Lithuania -- 2006 Article IV Consultation Concluding Statement of the IMF Mission

February 13, 2006

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

February 13, 2006

1. Having taken rapid strides, Lithuania stands at an important crossroads. High productivity-led growth with price stability has been achieved. Strong international trade links provide competitive discipline and financial links create access to foreign capital at virtually risk-free rates. This fortunate outcome is the consequence of commendable policy initiatives by the authorities over the past decade. However, with rapid growth, imbalances and warning signals have emerged. To be clear, these are not, as yet, a source of alarm, and the recommended measures to deal with them are not radical in nature. A new generation of more sophisticated policy measures is necessary to maintain price and financial stability, contain fiscal pressures, and ensure long-term competitiveness. Precautionary steps now will insure against untoward events and developments, guarding against short-term risks and preserving productivity growth.

Short-Term Outlook and Stability

2. Centered around non-traded goods production, GDP grew by a surprising 7.3 percent in 2005, though growth in 2006 is likely to moderate. Attractive returns in public road transportation projects and in property development, with the latter supported by strong credit growth, were reflected in especially buoyant real estate, construction, and financial intermediation sectors. Consumer demand contributed to growth of wholesale and retail trade. Export growth, however, was also strong, helped by increases in food exports following improved access to European markets, reducing the traditionally substantial negative contribution of net exports. A generally slowing momentum is expected to moderate growth in 2006 to around 6¼-6½ percent. If the European Union (EU) funds absorption rate is high, risks will be on the upside.

3. The economy has continued to receive stimulus from the combination of fiscal and EU expenditures—and the risks of overheating have risen. With potential growth estimated at about 5¾ percent a year, the economy has been operating above potential since 2004. The fiscal deficit, unbudgeted outlays for savings and property restitution, and the injection of EU funds have, to varying degrees, contributed to economic stimulus in the past two years and this is likely to continue in 2006. The stimulus in 2005 would have been greater absent some unexpected, one-off revenue gains. Bank credit grew by about 50 percent and mortgage lending almost doubled over the past year. Financial and housing markets have been buoyant. The headline year-on-year inflation rate has risen to about 3 percent a year, with risks mainly on the upside as convergence to EU price levels, energy price increases, and rapid wage growth continue.

4. Though important, the external vulnerabilities are as yet in a manageable range. The current account deficit is projected to remain between 7¼ and 8 percent of GDP in the next few years. A deficit of this size is consistent with Lithuania's relatively low per capita income, permitting higher investment rates and consumption smoothing. FDI and EU funds are expected to finance just over 50 percent of the current account deficit in 2005. In this context, the accumulating short-term external debt raises the concern that, under adverse international capital market conditions, reserves may not cover the repayment of the debt if it is not rolled over. But there are important mitigating factors. The short-term debt mainly comprises trade credits and lending from parent banks to their Lithuanian subsidiaries. Because the banking sector is largely owned by reputable foreign banks, rolling over of much of the short-term debt has a high probability. Also, the currency board has been well tested in adverse conditions.

5. The authorities are monitoring financial system stresses from domestic credit growth but should consider direct measures to cool down the property market. The competition among banks to satisfy the demand for credit has led to more aggressive lending practices, as seen in low interest margins and increasing loan-to-value ratios of new loans. Non-performing loans, though still low by international standards, have risen somewhat (to 2½ percent of gross loans). With the introduction of International Financial Reporting Standards in October 2005, the authorities have been compiling the loan impairment ratio, which also shows a similar increase. Provisioning against non-performing loans remains relatively low by international standards. At the same time, the capital adequacy ratio has come down to 10 percent. The rise in real estate lending, though offering banks some diversification from large corporate exposures, creates a new source of credit risk, especially in the context of an overheated property market. Four policy measures were discussed:

• In a welcome step to improve transparency, the Bank of Lithuania (BOL) will soon publish a Financial Stability Report to discuss the state of the financial system.

• The BOL has appropriately been in contact with banks to discuss guidelines to prevent erosion of lending discipline.

• Coordination between Lithuanian and foreign bank supervisors has been active.

• Given high home ownership, reduction of tax exemptions for mortgage interest payments should be an early priority. A gradual introduction of a broad-based property tax will reduce the speculative element in the housing market, as will the rationalization of land use regulations.

Euro Adoption

6. Lithuania stands to benefit from early euro adoption. First, the residual risks associated with the currency board would be eliminated. Second, trade and financial ties with the euro area would be strengthened, creating a stronger basis for participating in European production networks supported by stable sources of financing. Third, favorable preconditions suggest that euro area membership would hasten real convergence. Lithuania has established a track record of generally prudent macroeconomic policies, though expenditure policy could benefit from greater efficiency; structural reforms have increased the scope for entrepreneurship; entry and exit conditions are easy in most markets; and, since the inception of the recent growth spurt in 2000, labor markets have, on the whole, proven to be flexible—substantially more so than in many richer countries of the eurozone. However, with euro adoption, an important anchor that has aided political commitment to budgetary discipline will be lifted.

7. If euro adoption is postponed, it will be unfortunate, but no immediate economic risk should arise. Until recently, Lithuania appeared well on course to adopt the euro in January 2007. The budget deficit, public debt, and interest rates had all been running well below the Maastricht limits—and they continue to do so. In 2004, inflation was similarly safely under the ceiling. In 2005, external shocks, followed by administered price changes, and domestic demand pressures contributed to a rising inflation rate, which could breach the reference value and, hence, delay euro adoption. A year's delay, however, is unlikely to concern financial markets: the currency board, fiscal policy, and the process of trade and financial integration with Europe can be expected to stay on course.

8. To prevent continuing delays, the authorities can signal their commitment to euro adoption—guided in doing so by their own medium-term fiscal goals. If euro adoption is delayed, a continued breach of the inflation reference value is possible in case the upside risks to inflation materialize. As such, euro adoption may be further pushed back. The authorities are to be commended for not constraining regulated prices to lower reported inflation below the Maastricht limit. With fiscal policy as the main available tool, a renewed commitment to euro adoption could be expressed through:

• fiscal restraint in the current year; and

• the adoption of a Fiscal Responsibility Act.

Recognizing the lags from fiscal restraint to reduced inflation, an immediate commitment to a 2006 budget deficit of 1.0 percent of GDP rather than the projected 1.4 percent of GDP plus a reduction in the savings and property restitution payments also by the same amount would reduce the fiscal impulse by about 1 percent of GDP and could well bring the inflation rate just below rather than just above the Maastricht limit. In this context, it would be worth exploring if the repayment of obligations on account of savings and property restitution could be stabilized, through, for example, issuance of bonds with a steady repayment stream, instead of acting, as they currently do, in a procyclical manner. Short-term expenditure moderation could be achieved in goods and services, wages (taking into account the need to retain some high-skill employees), health, social assistance, and farm subsidies. A Fiscal Responsibility Act—tightening Ministry of Finance control and monitoring over general government budget preparation and execution—will provide reassurance of continued fiscal conservatism in an environment of pressures to reduce taxes, aging population, and emigration.

Medium-Term Fiscal Issues

9. Fiscal pressures are set to increase. Increased regional competition for foreign investment and the goal of reducing the informal economy create the pressure to lower tax rates, while the demand for safety nets and public goods continues to grow. The authorities' Convergence Program projects that, at the current legal retirement age, the first-pillar of the pension system will start running a deficit as early as 2020. Under plausible scenarios of emigration from Lithuania, the pressures on the pension system could start earlier and worsen more rapidly; similarly, the rise in doctors' salaries could hurt the financial position of the public health care delivery system.

10. The authorities have set a medium-term target of 1 percent of GDP for the structural budget deficit (in ESA'95 terms), but this may not be feasible absent additional efforts. Concerns regarding the relatively wide tax wedge have led to a planned gradual reduction of the personal income tax (PIT). Especially from 2008 onward, the revenue shortfalls from income tax cuts and the elimination of the social tax (the surcharge on the profit tax) could reduce revenues by about 2 percentage points of GDP, jeopardizing the deficit target of 1 percent of GDP. The authorities' convergence plan projects that buoyant revenues—especially from indirect taxes—will partly offset losses from reduced income tax rates. Despite commendable progress made in tax administration, a continued increase in the revenue-to-GDP ratio cannot be presumed. As such, the plan also projects wage restraint.

11. To ensure that the downward deficit path envisaged in the Convergence Program is achieved, several measures are possible. On the revenue side, reducing exemptions associated with PIT and the value-added tax (VAT) should broaden the tax base and help improve administration. Suggestions that the social tax may be eliminated earlier than planned may be premature—indeed, making the tax permanent, thus raising the profit tax to 19 percent, may be worth considering. As noted above, a property tax would be valuable for cooling down the property market but also for providing municipalities with an independent revenue base that could be the foundation of a system with greater municipal expenditure accountability. The long-proposed vehicle tax deserves continued consideration as does the possibility of caps on social security contributions and payments.

12. Expenditure rationalization will create space for the provision of needed public goods as well as likely increases in pension and health care expenses. In line with the technical assistance provided in 2004, the budget and its execution should both be reported on a consolidated basis with consistent classifications, budget preparation information should be provided to municipalities earlier, and a clear sanction regime should be established to dissuade arrears. With the deployment of EU funds for enhancing agricultural productivity and EU income transfers to farmers, the need for additional top-up payments from government resources to farmers is reduced. The mission assessed the scope for expenditure rationalization in health expenditures and social assistance. Despite progress in these sectors, the agenda is a challenging one:

Health care. Several options need to be considered: formalizing co-payments for health care; more transparency in the criteria of consolidating health care public institutions and in the listing of reimbursable pharmaceuticals; allowing for more price and quality competition, including through greater private initiative; sale or lease of surplus public facilities to private enterprises; contracting of territorial funds with private providers; and a greater role for private insurance companies.

Social assistance. A new system of child benefits, additional to the existing tax exemptions, is being phased in. An increase in the scope of unemployment benefits and employment subsidies is planned. While the amounts of individual social benefits are often small, the many benefits cumulate, creating, in some instances, disincentives to work. The centralized data base of benefits by the Social Insurance Fund and the local governments (to be soon joined by the Labor Exchange Fund) is a first step in providing a unified view of benefits. Ultimately, consolidation of these benefits reflecting criteria, such as poverty alleviation and social insurance, remains crucial.

13. A more ambitious medium-term expenditure framework (MTEF), set within the context of a Fiscal Responsibility Act, would provide for greater fiscal discipline.

The first steps in operationalizing the MTEF concept within the central government (through budget ceilings for a three-year period) need to be supplemented by: (i) bottom-up estimates of ongoing expenditure, based on cost drivers of their individual budgets and (ii) detailed presentation to Parliament. Such a framework will also help the effective prioritization of EU funds. In this context, a more careful scrutiny of spending by line ministries and municipalities remains an urgent task.

Competitiveness and Structural Reforms

14. Export growth faces new challenges. Price margins are likely to be squeezed in some sectors, such as fertilizers, which rely on gas supplied at increasingly higher prices. Mazeikiu Nafta, which experienced a surge in output and exports of petroleum products, is operating closer to capacity. Rising wage costs are creating more general pressures, not least because of emigration of workers. The price competition for labor intensive products, such as textiles, footwear, and furniture, is on the rise. The shift of the export structure towards higher technology products has slowed down markedly.

15. EU funds present a unique opportunity to maintain high productivity growth through investments in infrastructure and human capital. After a slow start, the use of EU Structural Funds has picked up, with the strongest pipeline in transport projects, energy efficiency measures, and science and education infrastructure. Several considerations are important in the effective utilization of the funds:

• While maintaining the valuable centralization of management of funds in the Ministry of Finance, delegation could be limited to fewer implementing agencies whose project evaluation and administration skills could be enhanced.

• Funds awarded to individual companies need special care to avoid creating the perception of political influence in the allocation of funds. Competition for subsidies should not become a substitute for competition in the market place.

• Independence of the project evaluators should be guaranteed by the system.

• Transparency should be ensured by publishing more data on awarded contracts and unsuccessful bids, without compromising sensitive commercial information.

• Caution should be exercised in shifting cofinancing obligations to the private sector through public-private partnerships.

• Looking ahead, the integration of the use of EU funds with structural reforms in such sectors as health and education will maximize their effectiveness.

16. Lithuania has made considerable progress in improving its business climate but the task remains unfinished. Progress has continued on the reform front, with recent high-profile privatizations. Anticipating the decommissioning of the second unit of the Ignalina nuclear power plant in 2009, the authorities are engaged in increasing domestic electricity supply and are in discussion with neighboring nations to improve energy security, through such initiatives as the Baltic Energy Market. International indices of regulatory burden typically place Lithuania in the middle of the new Central and Eastern European members of the EU. The gap, especially in relation to the more advanced nations, will need to be further closed to allow for dynamic entrepreneurship. The World Bank's Doing Business report gives high marks to Lithuania for ease of setting up a new business. However, the virtual prohibition of overtime work and the difficulties in hiring temporary workers limits the flexibility of small enterprises that are the dominant source of employment generation. Greater flexibility will be of particular importance in the context of the evolving competitive environment. Investments in effective vocational training and world-class tertiary education are priorities for dealing with skill shortages. Also, the European Bank for Reconstruction and Development deems the insolvency regime to be deficient.

The success achieved can reduce the urgency of needed policy measures, especially when they are technically sophisticated in nature and political coordination necessary for their implementation is not easy to mobilize. Yet, it is in this relatively benign moment that the costs of undertaking needed reforms are low. A vision of rapid catch-up with the advanced economic nations must continue to guide the policy decisions. We thank the authorities for, as always, their generous hospitality and the frank discussions. And, we wish them well in their endeavors.


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