Abstract
Selected Issues
The Lithuanian authorities highly appreciate constructive engagement with the Fund staff that provides a welcomed contribution to the internal policy debate on core economic and financial sector issues. The authorities broadly agree with the thrust of the staff appraisal that is well-aligned with the main policy recommendations formulated in the context of the economic surveillance by the EU regional bodies.
Lithuania has made strong progress in income convergence over the years despite a volatile economic and financial cycle, setbacks during the GFC, achieving the second highest average growth rate in the EU during 1996–2017 period. Lithuania’s transition story has been marked by substantial structural transformation and a successful European integration. Imbalances of the past have been fully addressed with the economy on a much stronger footing than before. A strong fiscal position and proactive macroprudential policy stance confirms that the authorities are strongly determined to minimize any possibility of resurgence of imbalances.
The near-term outlook remains favorable. The real GDP increased by 3.9 percent in 2017, driven by strong consumption, exports, and investment. Strong growth is expected to continue over the next two years. The labor market situation has improved, with high labor participation and declining unemployment. Rising wages contributed to inflation, although it was also influenced by an increase in excises. After reaching 3.7 percent in 2017, inflation is expected to moderate to 2.2 percent by 2019. External competitiveness has been maintained despite increasing labor costs, as evidenced by significant gains in export market shares, positive shifts in productivity, and the current account surplus.
With the near-term outlook broadly secured, the authorities are shifting their attention to the medium-term challenges and structural reforms. These challenges mostly relate to unfavorable demographics, productivity, income inequality, and quality of public services. The authorities are well-aware that the window of opportunity to address these challenges will not last for long, putting a higher premium on reform acceleration. Without broad reaching reforms, the growth potential is envisaged to slow and the old age dependency ratio set to double in the next twenty years, putting further strains on social services delivery and public finances. There is a broad acknowledgement of these challenges in the society, though finding efficient remedies so far proved to be difficult, not least due to the political economy constrains. The authorities are hopeful that the OECD membership will help to further strengthen reform diagnostics, benefiting from the OECD expertise on structural issues and identification of international best practices.
Fiscal policy
At around 40 percent of GDP, Lithuania’s public debt is among the lowest in the EU and is on a downward trend following the fiscal surpluses recorded over the last two years. Revenue growth has been supported by an improved cyclical position, whereas expenditure growth has been contained. Lithuania has high income inequality and the share of people at risk of poverty and social exclusion further increased since 2015. The authorities have taken a number of steps to remedy the situation. The tax wedge for low income earners has been lowered through a set of increases in the non-taxable PIT threshold. The 2018 budget maintains social orientation with a measured increase in social spending, pensions, and public sector wages. Low income earners benefited from redefined child benefits and an introduction of a universal child benefit, there was also an increase in state supported income. The headline fiscal balance will remain in surplus (0.6 percent of GDP) this year due to continued cyclical revenue growth, some tax adjustments, and expenditure rationalisation.
More recently, the government submitted to the Parliament a package of additional tax amendments and measures to improve pension system sustainability. The main elements of the proposed tax amendments include a three-year plan for envisaged tax changes, consolidation of the PIT and social security contributions for the basic pension, a ceiling on social security contributions, further increase in the PIT non-taxable allowance, a progressive PIT rate, hikes in excises, and broadening the real estate taxation. The associated loss in revenue is expected to be financed through further gains in tax administration and compliance.
Earlier reforms of the pension system have addressed long-term fiscal sustainability by increasing the retirement age and introducing the new indexation formula, though social sustainability of pensions remains a challenge, with low income replacement ratios and high old age poverty. The proposals under the current consideration include transferring the financing of the basic pension to the budget and measures to strengthen the Pillar II by increasing contribution rates, broadening participation, and enhancing its administrative efficiency.
The authorities take note of staff’s assessment of the existing fiscal rules that are viewed by staff as complicated even compared with the European framework. The authorities note that the fiscal framework should respond to country specificity. Lithuania is a small open economy, more susceptible to external shocks, therefore maintaining fiscal prudence and adequate fiscal buffers remains of utmost importance. The authorities agree that there might be scope to simplify the existing fiscal framework, though the issue should be approached cautiously not to increase risks to public finance sustainability and also taking into account the debate at the European level.
Financial sector
The financial sector clean-up has been largely completed. Lithuania’s financial system is dominated by the Nordic banks that are well capitalized and liquid. The banking sector maintains strong profitability with no legacy issues and the credit union sector has been significantly strengthened by broad-based structural reform. The level of NPLs came down to 3 percent. The banking sector cost efficiency, ROE and ROA are among the strongest in the region. The banking sector performance is also strong when comparing profits to risk weighted assets, confirming that profitability is driven not by an increase in risk taking but operational efficiency. The banking sector is domestically oriented, bank reliance on parent bank funding has decreased through time, and the share of non-resident deposits is negligible. The stress tests confirm that the banks would remain resilient even under the adverse economic scenario.
As confirmed by staff, Lithuania’s macroprudential framework is strong, with the Bank of Lithuania having a clear mandate, broad powers, and adequate tools to conduct macroprudential policy. The BoL maintains a proactive approach to conducting macroprudential policy, using a broad-array of policy tools at its disposal. Currently activated instruments include a capital conservation buffer, countercyclical capital buffer, O-SII capital buffer for systemically important banks, LTV, DSTI, and maximum loan maturity requirements. The available toolkit consists of additional instruments (e.g. systemic risk buffer, risk weight adjustments for real estate exposures, etc.) that could be activated if needed.
Credit growth has accelerated with improved macroeconomic prospects, positive changes in household income, and increased investment demand after reaching high capacity utilization in the corporate sector, though overall private sector indebtedness remains low. According to the latest available information, the corporate credit increased by 6.4 percent on an annual basis and that of households by 7.3 percent. Activity in the real estate sector has intensified since 2015, with an increase in housing prices and the number of transactions, though the housing prices did not deviate from fundamentals. Credit growth is in line with the nominal GDP and does not cause a concern for now. Nonetheless, against the backdrop of favorable trends in the economy, credit and real estate market, it is the right time to strengthen the resilience of the financial system by accumulating additional reserves. Thus, a decision to increase the countercyclical capital buffer rate up to 0.5 percent was taken in end- 2017 and will become binding by end-2018.
Structural issues
The authorities are using an economic upswing to accelerate the structural reform agenda and to make growth more inclusive. Steps have been taken to reform labor relations with passage of amendments to the Labor Code. The authorities have also taken steps to depoliticize the decisions on minimum wage by introducing a non-binding rule that the minimum wage should effectively be kept within 45–50 percent of average wages.
Reforms in health care and education have been long overdue and the authorities prioritize progress in these areas, with focus on network consolidation and efficiency, adequacy of salaries for education and health-care professionals. If spending on education is broadly in line with the EU averages, suggesting that the key issue is resource allocation, spending on health care remains among the lowest in the EU.
In line with past Fund recommendations, the authorities also aim to increase efficiency of public R&D expenditure, strengthening cooperation between business and science communities, streamlining governance of research and innovation policy, and addressing fragmentation.