Mission Concluding Statement 

Lithuania--2006 Staff Visit, Concluding Statement of the IMF Mission

September 8, 2006

To secure the benefits of the economy's impressive performance and potential, precautionary policy measures are advisable. In the past five years, GDP has grown at an average of over 7 percent a year. Lithuania can continue to enjoy high growth with moderate inflation if the, admittedly, limited policy tools are used early to address potential vulnerabilities. Achieving the Maastricht inflation criterion to adopt the euro in 2010 will require significant fiscal tightening. Rapid credit growth calls for continued proactive supervision and implementation of prudential measures to ensure financial stability.

Economic Outlook

Following recent robust growth, some slowdown can be expected. On a year-on-year basis, GDP grew in the first half of the year at over 8 percent, buoyed by sustained strength in consumption. Of concern is the recent weakness in investment despite rapid credit growth to the enterprise sector, suggesting weak business sentiment. The rise in inflation, real wages, and capacity utilization all point to an economy operating above its potential growth rate. For 2006 as a whole, GDP is projected to grow at 7½ percent, with a further slow down to 7 percent in 2007. The decline in asset prices should moderate consumer demand. However, the Lithuanian economy has defied predictions of deceleration in recent years, and the momentum may continue to propel growth. The policy challenge is to ensure that such growth does not generate—or cover-up—emerging imbalances.

The greatest policy challenge arises from the continued increase in inflation. While the current annual average inflation rate of about 3¼ percent is not high for an economy growing so rapidly, the real question is: Where is inflation headed? In the short-term, increasing energy prices are likely to raise the headline inflation rate above 4 percent in 2007. While this influence could moderate in 2008, temporary spikes from the necessary excise tax increases and longer-term convergence forces will tend to keep inflation above the Maastricht reference value. Wise policy decisions (adoption of the currency board arrangement, deregulation, and trade liberalization) have kept inflation low in the past. However, the catch-up process in an economy increasingly integrated with Europe brings with it inflationary pressures. These pressures are becoming more evident in the secular rise in the inflation of food and non-traded goods prices and can be mitigated, but not eliminated, by the appropriate regulation of monopolies.

Policy Discussions

Euro adoption in 2010 could once again be a close call. In important respects, Lithuania is well positioned to adopt the euro. Its labor and product markets are more flexible than in most European countries and it has operated successfully under a currency board arrangement now for more than a decade. Adopting the euro is next logical step, which would also eliminate the residual risk of the currency board being tested under severe conditions of international credit contraction. However, for euro adoption, inflation must meet the Maastricht criterion and remain contained. Under current inflation trends, the goal of 2010 is achievable but not easy. Since unfavorable external developments could once again push inflation above the reference value, a concerted fiscal policy effort now to ensure euro adoption by 2010 is called for.

As we have recommended in past years, fiscal restraint should be applied more aggressively. Reduction of the fiscal deficit does not quickly and reliably reduce inflation. Nevertheless, this is the only tool available to act upon inflation. Indeed, precisely because the lags from fiscal restraint to a demonstrable effect on inflation are significant, early and decisive action is desirable. For 2007, the authorities should consider a goal of a balanced budget, which would require a consolidation of 1½ percent of GDP, instead of the currently planned positive fiscal stimulus. In thus moving ahead of the budget target in the Convergence Program, the authorities would help cool the economy down—desirable in itself—and make the best case for their commitment to adopt the euro. Eliminating the deficit (and, further, moving into surplus) would also create the fiscal space for impending long-term fiscal commitments arising from migration, population ageing, provision of public goods and for planned tax cuts.

The challenges in managing rapid credit growth are significant. Rapid credit growth has been more an outcome, rather than a cause, of domestic demand pressures. The policy task is therefore to contain demand for credit, such as for mortgage loans, by imposing a comprehensive real estate tax (that has often been discussed) and eliminating tax incentives for mortgage borrowing. This would also benefit the fiscal position. In addition, the risks from aggressive bank lending practices need attention. The publication of the first Financial Stability Report is welcome and continuing editions must serve to create early awareness of impending problems. The recent tightening of the definition of bank capital to exclude some current year profits is helpful, as is the plan to require increased reserves to compensate for the reduced provisioning under International Financial Reporting Standards. Indeed, further increases in capital and provisioning requirements, while carrying the risk that they may be evaded, are worth considering. The government's priorities for such measures could be usefully discussed for implementation in the context of the Financial Stability Assessment Program in April 2007.

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We thank the authorities for, as always, their generous hospitality and the frank discussions. We wish them well in their endeavors.