Abstract
The 2011 Article IV Consultation reports that the economy in the Republic of Lithuania has staged an impressive recovery based on a supportive global environment and determined policy adjustment. The main driver of the recovery was export growth. Executive Directors commended the authorities for Lithuania’s impressive economic recovery, noting in particular the sizable fiscal consolidation and the maintenance of confidence in the banking system. Directors also supported the authorities’ goal of reducing further the fiscal deficit, thereby putting government debt on a downward path.
The Lithuanian authorities highly appreciate the Fund’s economic policy advice and thank Mr. Morsink and his team for productive discussions and valuable policy insights provided during the 2011 Article IV consultations in Vilnius. The authorities broadly agree with staff’s analysis and policy recommendations. The recent years have been exceptional for economic policy making in Lithuania. The authorities had to steer the economy to a safe landing after the domestic demand boom burst and when the worsening external outlook provided additional tailwinds. Supported by determined policy actions and inner flexibility of the economy, macroeconomic imbalances have been quickly reversed and the economy staged a quick recovery as the external demand strengthened. During one of the largest economic adjustments in the country’s history, the society demonstrated unique perseverance and political stability has been maintained. The economic adjustment in Lithuania is becoming more structural as the political capital is being increasingly allocated on deepening the structural reforms that should pave the way for a more sustainable growth model, enhance fiscal transparency and soundness, as well as financial resilience. Policies pursued by the Lithuanian authorities are fully aligned with the euro area membership objective.
Economic outlook and risks
The macroeconomic scenario foreseen by the authorities is in line with staff’s projections. The recently announced data confirm that robust economic expansion continued in the third quarter of 2011 with real GDP increasing by 6.6 percent year-on-year. Large internal adjustment and deleveraging that occurred in 2008-09 improved Lithuania’s economic competitiveness and allowed Lithuania to benefit strongly from the more favorable external conditions. The signs of economic reorientation have occurred with the tradable sector playing a more prominent role in the recovery. Significant improvement in unit labor costs supported export performance and allowed to gain export market shares. The export volume reached its pre-crisis highs already in October 2010 and strong positive developments in the export sector continued in the course of 2011 before moderating lately, in line with the changing economic sentiment in Lithuania’s key export markets.
The export-led recovery that started in 2010 broadened to domestic demand in 2011 and has eventually become a twin-engine growth. Demand for investment has returned with improving corporate profitability and higher capacity utilization, whereas increasing employment strengthened consumer confidence. The strong surplus in the services balance and increasing current transfers had a positive effect on the current account, but the current account recorded a small deficit as the demand for imported investment goods picked up markedly. Going forward, the modest current account deficit will be fully financed by the capital transfers from the EU. The net FDI flows should also increase as the authorities’ efforts to improve Lithuania’s investment environment should yield higher dividends.
While the annual HICP inflation remains at an elevated level, it started to come down lately following the decline in the global food and energy prices. The core inflation returned to a positive territory after prolonged deflation, but it remains contained.
The situation in the labor market has started to improve gradually, although the unemployment rate is projected to stay above its historical average. Observed positive developments in employment were broad-based and not limited to a narrow set of economic activities. The employment dynamics have been favorably affected by the improved economic outlook. The amendments to the labor code that provided better opportunities for temporary and part-time hiring also contributed to the labor demand as it allowed the companies to adjust more smoothly to the fluctuating demand for new orders.
Overall, the economy is now in a much healthier condition to withstand potential shocks, though trade and financial integration constitutes higher spillovers risks for Lithuania. Acknowledging this risk, the projected economic growth of 4.7 percent in 2012 could be revised by approximately 1 percentage point downwards.
Fiscal policy and structural reforms
The authorities’ fiscal strategy is geared towards restoring public finance sustainability, putting debt on a downward trajectory, and preserving market confidence in the consolidation efforts. The track record of implementation certifies that the consolidation path is firmly established. The fiscal outturn for 2010 was 1 percentage point better than initially projected due to stronger revenue growth and maintained strict expenditure control. Taking into account improved economic outlook, the authorities revised the 2011 fiscal deficit target to 5.3 percent of GDP and are well on track to secure the final outcome for the general government deficit even below 5 percent of GDP. The consolidation measures in 2011 included further extension of expenditure cuts on public sector wages and pensions, reduction of generous parental benefits, and better targeting social support. The reduced transfers to the private pension funds (Pillar 2) are maintained until the further reform of the pension system and its privately funded part has been implemented.
The draft 2012 budget is set to achieve the 2.8 percent of GDP fiscal deficit target. The general government debt is projected to slightly decrease in 2012 to 37.3 percent of GDP and the financing needs will be met by borrowing in domestic and international markets. The recent USD 750 million bonds (a tap of the existing USD 750 million bond due in 2021) issued in international capital markets serves as a pre-funding exercise for the next year and confirms Lithuania’s access to international capital markets at a reasonable price even during volatile markets. Under the 2012 draft budget, the public sector wage freeze will be maintained; appropriations for the ministries will be cut by additional 2 percent; and the reduced social assistance and unemployment benefits will become permanent. The primary expenditure excluding the co-financing for the EU supported investment projects will be 1.8 percent lower compared to 2011. Taking into account social vulnerability of the retired persons, the crisis related cut in pensions will not be extended, though the pensions will remain below their pre-crisis level in real terms due to absence of indexation. To ensure that the 2.8 percent fiscal deficit target is met, the budget law will establish an interim expenditure ceiling and introduce the requirement for a supplementary budget if it becomes clear that the revenue plan is unlikely to be met by the margin of 3 percent.
The authorities’ fiscal consolidation efforts are focused on the fruits that have matured and on the completion of the structural reforms that have already been started. No significant tax changes are foreseen for 2012 so far. Building on the success of the tax compliance strategy that has been developed with the technical support from the Fund, the authorities plan further measures to increase tax compliance. In addition to the numerical expenditure rule that is currently in place, the authorities consider further ways to strengthen the fiscal framework. To reduce possible fiscal risks due to liabilities incurred at the municipality level, the authorities are also revising the framework for municipalities’ financing. The authorities see potential for increasing wealth taxation, but it requires broad consensus and the exact modalities need to be worked out. The government already proposed to change the valuation method for the land tax, which would be based on the market value.
The structural expenditure reforms in social security, health care, and education sectors are advancing. The final decision to increase the retirement age was taken in June and the retirement age will be gradually increased from 2012. The Parliament also approved the comprehensive pension reform guidelines that aim to strengthen the link between pension benefits, demographic factors, and contributions. The authorities aim to complete the reform of the pension system in 2012. The reform of the health care and education sector is approaching a stage where the number of institutions providing health care and education services will start to be consolidated. The authorities also expect to reinvigorate the housing renovation program that will provide further impetus for employment and will yield significant savings on the imported energy bill, improving the current account balance over the medium-term.
The authorities underscore the significant transparency and efficiency gains they expect from reforming the management of state owned enterprises (SOEs). The reform aims to enhance efficiency of SOEs by setting higher requirements for financial reporting and accountability, revising management structure, introducing more stringent cost-benefit analysis, and separating SOEs commercial and non-commercial functions. The reform efforts should yield considerably higher revenue. Based on the analysis of the available data on the SOEs financial performance, also taking into account the proposed new rules for the SOEs profit sharing, the draft 2012 budget includes 0.4 percent of GDP in additional revenue from SOEs.
Financial stability and financial sector policies
As the macroeconomic outlook has improved, the banks operating in Lithuania were able to achieve higher net interest margins, the level of NPLs started to come down, and the profitability of the banking system has increased. The Lithuanian banks rely on stable sources of funding and hold sizeable liquidity buffers to withstand potential shocks. The liquidity ratio made up 41.7 percent for 2011 Q3 and significantly exceeded the 30 percent minimum established by the Bank of Lithuania. The share of retail deposits to total liabilities has increased to 60.1 percent in September 2011 and the parent bank funding has decreased to 30.6 percent of the total liabilities. The rigorous stress tests performed by the Bank of Lithuania showed that even under the adverse scenario the banking system’s liquidity ratio would remain close to the regulatory requirement. The capital adequacy ratio of the banking system stood at 14.1 percent as of 2011 Q3, and substantially exceeded the regulatory capital requirement of 8 percent. The banking system’s Tier 1 capital ratio increased from 10.9 to 11.2 percent over the year. However, some banks still need to increase loan loss provisioning and strengthen the capital base. The banks operating in Lithuania have only limited direct exposure to the sovereign debt of the Southern European countries with the spillovers that effect demand for export and the conditions for sovereign financing considered being a more important risk.
In 2011 the authorities advanced a number of important initiatives that will allow for further strengthening of the systemic resilience in the financial sector:
1) Seeking to achieve economies of scope in supervising Lithuania’s bank-based financial system and to ensure better coordination and systemic risk management, the authorities decided to consolidate the financial sector supervision under the Bank of Lithuania. The reform foresees transferring the insurance and securities sector supervision function to the central bank that will also assume responsibility to provide consumer financial protection services. The reformed supervisory authority will report to the designated member of the board of the Bank of Lithuania. The financial supervision function will be financed from market participants’ contributions and the central bank’s resources. The reform will enhance the institutional, political, operational, and financial independence in carrying out the financial sector supervision. The necessary legal amendments have been presented to the Parliament and should be passed into law by December 2011. The operational preparedness to implement the foreseen reforms from the beginning of 2012 is well advanced too.
2) The prudential framework has been strengthened by adopting the Regulations for Responsible Lending that established clear limits on loan-to-value, loan-to-income, loan maturity, and strengthened the requirements for banks to inform customers about the borrowing risks.
3) Further progress has been made on operational preparedness for cross-border crisis management. The Lithuanian authorities signed the Nordic-Baltic cooperation agreement on cross-border financial stability, crisis management, and resolution and participate in the Nordic-Baltic Cross-Border Stability Group, which was established to implement the provisions of the agreement. The Lithuanian authorities continued participation in the supervisory colleges established to supervise the cross-border banking groups.
4) With the help of the Fund’s technical assistance the authorities prepared the law on natural persons’ bankruptcy that should be adopted by December 2011. The law will enhance the insolvency regime by providing opportunities for orderly natural persons’ debt restructuring.