Republic of Lithuania: 2023 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Lithuania
Author:
International Monetary Fund. European Dept.
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Publication Date:
05 Sep 2023
eISBN:
9798400254048
Language:
English
Keywords:
foreign currency; potential GDP; statistics Lithuania; inflation risk; price signal work; Inflation; Global; Baltics
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1. Lithuania has experienced a successful income convergence particularly after the global financial crisis (GFC). The strong post-GFC policy response of fiscal and nominal wage adjustment boosted competitiveness and set the stage for an export boom that has steadily raised exports’ market share by about 60 percent since 2008. Although real wages have increased significantly across the economy, sustained productivity growth, particularly in the tradeable sector, has kept unit labor costs competitive and contributed to a strong competitive position (see Annex V). As a result, Lithuania’s per capita income has reached 92 percent of the EU average.

Context: Unprecedented Shocks Amidst a Successful Convergence Process

1. Lithuania has experienced a successful income convergence particularly after the global financial crisis (GFC). The strong post-GFC policy response of fiscal and nominal wage adjustment boosted competitiveness and set the stage for an export boom that has steadily raised exports’ market share by about 60 percent since 2008. Although real wages have increased significantly across the economy, sustained productivity growth, particularly in the tradeable sector, has kept unit labor costs competitive and contributed to a strong competitive position (see Annex V). As a result, Lithuania’s per capita income has reached 92 percent of the EU average.

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Wage, Productivity, and Unit Labor Cost Growth

(Percent)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: European Commission; Statistics Lithuania; Haver Analytics; and IMF staff calculations.

2. The pandemic and Russia’s war in Ukraine reinforce the importance of prudent policies and labor market flexibility to deal with shocks. Ample policy buffers and the safety net provided by European institutions, particularly after joining the eurozone, have been key to provide stability and predictability. Thus, the private sector entered these shocks with abundant buffers. First, despite negative real income growth, consumer spending remained resilient thanks to a strong labor market and unprecedented fiscal transfers during the pandemic and with energy subsidies last year. Second, nonfinancial corporates have low leverage and maintain a high level of profit margins providing flexibility to adjust during economic turbulences and cost shocks.

Pre War vs. Pre GFC vs. Pre Covid

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Sources: Eurostat, Haver, IMF staff calculations

2019 excludes tax and pension reform adjustment

2008, 2019 and 2021

2009, 2019 and 2021

3. With limited policy tools, high inflation—50 percent above the eurozone average— risks becoming entrenched, impacting competitiveness. The robust post-pandemic recovery resulted in stronger demand driven inflationary pressures than in the eurozone before the war. Subsequently, the war generated large supply-side inflationary pressures contributing to second-round effects notwithstanding the large decline in energy prices since last August. Furthermore, a tight but weakening labor market has added to cost-push inflation with high wage growth— although negative in real terms for the last year—increasing the risk of persistently high inflation. High wage growth, in turn, if delinked from productivity growth and sustained over time, could erode competitiveness. However, Lithuania’s labor market is flexible with wages being largely determined at the firm level. In contrast to the GFC, the absence of macroeconomic imbalances and the strong competitive position provide flexibility to absorb temporary deviations of wages from productivity. However, monetary conditions, determined largely by the European Central Bank (ECB), have tightened but remain looser than warranted by domestic conditions. Thus, the onus in terms of domestic policies to contain inflationary risks lays on fiscal policy.

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Competitiveness and Convergence

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: World Economic Outlook, IMF; Haver Analytics; Bank of Lithuania; Statistics Lithuania; and IMF staff calculations.1/ Tradables include agriculture, foresty, fishing and manufacturing.2/ Debt includes debt securities and loans. Sample includes 24 EU countries, Bulgaria, Croatia and Romania.

Drivers of Export Success: Price Competitiveness and Growing Sophistication

Beyond cost advantages, Lithuania’s exports increased in complexity, likely providing some protection from last year’s energy shock. The country’s ranking in the economic complexity index of the Center of International Development at Harvard has increased by ten points in the decade to 2020, showing a growing degree of sophistication, diversity of products, and international interconnectedness of large parts of Lithuania’s export sector. This development was driven by growing human capital, technological progress, and growing networks. The gains in export performance since the GFC thus went beyond mere increases in price competitiveness. Combined with a highly flexible labor market and a low-cost business environment, this part of the export sector should be well positioned to withstand a temporary energy price shock.

The transportation sector has made significant gains in external markets since 2014—even after the war started and the EU mobility package was approved. Net exports increased by one percentage point of GDP in 2022. The growth in the sector accelerated after Russia’s annexation of Crimea and the subsequent sanctions forced to shift towards the EU market in 2014, rendering the sector the main driver of the large and increasing services trade surpluses. This performance was driven by substantial cost advantages vis-avis other European economies. Taxes and charges on road transportation in Lithuania are the lowest in the EU, partly reflecting vehicle taxation unrelated to carbon emissions. Furthermore, labor unionization is modest and taxes are more competitive. Lithuanian road transportation companies’ revenues stand at 90 percent of their overall business with most activity conducted in the EU and the UK. This being a low-margin business, Lithuanian low-cost companies gained business when skyrocketing fuel prices drove up costs across the EU.

Recent Developments: Weakening Activity, Persistent Inflation and Geopolitical Risks

4. The economy remained resilient to the negative terms-of-trade shock until the last quarter of 2022 amid high inflation and global uncertainties. Lithuania started 2022 with strong growth and continuous signs of overheating. However, the economy started weakening in the last quarter of 2022 and, particularly, in the first quarter of this year amidst high inflation, heightened uncertainty, weak external demand and tightening financial conditions that impacted private consumption and private investment. External demand, while softening, was stronger-than-expected. At the same time, the labor market has remained broadly resilient with high wage growth, although negative in real terms. The influx of refugees from Ukraine—of 80,000 refugees, around 20,000 have found a job out of 1.4 million total employment—has helped moderate some of the labor-market bottlenecks.

5. Economic links to Russia have decreased significantly, limiting the direct impact of the war. The share of exports to Russia, Ukraine, and Belarus was 18 percent as of end-2021, down from 29 percent in 2014 before the introduction of sanctions and countersanctions due to Russia’s annexation of Crimea. In 2022 this share further declined to 12 percent. However, re-exports account for a significant share of this, particularly in the case of Russia, around 90 percent.

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Exports of Goods, 2021

(Percent of GDP)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: Statistics Lithuania; and IMF staff calculations.

6. Inflation, while falling, remains high in spite of tightening monetary conditions. Inflation increased at an annual average of 19 percent in 2022, one of the highest in the eurozone, along with Estonia and Latvia. Reflecting global supply-chain pressures, higher commodity prices and the robust recovery of demand after the pandemic. Core inflation, excluding energy and unprocessed food, is equally high, indicating broad-based inflation pressures. Lower energy prices and base effects have lowered inflation rates rapidly recently—11 percent in May from a peak of 23 percent in September last year—but it remains 5 percentage points above the eurozone average.

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Inflation

(Year-on-year percentage change)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: Eurostat; and Haver Analytics.

7. With energy prices decreasing, domestic energy tariffs are now broadly consistent with full pass-through of import prices. Lithuania depends heavily on imported energy, especially natural gas. The authorities took a pragmatic approach to the energy crisis by letting the price signal work, particularly for businesses, while preventing potentially costly macroeconomic disruptions by subsidizing part of the price increase and scaling up support to the vulnerable. This had a large fiscal cost, amplified by the untargeted nature of subsidies, around 1.3 percent of GDP in 2022 and 0.3 percent of GDP in the first quarter of 2023. However, with electricity prices decreasing rapidly since last August and below subsidized levels since January this year, in the absence of shocks, there will be no further electricity subsidies. Some gas subsidies to households—reflecting hedging operations taken when prices were high—remain until the end of the year at a modest fiscal cost (0.07 percent of GDP).

8. The fiscal stance in 2022 was moderately counter-cyclical, marginally contributing to containing inflationary pressures. The budget deficit—originally projected at 3.3 percent of GDP— narrowed to 0.6 percent of GDP from 1.2 percent in 2021 and 6.5 in 2020. A resilient economy, windfall revenues from high inflation (estimated at about 0.5 percent of GDP) and lower-than-planned spending on energy subsidies were the main contributing factors. Public debt remains comfortably low, below 40 percent of GDP in 2022—from 46.3 percent in 2020. As a result, Lithuania maintains substantial fiscal space with low risk of sovereign stress over the medium-term (Annex IV).

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Energy Prices and Subsidies

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: VERT and EmergingMarketWatch

9. Domestic demand and higher lending rates are supporting higher profitability of the banking system. Capital ratios are well above regulatory requirements (19 percent CAR), especially for systemically important banks, while NPL ratios are low and have continued to decline. The rapid pace of deposit accumulation during the pandemic has continued, raising the amount of bank deposits excluding non-residents from 54 percent of GDP at end-2019 to 62 percent of GDP by end-2022. With ample liquidity—390 percent liquidity coverage ratio—banks have been slow to increase deposit rates. However, they are benefiting from higher interest rates on new loans and the repricing of variable-rate mortgages that account for the great majority of the portfolio.

10. Macroprudential policy has been tightened as risks from volatile financial markets and higher interest rates increased. The low stock of mortgages (around 20 percent of GDP), the large share of transactions in cash (60 percent by value) and the relatively low average loan-to-value ratio suggest that the quantitative impact on households will be limited and the monetary transmission weaker than could have been expected. To address risks from the real estate market, the Bank of Lithuania (BoL) took measures including to increase the Countercyclical Capital Buffer (CCyB) from 0 to 1 percent in September 2022 effective October 2023. This decision reflected their assessment that the financial cycle, particularly for mortgages, was in an expansionary phase.

11. Lithuania’s financial system is undergoing a structural change driven by Fintech companies and the rapid ex pansion of Revolut. Since starting to operate as a bank by end-2019, Revolut has become the third biggest bank in Lithuania with 18 percent of system-wide assets. With an online banking model, it relies on non-resident EU depositors (98 percent of total deposits). The rapid increase in deposits (12 percent of GDP at end-2022) largely matches the increase in liquidity held at the BoL (10 percent of GDP). At the same time, the increase in the lending portfolio is much more timid (0.3 percent of GDP). While expected to be supervised by the Single Supervisory Mechanism (SSM) soon, Revolut’s deposits are covered by Lithuania’s deposit insurance fund. After an exponential expansion since 2014, the Fintech sector is consolidating with no growth in the number of companies operating in Lithuania from 2021 to 2022, around 260.

12. The real estate market is undergoing an adjustment after years of gains that accelerated during the pandemic. The rapid growth of real estate prices was largely explained by fundamentals before 2020—particularly the rapid growth of disposable income. However, given accommodative monetary conditions, large fiscal support, and the resilience of the labor market, growth accelerated during the pandemic to levels not fully justified by fundamentals. From 2010 to end-2022, house prices increased more than 140 percent— the third highest rate in the EU. With higher borrowing costs and weakening economic activity, the pace of nominal increase in property prices has slowed down to 14 percent as of April 2023 from an average of 21 percent in 2022. Prices are converging to, but remain above, levels consistent with fundamentals (Annex VIII).

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Residential Real Estate Indicators

(Index, 2015 = 100)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Bank of International Settlements; Haver Analytics; Eurostat, and IMF staff calculations.

13. The massive but transitory energy price shock deteriorated the trade balance but, so far, not price competitiveness vis-a-vis Lithuania’s main trading partners. Lithuania experienced a 20 percent decline in the terms-of-trade relative to countries outside the EU last year. With a heavy reliance on energy imports, the energy trade balance deteriorated by 7.6 percentage points of GDP, from -5.5 percent of GDP in 2021. However, the non-energy trade balance improved by 1.4 percentage points of GDP. Notably, the trade balance with other EU countries that were hit by a similar shock and are Lithuania’s main trading partners, improved by 2.2 percentage points. This suggests that the underlying competitive strength of the economy has not deteriorated to date. However, some sectors have been affected on a more permanent basis and will need to adjust to the new environment—such as the furniture industry and its reliance on low-cost lumber from Belarus. The economic slowdown in Lithuania and the euro area since late-2022 has compressed both exports and imports so far this year.

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Terms of Trade and the Current Account

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: Bank of Lithuania; Haver Analytics; and IMF staff calculations.

14. Lithuania’s external position was substantially weaker than fundamentals in 2022 (Annex III). The current account balance deteriorated strongly turning into a deficit of 5.1 percent in 2022. This deterioration was driven by a massive increase in net energy imports. Since most of the deterioration of the terms-of-trade is largely temporary, the current account is expected to converge over time to its norm under the current baseline.

Outlook and Risks

15. The economy is expected to experience a recession in 2023 given the weak momentum from late-2022 and early-2023 but with activity strengthening in the second half of the year. The baseline projections assume no further escalation of the war and a gradual decline in commodity prices that remain above pre-war levels.

  • Inflation will remain elevated for longer. Notwithstanding lower global energy and food prices and the recent slowdown, a weakening but still tight labor market and second round effects will result in more persistent inflation throughout this year and next. Thus, disinflation— driven by falling energy prices and weakening activity—is expected to be gradual towards the equilibrium level moderately above the euro area average given the convergence process.

  • Activity will be weak in the first half of the year with softening domestic and external demand, and a weaker labor market. With lower inflation and a resilient labor market, both domestic and external demand are expected to recover later this year and next also supported by high public investment financed by EU funds. Potential output should be only marginally affected from the recent shocks if inflationary risks do not materialize.

Main Macroeconomic Variables Under Baseline, 2022-2028

(in percent)

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16. The baseline is highly uncertain with risks—mostly external—tilted to the downside (Annex I):

  • Low growth-low inflation risks: Financial stability risks are associated with uncertain and volatile financial markets that could also trigger a disorderly correction of the real estate market. In response to demand shocks that lower growth and inflation relative to the baseline, the authorities should let automatic stabilizers operate and, if needed, provide targeted and timebound support.

  • Low growth-high inflation risks: On the domestic front, the biggest risk is persistently higher inflation than the euro area. Current deviations of wages from productivity can be accommodated given large past competitiveness gains provided they are transitory. However, if inflation remains high for longer, inflation expectations might adjust upwards, perpetuating high rates of price and wage growth that would eventually erode competitiveness. On the external front, the escalation of the war could trigger higher energy and food prices leading to higher inflation. In this scenario, the authorities’ response should not interfere with price signals and provide targeted support to the most vulnerable. Other external risks include high volatility of commodity prices, financial sector instability and geo-economic fragmentation.

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    Inflation Differential with the Euro Area

    (Percentage points)

    Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

    Sources: World Economic Outlook, IMF; and IMF staff calculations.

  • On the upside, the economy could prove more resilient than projected given the strength of private sector balance sheets, strong underlying fundamentals and an external demand that could recover quicker than projected.

Authorities’ Views

17. The authorities broadly agree with staff’s assessment of the outlook and risks and highlight the resilience of the labor market. They acknowledge the uncertainties coming from external factors and expect low or negative export growth this year as well as a somewhat faster convergence of inflation to its target. They see lower inflation and high wage growth supporting consumption and emphasize that high public investment this year will support activity. They agree with the assessment on inflation risks but caution that evaluating monetary conditions as being too loose is subject to uncertainty in a converging economy such as Lithuania. Regarding trade sanctions against Russia, they stressed that some sectors have been particularly affected as key production inputs need to be sourced at higher costs but are confident that, as in the past, Lithuanian companies can absorb this shock maintaining their competitiveness.

Policy Discussions: Fighting Inflation and Preserving Stability with Limited Policy Tools

Persistent high inflation is the biggest risk facing Lithuania. Therefore, fiscal policy should support the disinflationary effort. At the same time, financial policies should continue to be used proactively to preserve stability. Over the medium-term, implementing structural reforms is the only way to support further productivity gains. In any case, short-term challenges should not be addressed by introducing long-term distortions that reduce the structural flexibility of the economy.

A. An Appropriate Policy Mix to Reduce Inflationary Risks and Preserve Macroeconomic Stability

Fiscal Policy

18. Fiscal policy has an important role to play in containing the risks from high and persistent inflation (Annex V). External factors tend to be the dominant driver of inflation in the Baltics, but domestic factors play an important role as well. In this context, the ECB’s monetary tightening—aimed at bringing inflation back to target in the euro area as a whole—came late, starting more than a year after inflation began to pick up. Although monetary conditions have become significantly more restrictive, they remain loose relative to local economic conditions. Thus, fiscal policy is the main macrostabilization tool available and, although its effectiveness is reduced by the openness of Lithuania’s economy, it should be used proactively to reduce inflationary pressures.

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Taylor Rules for Lithuania

(Percent)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: European Commission; Eurostat; Haver Analytics; and IMF staff calculations.1/ ECB policy rate is the main refinancing operations rate and fiscal stance is measured as y/y change in cyclically-adjusted primary balance in percent of potential GDP.

19. The decrease of energy prices is contributing to lowering inflation and decreasing spending on subsidies. Thus, from a budget appropriation of 1.3 percent of GDP, subsidies will be less than 0.4 percent of GDP this year. Going forward, import prices should be fully passed through to consumers and no new subsidies should be provided.

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Inflation Base Effects 1/

(Percent)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Eurostat; and IMF staff calculations.1/ Assuming zero month-on-month inflation.

20. The latest Stability Program projects a fiscal relaxation this year adding to inflationary pressures. The 2023 budget was prepared under the assumption of a significantly better macroeconomic environment and that energy prices would remain high and require significant subsidies. This would have added to other spending pressures—defense and refugees—without commensurate revenue measures. The budget has conservative assumptions on revenues and recent developments, particularly in the energy market, suggest that a sizeable amount of spending may not be executed as reflected in the updated stability plan submitted to the EU that, nevertheless reflects an already outdated macroeconomic scenario. The projected fiscal policy stance is expected to become moderately expansionary with an estimated loosening of the structural balance by 0.3 percent of potential GDP—0.9 percent of GDP under the Stability Program.

Lithuania: Fiscal Stance 2020-2023 1/

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Measured as the change in the structural balance in percent of potential GDP excluding new non-wage military spending in 2022 and 2023 and using IMF’s macroframework.

21. To mitigate the risks of high and persistent inflation, fiscal policy should take a disinflationary stance notwithstanding a weaker economy. A small fiscal contraction this year would actively contribute to lower inflation and would have required an improvement of 0.5 percent of GDP in the structural fiscal balance. Any revenue overperformance and unnecessary spending on energy subsidies—already incorporated in our projections—should be saved in line with the Stability Program. At the same time, setting moderate minimum and public sector wages to mitigate risks of higher wage growth helps anchor inflation expectations in the private sector. The proposal by unions and businesses to increase the minimum wage by 10 percent next year stays below the current rate of inflation, but future increases will need to be prudent not to add to inflation persistence. Going forward and consistent with Lithuania’s fiscal rule, a tightening of at least 0.5 percent of GDP per year over the next few years will support the disinflationary effort.

22. Accommodating new and pre-existing spending pressures will require additional revenues under the existing fiscal targets. Lithuania’s spending pressures relate to negative demographics1, one of the worst in the EU; a pension system that, while financially sustainable, unrealistically projects declining replacement ratios from already low levels; permanently higher military spending; and moderately increasing interest payments on debt. In addition, reducing high poverty rates and social disparities, especially at the regional level, will require more and better social programs—currently pension spending is the main redistributive fiscal tool. With social protection spending below the EU average and discretionary spending low, accommodating additional expenditures will require revenue-generating tax reforms and/or a moderate relaxation of fiscal targets (see below). Importantly, given the transitory (energy subsidies) and targeted (pandemic measures) nature of most support measures since 2020, the structural fiscal position has remained strong.

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Structural Fiscal Position

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Ministry of Finance; and IMF staff calculations.

23. Rebalancing the tax system from labor towards wealth, capital, and environmental taxes can generate more revenue and improve efficiency (Annex II). The authorities’ recent tax reform proposals are a step in the right direction (Annex VII). However, these measures will only generate a modest 0.35 percent of GDP in additional net revenues. Existing environmental taxes are not enough to achieve the country’s strategy for climate change mitigation and green growth. This will likely require the introduction of an economy-wide carbon tax—set to gradually increase to USD50 (or about EUR60) per metric ton of CO2 emissions on all types of fossil fuel by 2030—that could also help lower labor taxes and increase public investment (see Box 2). There is also scope to generate revenues by removing inefficient tax concessions and exemptions—amounting to about 4.2 percent of GDP as of 2022 of which half are on the income tax and a sixth on the VAT.

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Tax Structures in 2020

(Percent of total tax revenue)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: OECD Revenue Statistics 2021.

Climate Policies

The EU plans to extend the Emissions Trading System (ETS) will effectively impose a carbon tax on a larger share of the Lithuanian economy but will not be an economy-wide measure that is necessary to achieve the country’s target by 2030. Changing the energy matrix and further improving energy efficiency could bring a significant reduction in CO2 emissions and help strengthen the country’s energy security. The current pace of CO2 emissions reductions has been slower than the EU average, largely because of the continuing increase in emissions in agriculture, transportation, services, and buildings.

Increasing the share of renewable energy and improving efficiency could contribute to a significant reduction in emissions and imported energy. The government has ambitious plans—mostly offshore wind, and solar—and aims to reach 9GW of capacity by 2030, matching domestic demand. The introduction of an economy-wide carbon tax—set to gradually increase to at least USD50 (or about EUR60) per metric ton of CO2 emissions on all types of fossil fuel by 2030—would be consistent with the ETS (and the recent introduction of a carbon component in excise taxes in Lithuania) and help move towards the emission reduction target and generate additional tax revenue (IMF WP No. 22/174).

24. The current discussion on the modification of the EU fiscal framework provides an opportunity to finetune Lithuania’s domestic fiscal rule. The fiscal rule sets tighter targets—a structural surplus—than required by the EU framework. However, it is overly complex—covered by two laws with overlapping overall and structural targets and many escape clauses that effectively weaken the expenditure correction mechanism (IMF 18/186). This has delivered ample fiscal space to respond to shocks, as reflected since 2020. However, the domestic fiscal rule could be finetuned to make it simpler and accommodate some structural spending pressures, such as the permanent increase in defense. Any modification should preserve the current strong counter-cyclical stance and ample fiscal buffers—low deficits and debt—needed in a small open economy in a monetary union.

Financial Policies

25. Higher interest margins and a cost-efficient business models have boosted profitability in the banking sector. Depositors’ behavior—driven mainly by forced and precautionary savings during the pandemic and the war, and the lack of domestic investment opportunities other than real estate—shows little sensitivity to deposit rates. Thus, while interest rates on new loans have been passed through in line with the eurozone or faster (particularly for new mortgages), deposit rates have adjusted at a slower pace. The resulting increase in interest margins, traditionally in line with or below the eurozone average, has boosted short-term profitability of banks.

26. Given the high profitability of the banking system, the authorities have introduced a temporary windfall levy on banks. Efficiency, rather than the high level of concentration, has traditionally explained the higher profitability of Lithuania’s banking system relative to European banks—a poor benchmark given their post-GFC sharp fall in profitability (see Annex V). In the current environment profitability will reach unprecedented levels. The new levy will be applied this year and next to all credit institutions and existing loans—new loans are excluded—to limit the increase in net interest income to, at most, 15 percent above last year’s level. The so-called “solidarity contribution” of 60 percent is applied on the net interest income that exceeds the average of the previous four years by more than 50 percent. Given the composition of the banking system, this levy mostly affects foreign banks. The proceeds, expected to be around EUR400 million, will finance military spending. This adds to what was initially planned to be a temporary increase in the corporate tax rate for big banks—again affecting mostly foreign banks—from 15 to 20 percent introduced in 2019 and made permanent last year. Thus, it will be important that the levy remains temporary to avoid being perceived as a tax on foreign investment and to minimize the potential negative impact on efficiency.

27. Higher interest rates bring significant—if manageable—non-systemic risks to the financial sector. The authorities have proactively taken appropriate macroprudential actions to address risks particularly from the real estate market due to higher interest rates—such as affordability requirements to higher interest rates for new mortgages since 2015 (see text table). The correction of property prices comes with risks given its potential impact on aggregate demand (as households cut back on consumption) and banks. However, balance sheet risks from higher interest rates and weaker activity are contained with large capital buffers and profitability able to absorb potential losses from a likely deterioration of the lending portfolio.2 In terms of banks’ securities portfolios, securities held to maturity only represent 5 percent of total assets or 60 percent of equity, making potential unrealized losses manageable.

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Euro Area: Share of Mortgages with Interest Rate Fixation of less than One Year (Percent of total loans for house purchase)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: ECB; Eurostat; Haver Analytics; and IMF staff calculations.

Lithuania: Macroprudential Measures

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28. While ample buffers position the financial system to withstand shocks, vulnerabilities will require close monitoring. Vulnerabilities could emerge if additional shocks results in even higher interest rates and weaker activity than under the baseline. Banks are building further resilience by not fully distributing 2022 profits in order to strengthen capital. If a sharp downturn causes credit supply disruptions or a disorderly correction of real estate prices, a relaxation of capital- and borrow-based macroprudential measures should be considered.

29. Lithuania’s AML/CFT framework should be further reinforced to address ML/TF risks from cross-border and non-resident financial activity. The value and volume of cross border financial flows have remained elevated since 2020, including with higher risk jurisdictions, driven in part by the BoL’s enabling foreign EMI and PI to use its payment system for SEPA payments directly, heightening the ML/TF risk (see Figure 7). The number of fintechs in Lithuania has stabilized (265 in 2021 to 263 in 2022) after seven years of significant growth. Staff have been engaging with the central bank on AML/CFT recommendations issued as part of the 2022 Article IV consultation and ongoing regional Nordic-Baltic AML/CFT technical assistance project to support it to address the ML/TF risks faced in the fintech sector and by the country’s cross-border and non-resident activity.

Select AML/CFT Recommendations from 2022 AIV Consultation and Ongoing Regional Nordic-Baltic AML/CFT Technical Assistance Project

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Impact of Higher Interest Rates on Deposit and Lending Rates

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: European Central Bank; Haver Analytics; and IMF staff calculations.

Authorities’ Views

30. The authorities emphasize that fiscal policy should contribute to macroeconomic stabilization and note that price stability is not its only objective. They are committed to save any revenue overperformance and savings from lower-than-budgeted energy subsidies in 2023. They consider that the broadly neutral fiscal stance this year and the gradual pace of fiscal adjustment going forward, strikes a balance between facilitating disinflation and supporting economic activity. They reiterate their commitment to prudent fiscal policy as reflected in the domestic fiscal rule that is set to become operational again next year. They also highlight that the proposed tax reform will make the system more fair and efficient, as well as support economic growth and underline that the approved changes in excises, including the increase of rates on fossil fuels and the introduction of a carbon component, will support the green transition.

31. The authorities emphasize that ample buffers in the banking sector provide stability and they have taken important steps in addressing risks from the maturing fintech sector. They stress that macroprudential actions have increased buffers and that risks from the real estate market are receding with the gradual decrease of housing price overvaluation. They emphasize that the solidarity contribution on banks is temporary and has been designed to avoid distortions and negative effects on financial stability. They stress that given unprecedented profitability, postcontribution profits will remain elevated so as to allow building further resilience if needed. They reiterate their determination to address risks associated with the fintech sector and highlight the decisive actions taken to increase supervisory resources and strengthen the regulatory framework including for virtual asset service providers (VASPs). They plan to continue enhancing the domestic AML/CFT framework.

B. Structural Reforms: Unlocking Growth Potential

32. Lithuania has outperformed its peers since the GFC, but structural reforms will be key to mitigate possible scarring from recent shocks and accelerate further income convergence. The balanced high-productivity growth path since the GFC has supported rapid wage growth. To further improve productivity it is critical to implement key structural reforms that enhance private sector-led growth and mitigate or reverse negative demographic dynamics.

33. The structural flexibility of the economy, particularly of the labor market, remains a key factor to absorb shocks and mitigate their impact. In the past, wages and productivity have been closely linked and temporary deviations have been self-corrected (see Annex V). The 2017 labor code reform introducing new labor contracts and reducing severance payments, increased flexibility further in what was an already flexible labor market. At the same time, it increased the benefits and duration of the unemployment insurance enhancing the social safety net. In this context, moderate increases in the minimum wage can contribute to fight inflation. In any case, the targeted range—45-50 percent of average wages—disproportionately affects low-skilled and young workers in rural areas whose wages are well below the national average reflecting lower productivity. The recently approved civil sector reform aims at increasing accountability, flexibility, and efficiency in the public sector.

34. Given poor outcomes in education and health, reforms in these areas, while politically difficult, are critical to support productivity and address disparities. On healthcare, expenditure is broadly in line with peers but the share of out-of-pocket spending is 15 percentage points higher, suggesting a significant burden on patients that, nevertheless, face the lowest life expectancy in the EU. On education, PISA scores are significantly below the OECD average. Spending on primary and secondary education is the lowest of the OECD with large inefficiencies focused on maintaining an overgrown network that does not reflect demographic trends. Finally, tertiary education outcomes do not align well with labor market needs resulting in some graduates needing vocational training to join the labor market and the third largest level of skills mismatch in the EU.

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PISA Score

(Scale ranges from 0 to 1000; averages for age 15 years)

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Source: Program for International Student Assessment (PISA), OECD.

35. Improving energy efficiency and strengthening energy security remain important priorities. The new energy matrix and the transition towards it—there are ambitious plans to increase the share of renewables from the current 30 percent to 50 percent by 2030—should be carefully calibrated to avoid hampering long-term growth. Moving away from fossil fuels and increasing energy efficiency are necessary to enhance energy security and reduce CO2 emissions in line with the country’s pledges for climate change mitigation.3 The current pace of reduction in emissions is not consistent with that objective. To this end, introducing an economy-wide carbon tax and other measures including “feebates” on fossil-fuel consumption would incentivize energy conservation, more investment in renewable energy, and raise additional fiscal revenues.

Authorities’ Views

36. The authorities are committed to structural reforms to unlock the country’s growth potential and address risks associated with climate change. They continue to pursue reforms in education and healthcare as well as innovation and green transition. They highlighted the approval of civil sector reform that will provide greater accountability and flexibility in the public sector enhancing productivity. The green transition and energy independence remain top priorities with the ambitious goal of renewables generating 100 percent of electricity demand by 2030.

Staff Appraisal

37. The Lithuanian economy remained resilient until the end of last year. High inflation and rising interest rates weakened disposable income which, combined with weak external demand, resulted in an economic contraction. Lower energy prices are helping decrease inflation, that remains significantly above the eurozone average. A recovery is expected later this year. Risks are tilted to the downside with persistently higher inflation than the euro area as the biggest risk.

38. Fiscal policy is projected to become moderately expansionary this year adding to inflationary pressures. To mitigate the risk of high and persistent inflation and notwithstanding weaker activity, a fiscal contraction would actively contribute to lower inflation. Going forward, the contractionary fiscal stance resulting from the reactivation of the domestic fiscal rule will help contain inflation risks.

39. Accommodating new and pre-existing spending pressures will likely require new revenues under the existing fiscal targets. At the same time and in the context of the discussions to modify the EU fiscal framework, the domestic fiscal rule can be simplified and adjusted to accommodate permanently higher defense spending. In any case, any modification should preserve ample fiscal buffers necessary to ensure an effective counter-cyclical stance.

40. Rebalancing the tax system from labor towards wealth, capital, and environmental taxes can generate additional revenue and improve efficiency. The recent reform of excise taxes adding an environmental component will not be enough to achieve the country’s strategy for climate change. Other tax proposals aim at improving efficiency and equity will largely reverse revenue gains from the increase in excises. These reforms are a step in the right direction but neither go far enough in rebalancing the tax system nor will they generate much additional revenue.

41. A weakening economy and higher interest rates bring risks to the banking sector but should remain manageable given high liquidity, capitalization, and profitability. The correction in property prices is bringing valuations closer to fundamentals in an orderly fashion so far. The negative impact of higher interest rates and weaker activity should be contained given large capital buffers and profitability. However, vulnerabilities will require close monitoring, especially if additional shocks result in even higher interest rates and weaker economic activity. A sharp downturn could cause credit supply disruptions or a disorderly correction in the real estate market. In such a scenario, the BoL should consider a relaxation of capital-based macroprudential and, potentially, borrower-based measures.

42. The levy on banks should remain temporary to avoid being perceived as a tax on foreign investment and minimize the potential negative impact on efficiency. While the levy has been carefully designed to avoid disincentivizing lending in the short-run, permanent sectorspecific taxes on excess profits have a distortionary impact over time. Furthermore, in the current environment, preserving financial stability is a key priority. Frequent ad hoc tax changes in sectors with significant foreign investment risk weakening Lithuania’s hard-fought reputation as a stable, predictable, and competitive tax destination.

43. There has been progress in addressing money laundering and terrorist financing (ML/FT) risks in the financial sector responding to the challenges from the fintech sector. Steps have been taken including increasing ML/TF supervisory resources and on risk assessment of new and existing clients of BoL’s payments system (CENTROLink). Progress has also been made in the VASP sector by upgrading the regulatory framework and introducing a sectoral risk assessment. Going forward emphasis should be placed on supporting risk-based supervision and increasing supervisory powers and market entry controls. Regarding the wider AML/CFT framework, some deficiencies identified in the country’s 2018 MONEYVAL Mutual Evaluation report have been addressed. However, further progress is needed on mitigating remaining risks in the VASP sector and on regulation and supervision of designated non-financial businesses and professions, through the passing of the draft amendments to the AML/CFT law.

44. Lithuania’s external position was substantially weaker than fundamentals in 2022 (Annex III). As the deterioration of the current account is largely temporary, it is expected to converge over time to its norm under the current baseline.

45. Preserving the flexibility of the economy and advancing long-overdue structural reforms will be needed to support further productivity gains and higher living standards. The recently approved civil service reform aimed at increasing flexibility, efficiency and accountability in the public sector is a step in the right direction. At the same time, it is critical to accelerate ongoing reforms in education and healthcare.

46. Developing renewable sources of energy and improving energy efficiency are necessary for climate change mitigation and energy security. The new energy matrix and the transition towards it should be carefully calibrated to avoid hampering long-term growth. Meeting Lithuania’s pledges for climate change mitigation will require the application of a carbon tax in sectors not covered by the ETS and other measures including “feebates”.

47. The next Article IV Consultation is expected to be completed on the standard 12month cycle.

Figure 1:
Figure 1:

Lithuania: Inflation Developments

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: European Central Bank; Consensus Forecast; Eurostat; IMF; and IMF staff calculations.1/ Measured as the gap between top and bottom quintile for each consumption category.
Figure 2:
Figure 2:

Lithuania: Macroeconomic Developments

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Haver Analytics; Statistics Lithuania; Bank of Lithuania; and IMF staff calculations.
Figure 3:
Figure 3:

Lithuania: Labor Market Developments

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Haver Analytics; Eurostat; Statistics Lithuania; and IMF staff calculations.1/ Based on the structure of earnings indicators released every four years.
Figure 4:
Figure 4:

Lithuania: Banking Sector Developments

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Bank of Lithuania; BIS; European Central Bank; Haver Analytics; and IMF staff calculations.1/ Data for Lithuania is as of 2022Q3.
Figure 5:
Figure 5:

Lithuania: Fiscal Developments

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Ministry of Finance; Statistics Lithuania; Haver Analytics; and IMF staff calculations.
Figure 6:
Figure 6:

Lithuania: Energy Imports by Partner Countries, 1991-2021

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Eurostat; and IMF staff calculations.
Figure 7:
Figure 7:

Lithuania: Evolving ML/FT Threats

Citation: IMF Staff Country Reports 2023, 316; 10.5089/9798400254048.002.A001

Sources: Invest Lithuania, 2022; Swift; and IMF staff calculations.
Table 1:

Lithuania: Selected Economic Indicators, 2018–28

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Sources: Lithuanian authorities; World Bank; Eurostat; and IMF staff estimates and projections. Note: Data are presented on ESA2010, and BPM6 manuals basis.

2019 adjusted for tax reforms.

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

Table 2:

Lithuania: General Government Operations, 2018-28

(ESA 2010 aggregates, in percent of GDP)

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Sources: Ministry of Finance; Ministry of Social Security; and IMF staff estimates. Note: Passive projections from 2022 onward. Projections incorporate only announced budgetary measures.
Table 3:

Lithuania: Balance of Payments, 2018-28

(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.

Derived from national accounts data.

Table 4:

Lithuania: Summary of Monetary Accounts, 2012-21

(Billions of Euros, 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).