Percent)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Source: IMF, Direction of Trade Statistics.

23. The authorities agreed that competiveness warranted close monitoring and were appreciative of staff’s emphasis on non-price competitiveness. The minimum wage was still lower than in neighboring countries and significant adverse side effects had not materialized, but the authorities agreed that it should not decouple from productivity developments, and intend to carefully weigh all the pros and cons before going ahead with further hikes. They shared concerns about recent disappointing productivity growth, though it could prove a temporary effect from weak external demand, which generated slack in some companies. Lithuanians should not be complacent about competitiveness—improving non-price competitivenss was particularly important as the country’s future lay in producing higher value products rather than being simply a low-cost producer.

Minimum Wage Developments in Lithuania in Regional Perspective1

If Lithuania implemented the hike considered for this July, its minimum wage would be the highest in Central Eastern and South Eastern Europe (CESEE) relative to the average wage. Minimum wages were generally frozen in the post-crisis adjustment period throughout the region, but many countries implemented sharp increases when the recovery took hold. In Lithuania, minimum wages are up 50 percent from August 2012—and 60 percent if the increase considered for July is included. Minimum wages would then exceed 50 percent of average wages and affect around 20 percent of workers. Such minimum wage ratios are unprecedented in CESEE and would put Lithuania at par with the European record in France, where excessive minimum wages are seen as a factor behind high unemployment, together with other labor market rigidities. While minimum wages have their role in protecting low-wage earners, adverse side effects are increasingly likely to come to the fore as they rise relative to the productive capabilities of the economy.

A01ufig9

CESEE Minimum Wages

(Percent of average wages)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Minimum wage hikes are contributing to overall wage growth, which could hurt competitiveness. Minimum wage hikes are estimated to account for one third of overall wage growth during 2012–15. Economy wide, the elasticity of the average wages with respect to minimum wages stood at some 30 percent, with considerably larger effects in sectors with high minimum wage incidence. Analysis for CESEE shows that minimum wages tend to weigh on export performance of labor intensive sectors, as well as on profits and employment growth in the tradable sector.

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Lithuania: Minimum Wage Pass-through

(Degree of pass through after a year, percent)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat, Statistics Lithuania, and IMF staff calculations.

At its current level, the minimum wage likely reduces employment prospects, especially for the low-skilled and young. At low levels, employment effects are small and statistically difficult to detect. But once minimum wages start to substantially exceed 40 percent of average wages, negative employment effects start to bite. For example, at a minimum wage ratio of 30 percent, a 10 percent minimum wage hike reduces youth employment by 0.4 percent, but at a ratio of 50 percent the reduction rises to 2.8 percent.

Minimum wage policy alone improves the income distribution by less than is commonly believed and needs to be supplemented by other policy tools. Minimum wage hikes may not raise actual remuneration as under-the-table wage supplements (“envelope payments”) are regularized or official working hours reduced in response. Moreover, minimum-wage recipients may be second-income earners in relatively well-to-do households and the people truly at the bottom of the income distribution are likely not to be employed at all. Addressing legitimate inequality concerns, other policies need to be brought into play.

1/ Based on Cross-country Report on Minimum Wages: “Getting Minimum Wages Right in Central Eastern and South Eastern Europe.”

C. Preserving Fiscal Gains and Tackling High Income Inequality

24. Based on the 2016 budget, the structural deficit is projected to be at a broadly appropriate level, but there is no room for new unfunded tax cuts or spending initiatives. Headline and structural deficits should reach 1.1 and 0.6 percent of GDP, respectively, essentially achieving the staff-recommended ½ percent of GDP for the structural deficit. This level would ensure a reliable gradual decline of the public debt ratio, beginning to reverse its sharp increase since the 2008/09 crisis and building fiscal buffers critical for a small open economy in a currency union.7 It would also provide for a moderate fiscal stimulus of some ½ percent of GDP to help close the output gap. In addition, the government should allow automatic stabilizers to operate freely.

25. The policy focus should now be squarely on fiscal structural reforms to generate fiscal space. There is room to increase the quality of spending, notably in the areas of health and education where the infrastructure is oversized.8 Tax administration is another area with ample scope for further improvements—Lithuania’s overall revenue take relative to GDP is among the lowest in the EU and this is not only due to low income tax rates and limited wealth taxation.9 The resulting fiscal space should be used for growth promotion and lowering income inequality.

26. Income inequality in Lithuania is among the highest in the EU and likely weighs on economic performance (Box 4). Over 20 percent of the population is estimated to be at-risk-of-poverty—a rate around 11 percent higher than the EU average, and considerably higher than other CEE countries. The Gini coefficient and wages earned in the top decile relative to the bottom decile also place Lithuania amongst the most unequal European societies. High income inequality may not only be socially undesirable, but can also undermine macroeconomic performance: low income households do not have the means to appropriately develop their potential and adverse shocks can easily derail their efforts. Furthermore, it can spur emigration if people see their opportunities curtailed at home. This weighs on potential growth and exacerbates output volatility.10

27. In addition to dual purpose measures that are also desirable in their own right, Lithuania should also begin to consider redistribution-focused fiscal measures depending on social preferences.

  • Dual purpose measures. This agenda largely coincides with that to enhance the employability of labor, which would disproportionately benefit the less well off (¶15).

  • Redistribution-focused fiscal measures. In Lithuania, the progressivity of the tax system is relatively low, reflecting strong reliance on indirect taxes and flat income taxes. Social protection spending is modest, because low revenues constrain all spending and also because its share in total expenditure is relatively small. Fiscal policy thus redresses market inequality by less than in most other countries. Rebalancing the tax system from indirect and labor taxes toward wealth and capital taxation, and higher income tax rates for high-income earners would improve income distribution. So would higher social protection spending, especially if directed at unemployment benefits to allow for proper job search, active labor market programs, and old-age pensions. These additional outlays could be covered by the space generated by fiscal structural reform and potential revenue gains from tax rebalancing, so as not to undermine overall fiscal performance.

A01ufig11

GINI Coeffcient and Its Reduction Through Social Transfers, 2014

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat and IMF staff calculations.
A01ufig12

Social Protection Spending, 2013

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat; and IMF staff calculations.* Denotes 2012 data.

28. The “New Social Model” addresses distributional issues to some extent, but the financial and social implications of proposed measures need to be carefully considered. Apart from Labor Code reform, the legislative package under discussion in Parliament comprises social benefit and social security reform (¶17).

  • Social benefit reform. The principal change is a welcome improvement in the unemployment insurance system—an extension of the benefit period from six months to nine and a higher cap on benefits. There are also small adjustments to parental benefits, sickness pay, and the accident insurance. Changes to social assistance are not envisaged.

  • Social security reform. Here the proposal would increase coverage to more of the self-employed, small farmers, and heads of micro companies, all of whom would become subject to contributions and eligible for benefits. This should reduce inequality. But at the heart of social security reform is a wide-ranging reorganization of the old-age pension system: a new pension formula, linking the statutory retirement age to life expectancy, indexing pensions to developments in the overall wage bill of the economy rather than relying on discretionary adjustments, shifting responsibility for basic pensions—the part of retirement benefits that is not earnings related—from the Social Security Fund to the State Budget, introducing a cap on social security contributions, and cutting contributions rates. The social and financial sustainability and distributional consequences of the original proposal and any amendments in the context of the parliamentary deliberations need to be considered with utmost care. Any agreed new arrangement should be subjected to careful scrutiny before it takes effect, even if this means that social security reform moves ahead more slowly than the other elements of the “New Social Model.”

29. The authorities agreed that more focus on income inequality issues is warranted, but pointed to a number of constraints. They agreed that fiscal consolidation had been successful, but cautioned that further efforts might still be necessary under EU rules, because of a different take on the business cycle position and hence the fiscal structural balance. Moreover, aiming for fiscal surpluses in the longer run may be prudent. Regarding income inequality, the authorities were most concerned about the low absolute level of income of those at the bottom of the distribution rather than their position relative to those well off. Accordingly, they largely subscribed to the desirability of the dual purpose measures suggested by staff, but were not ready for a major redistributive overhaul of the tax system. Smaller tax changes had already been implemented and there was scope for further strengthening capital and wealth taxation in the medium term. They also saw constraints on the ability to expand social protection spending significantly, because of limited scope for further expenditure cuts in other areas and for raising additional revenue, other than through better tax administration. Regarding the “New Social Model,” they considered pension indexation beneficial for reducing income equality. They agreed on the need for careful analysis of the effects of pension reform, including after amendments by Parliament, and for phased implementation to contain costs.

Income Inequality in Lithuania1

Transition to a market economy increased income inequality by more in Lithuania than in other Central and Eastern European (CEE) countries. Income inequality kept rising through the mid-2000s until the economic boom and the associated fall in unemployment briefly reduced it. But the 2008/09 crisis erased the gains and inequality has hovered around high levels since then. Today, Lithuania is the fourth most unequal country in the EU, after Bulgaria, Estonia, and Latvia. Upward social mobility is also relatively low while downward mobility is higher than elsewhere.

A01ufig13

GINI Coefficients in the EU

(Index)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: World Development Indicators and IMF staff calculations.

Income inequality pervades all sources of income. Income from dependent employment, self-employment income, and earnings from wealth and capital are all more unequally distributed than the EU or CEE average. However, income from wealth and capital accounts for a smaller share of total income than elsewhere and, because it is typically the most unequally distributed income component, contributes relatively less to overall inequality.

Lithuania’s income inequality is concentrated at the tail ends of the distribution and particularly pronounced among the unemployed, retired, and unskilled. Comparing income deciles shows that the contrast between what the top 20 percent earn relative to the bottom 20 percent is particularly stark in Lithuania. The rest of income distribution is less out of line with peers. Dissecting by various population characteristics reveals a concentration of income inequality among the unemployed, retired, and less educated that is stronger than in the EU and CEE. Gender and age also make a difference. These population characteristics jointly account for a larger share of inequality that elsewhere, although they are not the full story of inequality by far. They jointly explain only about a third of Lithuania’s income inequality.

A01ufig14

Median Income by Activity Status

(Difference from total median income in percent)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Eurostat and IMF staff calculations.
A01ufig15

Median Income by Educational Attainment

(Difference from total median income of population)

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

1\ Based on Selected Issues Paper “Inequality and Income Distribution in Lithuania in an International Comparison: Trends, Causes, and Policies.”

Staff Appraisal

30. Strong economic fundamentals and a favorable business environment should ensure solid growth going forward. Growth is projected to rebound to 2.7 percent this year as the external drag, notably from trade with Russia, eases and the expansion of domestic demand remains strong. Risks are tilted to the downside, reflecting primarily the global risk balance. Assuming the maintenance of sound macroeconomic and business conditions, and counting on continued structural reforms supporting productivity and human capital development, growth should rise to some 3½ percent over the medium-term.

31. Multi-year fiscal consolidation has come to fruition with the structural fiscal deficit reaching balance in 2015. These gains should be protected by capping the structural fiscal deficit at ½ percent of GDP going forward, to begin reversing the sharp rise in the public debt ratio since 2008, thereby reliably rebuilding fiscal buffers critical for a small open economy in a currency union. The 2016 budget essentially achieves this goal, but new unfunded spending initiatives or tax cuts should be avoided. Public finances are strong enough to let automatic stabilizers operate freely.

32. Productivity enhancing reforms remain the principal vehicle for sustainably raising living standards and should be framed in a coherent package to leverage their impact. The focus should be on improving the employability of labor by boosting training, addressing labor market mismatches, and lowering the tax wedge for low-income earners. Innovation policies should emphasize company upgrading more. As drafted, the proposed new Labor Code would address a key shortcoming in Lithuania’s otherwise favorable business environment. The authorities should guard against amendments that would weaken it.

33. External competitiveness is intact, but could come under pressure. Productivity gains have fallen short of fast real wage growth in recent years, unwinding previous competitiveness gains. Buffers in the tradable sector have now been all but exhausted up. While boosting productivity growth is the priority, wage growth will also have to slow. In this context, minimum wage hikes should be paused for now. The apparent recent stagnation of non-price competitiveness also needs monitoring.

34. Lithuania’s high income inequality needs to be addressed. Beyond its social implications, high inequality is also likely to weigh on macroeconomic prospects. Dual purpose measures that boost growth and especially benefit the disadvantaged should be pursued. Depending on social preferences, more redistributive fiscal policies could also be considered, which would aim making the tax system more progressive and lifting low social protection spending. Reforms proposed under the “New Social Model” initiative would the improve distribution to some extent, but far-reaching changes to old age pensions need more scrutiny before becoming law. Minimum wages have their role to play in income distribution. At current levels though further increases risk compromising employment and competitiveness.

35. The financial system is sound and the resumption of credit growth is a welcome development. Financial soundness indicators are solid and access to ECB liquidity since euro adoption in 2015 further reduced vulnerabilities. Legislation to fundamentally address weaknesses in the (small) credit union sector is now overdue. The recent revival of credit growth is a boon for the economic outlook, even though SMEs will continue to require support from government sponsored schemes. There are currently no signs of financial excess on the horizon. Should they emerge a comprehensive macroprudential toolkit is in place to address them. Close cooperation with banks’ home-country authorities increases the traction of potential measures.

36. It is recommended that the next Article IV Consultation be held on the 12-month cycle.

Figure 1.
Figure 1.

Republic of Lithuania: Real Sector Developments

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Haver; Lithuania Statistical Office; and 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.

Republic of Lithuania: Labor Market and Competitiveness Developments

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Haver; Eurostat; Lithuania Statistical Office; and IMF staff calculations.1/ REER and NEER against a group of 42 trading partners including Russia.2/ Manufacturing ULC-based REER agianst a group of 38 trading partners not including Russia.
Figure 3.
Figure 3.

Republic of Lithuania: Banking Sector Developments

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Sources: Dx Time; Bank of Lithuania; and IMF staff calculations.1/ From January 2015 onwards, banks’ external liabilities are redefined as those towards non-euro area countries.
Figure 4.
Figure 4.

Republic of Lithuania: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2016, 125; 10.5089/9781484355770.002.A001

Source: Ministry of Finance.
Table 1.

Republic of Lithuania: Selected Economic Indicators, 2013–211/

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

Data are presented on ESA2010, and BPM6 manuals basis.

The projections for 2014 include 302 million euros (0.8 percent of GDP) in compensation payments for past pension cuts on accrued basis.

The payments are spread over 2014-16, affecting the debt profile for these years. ESM contributions are spread over 2015-19 and also increase debt.

Passive projections from 2016 onward; incorporate only announced budgetary measures; budgetary impact of further defense spending, wage compensation and their potential offsetting measures are not included.

Fiscal balance for 2012 according to the definition for purposes of the Excessive Deficit Procedure (EDP).

Calculation takes into account standard cyclical adjustments as well as absorption gap.

Government external debt includes guaranteed loans.

Table 2.

Republic of Lithuania: General Government Operations, 2013–21

(ESA 2010 aggregates, in percent of GDP)

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

Passive projections from 2016 onward; incorporate only announced budgetary measures; budgetary impact of wage compensation and its potential offsetting measures are not included.

Table 3.

Republic of Lithuania: Balance of Payments, 2013–21

(BPM6, Billions of Euros, unless otherwise indicated)

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

Government external debt does not include guaranteed loans.

Short-term debt at remaining maturity.

Derived from national accounts data.

Table 4.

Republic of Lithuania: Summary of Monetary Accounts, 2010–15

(Billions of Euro, unless otherwise indicated)

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Sources: Bank of Lithuania; and IMF 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.