Mission Concluding Statement 

Republic of Lithuania: Staff Concluding Statement of the 2017 Article IV Mission

May 16, 2017

Lithuania’s economy has performed strongly over the long term and has successfully overcome the setback of 2008/09. However, productivity has stopped catching up with Western European levels in recent years, threatening convergence of living standards. With macroeconomic and financial stability in place, the onus to reinvigorate inclusive income convergence is on structural reforms, including in the fiscal area. There is broad consensus on the reform needs. Making headway is now a matter of setting priorities and determined implementation.

The Lithuanian economy is entering a cyclical upswing, supported by continued strong consumption and wage growth, a pickup in investment on the back of broad-based credit growth and higher EU-funds absorption, and improving global conditions. While higher world energy prices will act as a drag, growth should still rise to 3.2 percent this year and next, removing economic slack by 2018. Inflation will likely run at a relatively high rate of 3.4 percent in 2017 on average because of energy price developments and excise tax hikes, but it should moderate next year.

The growth potential of the economy is estimated to recover to just above 3 percent, but there are downside risks to its medium-term sustainability. Achieving this pace despite the adverse demographic outlook requires a substantial pickup in total factor productivity growth. While waning aftereffects from the global financial crisis may bring some improvement, it will be critical to decisively push ahead with growth-enhancing structural reforms. It will also be important to ensure that wage growth does not get ahead of the economy’s ability to support it through productivity gains. The risk is that in the medium term, growth would suffer as external competitiveness erodes and economic resources accordingly shift to activities in the non-tradable sector where growth opportunities are more limited. Inflation would also likely remain materially higher than in the rest of the euro area.

Public finances have improved substantially. A commendable multi-year consolidation effort culminated in the first ever fiscal surplus last year. The sharp increase of the public debt ratio has been arrested and it has stabilized at around 40 percent of GDP in recent years. A package of measures, largely geared toward achieving social objectives, will deteriorate the fiscal balance to a deficit of an estimated 0.4 percent of GDP in 2017, but this would still broadly correspond to balance in structural terms. The outcome could be even somewhat better if tentatively emerging payoffs from efforts to improve tax administration are confirmed.

A medium-term target of ½ percent of GDP for the structural fiscal deficit is appropriate for Lithuania. With such a deficit, the debt-to-GDP ratio would decline to just above 30 percent of GDP by 2022, thereby building fiscal buffers essential for a small open economy. Room under this target is available to finance fiscal structural reforms or cover temporary costs of reforms in other areas. In the longer run, public finances will come under pressure from rising spending related to adverse demographics and declining EU funds. Rather than cutting benefits or scaling back investment, fiscal pressures should be addressed by boosting Lithuania’s low tax revenues, primarily through tax administration improvements but also through selected tax hikes if needed. Realizing the above agenda may necessitate looking again at Lithuania’s fiscal rules. They are currently more restrictive than they need to be according to EU and euro area requirements.

Fiscal structural reforms should focus on pro-growth measures that strengthen the economy’s potential and policies that help realize the government’s income equality objectives. In particular, the government could consider lowering social security contributions for low-wage earners, improving Active Labor Market Programs, and making unemployment benefits more generous. There is room under the recommended medium-term structural deficit target of ½ percent of GDP to accommodate associated costs to some extent, but larger initiatives would also need to be accompanied by some offsetting measures. The government’s intention to improve the quality of public spending through performance-based budgeting is welcome although payoffs may materialize only over time.

In the financial sector, there are no immediate risks to stability, although the strength of some small non-systemic financial institutions needs continued attention. Strong soundness indicators and stress tests attest to the resiliency of the sector. Spillovers from vulnerabilities in parent banks are a potential risk but are hard to assess. Further strengthening of Nordic-Baltic cooperation will help to better understand and defuse such risks, in particular through the planned crisis simulation exercise, in which ECB supervisors should participate. The revival of credit growth is generally welcome, especially since it encompasses loans to small and medium-size enterprises, is funded by domestic deposit growth, and is set to remain prudent according to banks’ business plans. Credit and housing price developments are rightly monitored by the authorities and tools are in place to step in if needed. Credit Union reform is on track and should be completed in line with current plans.

Amongst structural reforms, overhauling the education system should be at the top of the priority list, as human capital is a principal driver of productivity growth in modern economies. While the need for reform is well recognized in Lithuania and by outside observers alike, decisive action has so far been lacking. Addressing poor educational outcomes requires improving the management of educational institutions, stepping up standard setting and enforcement, tackling rapidly rising overcapacities due to declining school-age populations, and ensuring better pay for a smaller teaching staff. Reform needs permeate all levels of education, from higher education, to still underdeveloped vocational training and general education.

Innovation policy is another area critical for the Lithuanian economy to catch up with Western Europe. But innovation promotion efforts to date have achieved little considering the sizable allocation of public resources. To overcome the high fragmentation of the system, the number of implementing, advisory, and decision making institutions needs to be reduced through mergers. Rather than the current plethora, there should be only a limited number of promotion instruments that can be used more flexibly for a broader range of innovation activities. Instead of ever more programs that are underused by businesses, direct financial support for innovation-related outlays by businesses should be stepped up. Innovation support in the form of infrastructure investment is being scaled back in favor of “soft measures” but remains quite high.

Efforts to further improve Lithuania’s generally favorable business environment are welcome. The main issue is to modernize labor relations. The new Labor Code has been under discussion for over two years and its implementation is now overdue. While not perfect in every respect, potential deficiencies remaining after the latest agreements in the Tripartite Council should be addressed later. This could be achieved by way of further amendments after some experience with how the new legislation works in practice. Ongoing reform of the governance framework for state-owned enterprises is welcome and should help boost their efficiency, as well as that of the broader economy to which it provides often critical inputs.

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The IMF team is grateful for the generous hospitality of the Lithuanian authorities and would like to thank all its interlocutors in government, the Bank of Lithuania, the European Central Bank, the private sector, and NGOs for constructive and fruitful discussions.