Mission Concluding Statement 

Lithuania--2007 Article IV Consultation: Concluding Statement of the IMF Mission

January 30, 2007

Lithuania--2007 Article IV Consultation
Concluding Statement of the IMF Mission
January 30, 2007

The policy challenges the Lithuanian authorities face today are the outcome of much success. In the wake of impressive economic achievements, imbalances have begun to appear. Following the successful establishment of a market economy, the momentum accelerated as accession to the European Union (EU) drew closer. High growth may, however, not be sustainable if rising wages erode international competitiveness. The inflation rate, anchored at a modest level by the currency board, has picked up and will likely remain above the Maastricht reference value as prices converge to European levels. Euro adoption has, for now, receded. Notwithstanding the banking sector's strengths, rapid credit expansion, associated with the greater than projected widening of the current account deficit, requires continued vigilance.

Early precautionary policy measures can ensure that economic progress is not derailed. These include, first, ambitious fiscal consolidation to prevent a hard landing from recent buoyancy and to contain inflation. Second, complementary tax and expenditure reforms would contribute to fiscal sustainability. Third, it remains essential to keep a step ahead of possible financial vulnerabilities. Finally, measures to achieve wage moderation and productivity enhancement will help preserve competitiveness.

Background and Economic Outlook

Strong growth has led to tightening labor markets and an escalation in wage claims. Increasing labor demand and emigration have contributed to a declining unemployment rate and more job vacancies. The resulting wage growth has raised standards of living. However, real wage growth is currently running at rates well above growth of labor productivity, and, in the first nine months of 2006, unit labor cost increased by 11½ percent year on year. Capacity utilization reached 75 percent--a level denoting excess demand pressures in several Western European countries.

The growth outlook--a combination of convergence and exuberance-is characterized by uncertainty. Cross-country analyses suggest a strong potential growth rate, just below 6 percent a year. Growth accelerated in 2003 and has since averaged 8¼ percent a year. It is possible that the "extra" (above-potential) growth is the result of a temporary reinforcing dynamic of rapid consumption growth, wage acceleration, and a falling unemployment rate. This dynamic cannot continue indefinitely because it will erode international competitiveness. However, it is hard to predict when the exuberance will subside.

Thus, Lithuania's growth prospects are best thought of in terms of two scenarios, hinging on how the labor market, especially wage, developments play out. If wage pressures prove to be temporary or are resisted by employers, continued profitability and investment could maintain export competitiveness. Under this benign scenario, growth would moderate because the consumption-wage growth cycle will weaken. The growth rate would decline to about 7 percent in 2007 and to 6 percent by 2009. The current account deficit would also moderate, but only modestly from 12 percent in 2007 to 10 percent of GDP in 2009 given the rising propensity to import. In the second, less benign, scenario, growth would actually accelerate in 2007, but the cumulative wage growth would substantially weaken competitiveness. The ensuing fall in growth would be sharper than in the first scenario. Moreover, the weaker competitive position would keep the current account deficit at about 13 percent of GDP. Weakening growth would also worsen the fiscal position. Despite Lithuania's structural strengths, a further fall into a prolonged slump, as in Portugal, could then not be ruled out. The high current account deficit will restrict policy options to reverse the slump.

The inflation outlook is influenced by the path of energy prices and the inevitable convergence of prices to European levels. In 2007, inflation is likely to accelerate to just over 4 percent reflecting the pass-through of Gazprom's price increases and higher excise taxes. These influences will moderate in 2008. That moderation, if accompanied by further downward shocks (due to energy prices or an appreciation of the nominal effective exchange rate), could bring Lithuania close to the Maastricht reference inflation rate and in a position to try for euro adoption once again. However, the pace of price convergence to European levels, which has risen since accession to the EU, will keep upward pressure on inflation.

Fiscal Consolidation

Fiscal consolidation remains the only available tool to mitigate the risks from exuberance. The authorities should not rely on market-based self-correction of the exuberance. Instead, early fiscal consolidation could provide four benefits. First, while short-term growth will be somewhat slower than without the consolidation, the measure will help keep the economy within the benign soft-landing scenario. Second, if a competitiveness-induced slump nevertheless materializes, the preemptive consolidation will allow for future stabilizing options. Third, while recognizing that the links between fiscal policy and inflation are weak, this precautionary approach would contain the risk of amplified inflation through second-round price effects. Finally, structural pressures on the budget imply that creating fiscal space is important. Aging and the emigration of skilled and semi-skilled workers will add to the burden of the pension system and the costs of health care. Also, without additional fiscal space, the calls for a reduction of the PIT to 20 percent are untenable.

Fiscal consolidation should be appropriately ambitious. A laudable tax administration effort helped balance the ESA'95 budget in 2006, though when restitution payments are included, the deficit was about ½ percent of GDP. Looking to 2007, it would be desirable to eliminate the full extent of the stimulus to the economy from the combined fiscal operations (including payments for restitution) and from the use of EU funds. Under current projections, this would require a fiscal consolidation of 2 percent of GDP in 2007, leading to a headline surplus of about ¾ percent of GDP (including restitution payments). A somewhat less ambitious objective could be to balance the headline budget in 2007. Either choice of front-loaded consolidation to reduce macro imbalances should be integral to a medium-term objective of a structurally balanced budget by 2009, implying a consolidation of about 3 percent of GDP over 3 years.

Fiscal consolidation will require use of all revenue overperformance for deficit reduction as well as expenditure restraint. In the spirit of the recent multi-party agreement, a supplemental budget should be avoided in mid-2007. Instead, all revenue overperformance should be used for deficit reduction. Further consolidation of staff positions in the public sector remains an avenue for savings on the general government wage bill. Short-term expenditure moderation could also be achieved in goods and services. These efforts must be accompanied by structural fiscal reforms.

Structural Tax and Other Fiscal Reforms

The ad hoc use of the tax code to address short-term social pressures hurts rather than helps. A variety of exemptions--especially on the personal income tax (PIT) and the value-added tax (VAT)--are granted to support the weaker sections of society. These are typically poorly targeted and the benefits accrue in substantial measure to those who do not need the support. Unfortunately, the culture of granting exemptions is being increasingly legitimized, and the pressure for further tax breaks to particular groups appears set to exert a continuing influence on tax policy. The pernicious erosion of the tax base must be reversed.

Eliminating existing exemptions will broaden the tax base and improve the fairness of the tax system. Independent businesses and professions currently paying tax under special regimes should be brought into the regular income tax and pension net. There is significant scope to tax currently untaxed income and remove exemptions. With regard to VAT, pressures for further exemptions should be resisted and existing exemptions removed; the distributive concerns that partly motivate these pressures are more effectively dealt with through the income tax.

While maintaining the current flat tax structure, the simplicity, equity, and efficiency of the PIT can be enhanced. Together with scaling back exemptions, a package of measures would improve the PIT system in all three respects. The priority should be rebalancing the tax burden rather than lowering the PIT rate beyond 24 percent in January 2008.

· Reduce the no-tax amount from its current level to possibly LTL 200 or even lower. Because high income individuals benefit from the no-tax amount, reducing its level would raise significant revenues without unduly increasing disincentives to work;

· use the additional resources to provide tax credits to low-income families, so that the lowest income earners actually receive cash through the tax system; and

· cap the value of employer plus employee contributions to the pension plan at a suitable earnings level to ensure broad revenue neutrality for general government.

Thus, low-income households would receive more support (which could either complement or substitute other welfare programs). Their incentives to participate in the labor market will be enhanced and could be combined with measures for increasing the demand for younger workers. Lowering the tax wedge at higher income levels through the cap in social security contributions will help improve competitiveness and induce more investment.

Expenditure efficiency needs to be increased. Social assistance programs are numerous but individually small in magnitude, obscuring the welfare system and adding to administrative cost. Consolidation and better targeting of social assistance would benefit at-risk groups within the existing expenditure envelope while increasing transparency of benefits. Health care consumers experience long queues and a system of informal payments. Better delivery of health care services requires that the informal charges be formalized into co-payments, price and quality competition be increased (including by encouraging greater private initiative), and criteria be made more transparent for consolidating health care institutions and listing reimbursable pharmaceuticals.

Efforts to develop a Fiscal Responsibility Act (FRA) are welcome, but yet insufficient. The current multiparty agreement includes setting aside revenue overperformance for deficit reduction. Together with the established practice to seek new revenue sources for additional spending initiatives, further fiscal safeguards would be important steps forward. For example, a FRA should also specify methods to strengthen budget transparency and institute independent scrutiny of the budgeting process. This could be accomplished through enhancing the role of the State Audit Office and establishing expert reviews of the demand impact of fiscal policy. A more ambitious medium-term expenditure framework should be embedded into the framework of the FRA. The medium-term framework would include better integration of strategic expenditure planning and budgeting and greater scrutiny of expenditure plans of line ministries and municipalities.

Financial Sector Stability

Despite the decline in the capital adequacy ratio from earlier in the decade, financial buffers appear sufficient to cover non-systemic risks. Nonperforming loans, which were redefined to include only loans overdue by 60 days in December 2005, have modestly increased since that time to about 1 percent of all loans. The deterioration was of a non-systemic nature, mainly reflecting bankruptcy proceedings at a single electronics manufacturer. Aggregate stress tests indicate that a three- to five-fold increase in nonperforming loans would not reduce the banking system's capital below the regulatory minimum. Recent bank-by-bank stress tests, undertaken by the authorities, confirm that this would also be the case for systemically important banks. Also, domestic banks are adopting best practices in risk management, reflecting the methods of their reputed parent banks that have an incentive to protect their high credit ratings.

Moreover, the authorities have taken steps to maintain the integrity of the banking system. The capital adequacy ratio, which had fallen to 9¾ percent in June, has, at the urging of the supervisory authority, been increased and currently stands at 10¾ percent. Also encouraging are the steps to increase information disclosure by January 1, 2008 under Pillar 3 of Basel II. Ongoing efforts to facilitate supervisory and crisis management cross-border arrangements include the recently concluded agreement with Swedish Riksbank, the Bank of Latvia, and the Bank of Estonia.

The authorities must maintain their efforts to stay ahead of financial vulnerabilities. Though the results of the bank-by-bank stress tests are reassuring, there remains the task of guarding against systemic risk arising from a macroeconomic slowdown. The magnitude of macroeconomic stress, with or without a significant price correction in real estate, is hard to assess. Nevertheless, further efforts to model macroeconomic risks, including in conjunction with the forthcoming FSAP update mission later this year, should provide useful estimates of the effects of such shocks. In the meantime, the considerable variance in the strength and performance of banks implies the continued need for supervisory efforts to identify bank-specific capital requirements and raise them where needed, as in the past.

Competitiveness and Productivity

Raising investment levels--including through attracting foreign investors-will require further improvements in the investment climate. In addition to the fiscal reforms discussed above, other areas deserve attention. In the labor market, restrictions on overtime and part-time work and on individual agreements on work hours and holidays limit the flexibility of small- and medium-scale production. Enhancing flexibility is important since a quick response to changing European demand is key to the competitive advantage of Lithuanian producers. Also, to alleviate labor market pressures, an important challenge for the authorities is to creatively explore the possibilities of migration of labor into Lithuania. The land restitution program introduced uncertainty in property rights, but even when it is completed, these uncertainties are likely to persist on account of cumbersome land planning processes. Also, frequent and overlapping inspections of compliance with regulatory standards by government institutions create a burden for business. The Government's plans to rationalize these regulatory services are therefore welcome.

To improve the absorptive capacity of EU funds, the authorities' plans to find a new balance between prudence and flexibility in the implementation system are welcome. Lithuania's utilization of structural funds stood close to the CEE-8 average at end-2006. The current framework, designed to prevent the misuse of EU grants, although commendable, causes delays. The authorities' plans include, first, a risk-based approach to verifying payment claims and more flexible procurement regulations, particularly where projects are small; and, second, project pre-selection within regional programs to ensure coherence in development policy. These initiatives are in line with practices elsewhere in Central and Eastern Europe.

Flexibility should come in tandem with stronger coordination. The role of the Ministry of Finance in project selection should be enhanced to ensure consistency between its decision-making powers and accountability before the European Commission. At the same time, the capacity of the line ministries in implementing projects needs strengthening. Finally, limiting room to carry over unused co-financing appropriations, within so-called special programs, should be considered. This would increase the incentives of line ministries for more accurate budgeting and timely implementation of EU projects.

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The political commitment to achieving equity and fairness can be met alongside the goals of higher economic efficiency and growth. Continued progress along these dimensions remains well within reach. We thank the authorities for, as always, their generous hospitality and the frank discussions. We wish them well in their endeavors.