## 1ltuea2022001

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### Inflation: persistence, drivers, and distributional impacts
- Inflation timeline and magnitudes:
  - Inflation increased from -0.1 percent at the end of 2020 to 6.4 percent by September 2021.
  - Inflation reached 20.5 percent in June 2022 — the second highest rate in the euro area.
- Model-based drivers (average contributions, 2020q1 to 2022q1):
  - about a third explained by past inflation
  - another third by the vacancy rate
  - a fifth by expected inflation
  - the remainder by energy prices (which had had a negative contribution in 2020)
- Additional drivers:
  - Initial demand-driven inflation preceded the spike in energy and commodity prices and the impact of the war.
  - Global supply bottlenecks, higher energy and commodity prices, and above-trend growth in employment and disposable income further fueled inflation.
  - Core inflation (excluding energy and food) has increased alongside strong wage growth.
- Distributional effects:
  - Low-income households allocate 60 percent more of their consumption on food and energy than higher-income ones.
  - Income-quintile specific inflation rates show higher inflation for lower income quintiles than for the top income quintile, disproportionately reducing their purchasing power.
  - Pensioners and lower income groups exhibit increasing inflation rates because their consumption is more heavily biased towards energy and food.
- Inflation–wage correlation:
  - Increasingly positive correlation between inflation and private sector wage growth, particularly in manufacturing.
  - Wages in manufacturing have shown a positive, large, and stable correlation with inflation since 2020q2.
- Policy constraint:
  - ECB monetary policy stance described as "too loose for Lithuania," limiting autonomous monetary policy responses.

### Labor market: shortages, wages, and risks
- Pre-war labor market developments:
  - Employment reached pre-pandemic levels by mid-2021; total hours worked remain below pre-pandemic levels.
  - Job vacancies increased markedly in 2021.
  - Employment growth post-pandemic strong in communications, transportation, and manufacturing.
- Wage and labor cost dynamics:
  - Double-digit wage growth was a key driver of domestic demand.
  - By end-2021, labor costs per hour worked in manufacturing, construction, and services were more than 15 percent higher than a year earlier.
  - Labor cost increases ranged from 7 percent in transportation to 43 percent in hospitality.
  - High public sector wage growth since 2017 and moderate private sector wages in 2020 widened the public–private pay gap to around 10 percent.
  - Lithuania has one of the highest shares of low-income earners in the EU — more than 22 percent — second only to Latvia.
  - Large increases in the minimum wage, with a single national high minimum wage relative to average wages of around 45–50 percent, disproportionately affect employment of low-skilled, young workers in rural areas and may incentivize informality.
- Risks:
  - Labor shortages and fast-rising cost of living will maintain upward pressure on wages and inflation, risking an entrenched wage–inflation cycle that could erode competitiveness and stall reforms.

### Financial sector and fintech: resilience and emerging risks
- Financial sector soundness:
  - Capital adequacy ratios neared 23 percent at end-2021 (Regulatory capital to risk-weighted assets (Dec-21): 23.5).
  - Profitability (Return on Equity (RoE) (Dec-21): 10.3) remains below pre-pandemic levels but above euro area peers.
  - Nonperforming loans to total (non-interbank) loans (Dec-21): 0.7.
  - Residential real estate loans to total (non-interbank) loans (Dec-21): 24.5.
  - Loan-to-deposit ratios are at historic lows; banking sector highly liquid.
  - EMI and PI incomes soared by 250 percent from 2020, with payment transactions up 280 percent.
- Fintech expansion and ML/TF threats:
  - Since 2016 Lithuania attracted many fintech firms; 35 new market participants in 2021; became the largest fintech hub in the EU in terms of licensed companies.
  - 407 registered VASPs, with most entering in the last year.
  - Number of employees in the sector reached 5,900 at the end of last year—about 30 percent of employment in the financial and insurance sector.
  - Specialized banks increased market share fourfold, to 2.3 percent of total assets in 2021.
  - ML/TF assessment rated Lithuania’s system as insufficiently effective in ten out of eleven areas.
- AML/CFT recommendations:
  - Broaden AML/CFT supervisory coverage and increase BoL’s resources and capacity.
  - Strengthen AML/CFT controls to access the BoL payment system (CENTROlink) by non-bank payment service providers.
  - Develop robust AML/CFT risk-based supervision of VASPs with stronger supervisory powers and market entry controls.
  - Tighten light registration regime for VASPs and enhance supervisory powers.

### Fiscal position and public finances
- Recent fiscal performance:
  - Fiscal position improved by 6.3 percentage points to an overall deficit of 1 percent of GDP in 2021.
  - Government debt fell to 44.7 percent of GDP in 2021.
- 2022 fiscal shock and measures:
  - Russia’s invasion of Ukraine undermines fiscal performance via lower growth and higher spending on military, refugees, energy subsidies, pension increases, and transfers to the state-owned railway company.
  - Government announced a fiscal package of about 3.5 percent of GDP in April 2022; half repurposing of existing budget allocations and use of EU funds.
  - 2022 fiscal stance: Fiscal policy will be moderately pro-cyclical in 2022 with new spending leading to a deterioration of the underlying fiscal position.
  - Additional defense expenditures of around 0.5 percent of GDP are creating some permanent spending commitments.
  - The budget deficit is projected to widen by 1 percent of GDP.
- Medium-term fiscal guidance and numbers:
  - In 2023 and beyond, fiscal position should be tightened in a counter-cyclical manner, in line with the national fiscal rule without activating the escape clause.
  - Distortionary tax expenditures amounted to EUR2.4 billion in 2021.
  - Lithuania will benefit from cohesion funds (11 percent of GDP over the 2021–27 programming period) and RRF funds (3 percent of GDP).
- Fiscal projections (selected):
  - Net Lending (+) / Borrowing (-) (percent of GDP): 2021: -1.0; 2022: -2.0; 2023: -1.3; 2024: -1.2; 2025: -1.2; 2026: -1.2; 2027: -1.0.
  - General government debt (percent of GDP): 2021: 44.7; 2022: 42.1; 2023: 38.3; 2024: 36.5; 2025: 35.2; 2026: 34.1; 2027: 33.1.

### External sector, trade linkages, and the war’s impact
- Trade linkages with Russia, Ukraine, and Belarus:
  - Exports to Russia, Ukraine, and Belarus were about a sixth of total exports in 2021.
  - Re-exports constitute about 90 percent of exports of goods to Russia and Belarus and 30 percent of exports to Ukraine.
  - Lithuania’s share of exports to Russia, Ukraine, and Belarus was 16 percent as of end-2021, down from 30 percent in 2014.
- External position and buffers:
  - Lithuania’s external position was moderately stronger than fundamentals in 2021; current account surplus decreased to pre-pandemic levels.
  - The 2021 SDR allocation of 423.3 million (around EUR512 million) has been kept as part of international reserves.
- War’s expected impact:
  - Under the baseline of no further escalation, direct impacts through trade linkages and sanctions are modest but magnified by a worsened global outlook, rising commodity prices, and confidence effects.
  - The war is expected to dent real GDP growth by about 2 percentage points in 2022 relative to the pre-conflict baseline; half of that impact would come from disruption of trade with Russia, Ukraine, and Belarus.
- Balance of payments and projections (selected):
  - Current Account Balance (billions of euros): 2021: 0.8; 2022: -0.9; 2023: -1.1; 2024: -0.8; 2025: -0.4; 2026: -0.2; 2027: 0.1.
  - Gross external debt (percent of GDP): 2021: 70.8; 2022: 61.0; 2023: 55.6; 2024: 51.9; 2025: 48.7; 2026: 46.1; 2027: 43.7.

### Outlook, scenarios, and risks
- Baseline assumptions:
  - Baseline assumes no further escalation of the war and a gradual decline in commodity prices in 2023 and beyond towards pre-war levels.
  - Real GDP growth projected to slow markedly in 2022; economic growth projected to be half the pre-war forecast due to lower net exports and lower demand from EU trading partners.
  - Strong balance sheets, RRF funds, and a tight labor market expected to limit impact on domestic demand despite high inflation eroding real disposable incomes.
  - The output gap is estimated to be positive but small in 2022 and close going forward.
- Inflation outlook:
  - Inflation will remain elevated for longer due to high global energy and food prices and supply-side disruptions, keeping inflation high throughout 2022 and early 2023.
  - Core inflation expected to remain elevated on the back of tight labor market conditions.
  - Inflation expected to decelerate in 2023 and beyond as commodity prices decline, but risks are skewed to the upside.
- Financial market indicators and buffers:
  - Increase in long-term bond spreads relative to Germany has been modest (about 20 basis points).
  - Some modest deposit withdrawals early in the war, but deposit levels remain at historic high and significantly above a year earlier.
- Downside risks:
  - Further escalation of the war, refugees, lingering conflict with China, lack of structural reform momentum, and tightening financial conditions.
  - Abundant downside risks could hinder growth and lead to high and persistent inflation, higher interest rates, and more volatile financial markets.
- Policy stance in shock scenarios:
  - Automatic stabilizers should be allowed to respond and targeted support to the vulnerable might be needed.

### Energy markets, policy response, and fiscal costs
- Energy market structure:
  - Nuclear power plant had covered 70 percent of the electricity consumed prior to its decommissioning in 2009.
  - Domestic electricity production accounts for a third of total consumption.
  - Household electricity market liberalization initiated in 2020 and foreseen to be completed by end-2022.
- Regulated price changes and subsidy packages:
  - Regulated natural gas increased between 25 and 35 percent at the beginning of the year; between 27 and 40 percent in July.
  - Regulated electricity prices increased by 10 percent and 46 percent (respective increases).
  - Under the revamped May scheme, expected cost of subsidies: 690 million (1¼ percent of GDP).
  - Parliamentary approval: 570 million in funding to cover previous subsidies and envisaged household subsidies for the second half of 2022; additional 120 million approved to support businesses.
  - Temporary reduction to zero of VAT on district heating for households from January to April at an expected cost of EUR23 million.
- Policy design principles:
  - Allow energy price pass-through while providing targeted support to vulnerable groups; interventions should have clear sunset clauses and preserve price signals.
  - Shift support from untargeted subsidies to budget-funded, transparent, and targeted measures to protect supplier balance sheets and advance liberalization.

### Structural reform priorities and greening growth
- Top reform priorities:
  - Education and healthcare reforms to address overcapacities and improve outcomes.
  - Close gaps in transport infrastructure, human capital, and access to financing for SMEs.
- Greening and energy security commitments:
  - Committed to cut emissions by 80 percent—by increasing the share of renewables to 45 percent and improving energy efficiency—and sequester 20 percent to achieve carbon neutrality by 2050.
  - Proposal: national economy-wide carbon tax set to gradually increase to EUR50 per metric ton of CO2 emissions by 2030.
- Fiscal and policy recommendations to support reforms:
  - Improve the quality of spending.
  - Broaden the tax base in growth-friendly ways by eliminating distortionary tax expenditures.
  - Strengthen the composition and collection of environmental and housing-related taxes.

### Key policy recommendations (concise)
- Continue prudent fiscal policies and avoid measures that introduce distortions or weaken the strong policy framework.
- Target support measures to address the most vulnerable households hit by higher food and energy prices; allow automatic stabilizers to operate.
- Allow energy price pass-through while providing targeted support with clear sunset clauses; make subsidies transparent in the budget.
- In 2023 and beyond, tighten fiscal stance in a counter-cyclical manner in line with the national fiscal rule without activating the escape clause.
- Set public sector wage and minimum wage increases cautiously to avoid a wage-price spiral.
- Implement structural reforms in education, healthcare, housing supply, regional development, and tax policy (including eliminating EUR2.4 billion of distortionary tax expenditures in 2021).
- Continue and strengthen macroprudential measures for housing and address housing supply bottlenecks.
- Strengthen AML/CFT frameworks and supervisory capacity of the Bank of Lithuania; tighten VASP registration and supervisory powers; strengthen controls on access to the national payment system (CENTROlink).

*Source: IMF staff report, "Republic of Lithuania" (selected excerpts; content unit 1ltuea2022001).*

### 1. Inflation May Prove Persistent, Eroding Real Incomes, and Increasing Inequality ________________ 6

### 1. Inflation May Prove Persistent, Eroding Real Incomes, and Increasing Inequality

### Context: an overheating economy facing inflationary and supply-side shocks
- Robust post-pandemic recovery with resilient macroeconomic fundamentals, decisive policy response, and high immunization avoided a recession in 2020 and produced a vigorous rebound in 2021.
- High real wage growth, a tight labor market, loose monetary conditions, and strong private sector balance sheets were fueling an overheating economy.
- High energy prices and supply-side disruptions resulting from Russia’s invasion of Ukraine have and will continue to negatively affect economic activity and add to inflationary pressures.
- Inflation is expected to remain high in the short-term and be more persistent over the medium-term than previously anticipated, creating new challenges for policymakers given the lack of autonomous monetary policy.

### Recent developments: inflation surge and distributional impacts
- Inflation timeline and magnitudes:
  - Inflation increased from -0.1 percent at the end of 2020 to 6.4 percent by September 2021.
  - Inflation reached 20.5 percent in June 2022 — the second highest rate in the euro area.
- Drivers of inflation:
  - Initial demand-driven inflation preceded the spike in energy and commodity prices and the impact of the war.
  - Global supply bottlenecks, higher energy and commodity prices, and above-trend growth in employment and disposable income further fueled inflation.
  - Core inflation (excluding energy and food) has increased alongside strong wage growth, indicating more broad-based consumer price increases.
- Distributional effects:
  - Low-income households face a higher inflation rate because they allocate a larger share of consumption to food and energy — the report notes low-income households allocate 60 percent more of their consumption on food and energy than higher-income ones.
  - Inflation inequality is increasing: income-quintile specific inflation rates (using Household Budget Survey 2015 data) show higher inflation for lower income quintiles than for the top income quintile, disproportionately reducing their purchasing power.
- Policy response constraints:
  - The ECB’s monetary policy stance was looser than warranted for Lithuania alone given its more advanced cyclical position.
  - Authorities have taken steps to limit the increase in administered energy prices (Annex V).

### Labor market: shortages stoking wage growth
- Pre-war labor market:
  - The rebound reignited pre-pandemic labor shortages; employment growth post-pandemic was particularly strong in communications, transportation, and manufacturing.
  - Employment reached pre-pandemic levels by mid-2021, though total hours worked remain below pre-pandemic levels.
  - Job vacancies increased markedly in 2021.
- Labor cost and wage dynamics:
  - Double-digit wage growth was a key driver of domestic demand.
  - By end-2021, labor costs per hour worked in manufacturing, construction, and services were more than 15 percent higher than a year earlier.
  - Labor cost increases ranged from 7 percent in transportation to 43 percent in hospitality.
  - High public sector wage growth since 2017 and moderate private sector wages in 2020 widened the public–private pay gap to around 10 percent.
  - Lithuania has one of the highest shares of low-income earners in the EU — more than 22 percent — second only to Latvia.
  - Large increases in the minimum wage, with a single national high minimum wage relative to average wages of around 45–50 percent, disproportionately affect employment of low-skilled, young workers in rural areas and may incentivize informality (see Annex III, IMF Country Report No. 18/185).
- Risks:
  - Labor shortages and fast-rising cost of living will maintain upward pressure on wages and inflation, risking an entrenched wage–inflation cycle that could erode competitiveness and stall reforms.

### Financial sector and fiscal position
- Financial sector soundness:
  - Capital adequacy ratios neared 23 percent at end-2021, well above the required minimum.
  - Profitability remains below pre-pandemic levels but above those of euro area peers.
  - The banking sector is highly liquid; loan-to-deposit ratios are at historic lows.
  - Asset quality improved; NPL ratios are among the lowest in the EU.
  - Credit growth to households remains solid; credit to nonfinancial corporations is recovering strongly.
  - EMI and PI incomes soared by 250 percent from 2020, with payment transactions up 280 percent.
  - Authorities are strengthening the AML/CFT framework as the fintech sector matures.
- Fiscal position:
  - Fiscal improvement in 2021: the fiscal position improved by 6.3 percentage points to an overall deficit of 1 percent of GDP; government debt fell to 44.7 percent of GDP.
  - 2022 fiscal shock: Russia’s invasion of Ukraine undermines fiscal performance via lower growth and higher spending on military, refugees, energy subsidies, pension increases, and transfers to the state-owned railway company.
  - In April 2022, the government announced a fiscal package of about 3.5 percent of GDP; half of this package is repurposing of existing budget allocations and use of EU funds.

### External sector and trade links with Russia, Ukraine, and Belarus
- External position:
  - Lithuania’s external position was moderately stronger than fundamentals in 2021; the current account surplus decreased to pre-pandemic levels.
  - National savings remained buoyant, reflecting temporary factors rather than long-term misalignment.
  - The 2021 SDR allocation of 423.3 million (around EUR512 million) has been kept as part of international reserves.
- Trade linkages and vulnerabilities:
  - Exports to Russia, Ukraine, and Belarus were about a sixth of total exports in 2021.
  - A large fraction of these exports represents re-exports: about 90 percent of exports of goods to Russia and Belarus and 30 percent of exports to Ukraine are re-exports.
  - Lithuania’s share of exports to Russia, Ukraine, and Belarus was 16 percent as of end-2021, down from 30 percent in 2014.
  - The war’s impact:
    - Under the baseline of no further escalation, direct impacts through trade linkages and sanctions are modest, but magnified by a worsened global outlook, rising commodity prices, and confidence effects.
    - Trade disruptions affect industries such as metals, chemicals, and furniture via higher import prices and supply disruptions.
    - The conflict will weaken demand from EU trading partners (about 60 percent of merchandise exports of Lithuanian origin).
    - The war is expected to dent real GDP growth by about 2 percentage points in 2022 relative to the pre-conflict baseline; half of that impact would come from disruption of trade with Russia, Ukraine, and Belarus.

### Key risks and policy implications
- Risks:
  - A reinforcing wage–inflation cycle that becomes entrenched, with asymmetric social impacts that widen inequality.
  - Erosion of competitiveness and potential scarring of long-term growth if short-term policy responses introduce distortions or weaken the policy framework.
  - Heightened uncertainty that could dampen activity through lower investment and consumption.
- Policy guidance emphasized in the report:
  - Continue prudent fiscal policies and avoid measures that introduce distortions or weaken the strong policy framework.
  - Target support measures to address the most vulnerable households hit by higher food and energy prices.
  - Implement structural reforms to address long-standing challenges on productivity, income convergence, and demographics while responding to current shocks.
  - Strengthen AML/CFT frameworks in light of fintech sector growth.

*Source: IMF staff report, "Republic of Lithuania" (selected excerpts).*

### introduction  of sanctions and countersanctions due to

### 1ltuea2022001 - introduction  of sanctions and countersanctions due to

### Outlook and Risks
- Baseline assumes no further escalation of the war and a gradual decline in commodity prices in 2023 and beyond towards pre-war levels.
- Real GDP growth in Lithuania is projected to slow markedly in 2022, with economic growth projected to be half the pre-war forecast due to lower contribution from net exports reflecting trade linkages with Russia, Ukraine, and Belarus, and significantly lower demand from EU trading partners in 2022.
- Strong balance sheets, Recovery and Resilience Facility (RRF) funds, and a tight labor market are expected to limit the impact on domestic demand despite high inflation eroding real disposable incomes.
- The output gap is estimated to be positive but small in 2022 and close going forward.
- Inflation
  - Inflation will remain elevated for longer due to high global energy and food prices and supply-side disruptions, keeping inflation high throughout 2022 and early 2023.
  - Core inflation is expected to remain elevated on the back of tight labor market conditions.
  - Inflation is expected to decelerate in 2023 and beyond as commodity prices decline, but there is considerable uncertainty with risks skewed to the upside.
- Financial market indicators and buffers
  - Increase in long-term bond spreads relative to Germany has been modest (about 20 basis points).
  - Equity markets have remained broadly stable.
  - Some modest deposit withdrawals early in the war, but the level of deposits remains at an historic high and significantly above a year earlier.
- Downside risks
  - Abundant downside risks could hinder growth and lead to high and persistent inflation, higher interest rates, and more volatile financial markets.
  - Other risk factors: further escalation of the war, refugees, the lingering conflict with China, lack of momentum in structural reforms, and tightening financial conditions, especially at the peak of the real estate market.
- Policy stance in shock scenarios
  - Automatic stabilizers should be allowed to respond and targeted support to the vulnerable might be needed (Annex VI).
  - On the upside, the economy could prove more resilient than projected and precautionary savings weaker than expected due to strong private sector balance sheets and fundamentals.

### Authorities’ Views
- Authorities broadly agree with staff’s outlook and risks while highlighting significant global uncertainty.
- They emphasize Lithuania’s economic resilience during the pandemic and acknowledge significant social and economic ramifications from the war in Ukraine.
- Authorities expect inflation to moderate in the second half of the year but see persistently high inflation as a significant risk.
- They indicate Lithuania has ample policy and macroeconomic buffers to absorb shocks.
- Fiscal and structural priorities noted by authorities:
  - Commitment to prudent fiscal policy and plans to implement countercyclical policies going forward provided energy and food prices moderate.
  - Need to adjust the tax system, particularly real estate taxation (reform proposal to broaden immovable property taxation).
  - Continued proactive bank supervision and focus on fintech sector maturity, risk management, and AML/CFT strengthening.

### Policy discussions: dealing with inflation without jeopardizing long-term stability
- Main short-term challenge: respond to high and persistent inflation without an independent monetary policy.
- Medium-term challenge: adapt to a higher inflation-and-higher interest rate environment.

A. Fighting inflation with limited policy instruments and loose monetary conditions
- High and persistent inflation is the biggest short-term challenge.
  - Demand-driven inflationary pressures built last year; compounded by external factors and supply-side disruptions after the war that could cause second-round effects.
  - ECB tightening cycle is expected to remain looser than warranted for Lithuania alone, implying higher and more volatile inflation for longer.
- Energy price policy prescriptions
  - Energy price fluctuations should be allowed to pass through to domestic consumers while providing targeted support to vulnerable groups.
  - Policy actions to prevent excessive volatility in energy prices could play a role if they have clear sunset clauses and do not eliminate the price signal.
- Government measures already implemented
  - Most gas and electricity market is deregulated; gasoline and diesel are unregulated and not subsidized.
  - Regulated prices increased significantly; authorities extended measures to all households since July until the end of the year (Annex V).
  - Enhanced targeted programs to subsidize heating for vulnerable households.
  - Temporarily reduced VAT rate on district heating for all households to zero at an expected cost of EUR23 million.

B. Fiscal policy stance and medium-term considerations
- 2022 fiscal stance
  - Fiscal policy will be moderately pro-cyclical in 2022 with new spending leading to a deterioration of the underlying fiscal position.
  - Additional defense expenditures of around 0.5 percent of GDP are creating some permanent spending commitments.
  - The budget deficit is projected to widen by 1 percent of GDP.
- Medium-term fiscal guidance
  - In 2023 and beyond, fiscal position should be tightened in a counter-cyclical manner, in line with the national fiscal rule without activating the escape clause.
  - In the current high inflation environment, cautiously set increases in public sector wages and the minimum wage could help prevent a wage-price spiral.
  - Deficits over the medium-term are expected to moderate, consistent with the national fiscal rule (tighter than the EU framework).
  - Lithuania will benefit from cohesion funds (11 percent of GDP over the 2021–27 programming period) and RRF funds (3 percent of GDP), helping address infrastructure needs and preserve fiscal space.
- Medium-term structural fiscal pressures
  - Aging-related spending pressures, particularly pensions, are significant: one of the highest old-age dependency ratios in the EU, expected to double by 2060.
  - Recent pension adjustments have exceeded the existing formula, which would otherwise produce significantly lower replacement ratios.
  - Distortionary tax expenditures amounted to EUR2.4 billion in 2021.
- Recommended components of a comprehensive fiscal strategy
  - Improve the quality of spending.
  - Broaden the tax base in growth-friendly ways by eliminating distortionary tax expenditures.
  - Strengthen the composition and collection of environmental and housing-related taxes.

### Financial sector resilience and risks
- System-wide strength
  - Ample buffers: excess capital and liquidity ratios and healthy profitability.
  - Bank of Lithuania (BoL) stress tests suggest the system would be able to absorb losses under a severe downside scenario assuming a cumulative decline in output and real estate price of 7.5 and 17.5 percent respectively over two years.
  - As the ECB tightens in the medium-term, banks’ profitability will likely improve as interest margins are expected to increase while portfolio quality is expected to remain resilient given strong household and corporate balance sheets.
- Macroprudential measures and housing market
  - BoL implemented tighter down payment requirements for second and subsequent housing loans and a new sectoral systemic risk buffer for banks with the largest mortgage portfolios.
  - Distribution of loan-to-value ratios on new loans has shifted down since implementation.
  - BoL estimates these measures could reduce new mortgages by 10 percent and slow house price growth by as much as 3 percent.
  - Effectiveness of capital-based measures might be limited given excess capital and banking profitability.
  - Structural bottlenecks in housing supply need addressing to contain prices, requiring regional development and land-use policy changes.
- Financial stability concerns
  - Banking sector remains among the most concentrated in the EU, though concentration across loan segments has declined after restructuring of the third largest bank.
  - Low interest rates and strong household income have driven the residential real estate boom: rapidly rising house prices, record sales, buyer intent indicators, and increased secondary mortgages may signal overheating.
  - Nearly half of real estate transactions do not involve a mortgage, suggesting interest rate rises may have limited effect on house prices.
  - The expected rapid growth of an online fintech bank focused on non-resident activity and ambitious EU expansion will require sustained supervisory efforts.

### Fintech expansion and AML/CFT challenges
- Fintech sector developments
  - Since 2016 Lithuania has attracted a growing number of fintech companies, with 35 new market participants in 2021, becoming the largest fintech hub in the EU in terms of licensed companies.
  - Core activities: payment services, financial software, lending, digital banking, and blockchain.
  - Lithuania has become a hub for virtual asset service providers (VASP), with most of the 407 registered VASPs entering in the last year.
  - In 2021, specialized banks increased their market share fourfold, to 2.3 percent of total assets.
  - Number of employees in the sector reached 5,900 at the end of last year—about 30 percent of employment in the financial and insurance sector.
  - The fintech hub’s cross-border payment focus (many transactions originate and terminate outside Lithuania) has reshaped the country’s financial sector and risk profile, requiring commensurate supervisory resources.
- AML/CFT framework and recommendations
  - The ML/TF risks from non-resident activity have increased; an assessment rated Lithuania’s ML/TF system as insufficiently effective in ten out of eleven areas.
  - Authorities have strengthened the AML/CFT legislative framework, developed a risk-based approach to supervision, and increased BoL and financial intelligence unit staffing and resources.
  - However, substantial increase in cross-border payments, including with higher-risk jurisdictions, has increased the ML/TF threat.
  - Recommendations:
    - Broaden AML/CFT supervisory coverage of the financial sector and increase BoL’s resources and capacity.
    - Strengthen AML/CFT controls to access the BoL payment system (CENTROlink) by non-bank payment service providers.
    - Develop robust AML/CFT risk-based supervision of VASPs combined with stronger supervisory powers and market entry controls.
    - Light registration regime for VASPs should be tightened and supervisory powers enhanced.

### Policy recommendations and actions highlighted
- Allow energy price pass-through while providing targeted support to vulnerable groups; any interventions should have clear sunset clauses and preserve price signals.
- Maintain fiscal discipline: tighten fiscal stance in 2023 and beyond in a counter-cyclical manner aligned with the national fiscal rule.
- Ensure public sector wage and minimum wage increases are set cautiously to avoid a wage-price spiral.
- Implement a comprehensive fiscal strategy focusing on improving spending quality, eliminating distortionary tax expenditures (EUR2.4 billion in 2021), and strengthening environmental and housing-related taxes.
- Continue macroprudential measures for housing (down payment requirements, sectoral systemic risk buffer) and address housing supply bottlenecks via regional development and land-use policy changes.
- Strengthen supervision and resources for the fintech sector and BoL, including AML/CFT supervision, controls for VASPs, and access to the national payment system.
- Allow automatic stabilizers to operate and provide targeted support to vulnerable groups in the event of shocks.

*Source: 1ltuea2022001 - introduction  of sanctions and countersanctions due to (IMF staff content provided)*

### 24.      Lithuania has strong institutions, good governance, and a robust policy framework,

### Lithuania has strong institutions, good governance, and a robust policy framework

### Institutional strengths and need for structural reforms
- Lithuania has strong institutions, good governance, and a robust policy framework, described as the most important pillars for sustainable growth.
- Structural reforms are necessary to ensure continued income convergence (Annex VI IMF Country Report 21/192).
- Top reform priorities identified: education and healthcare reforms (IMF Country Report No. 21/192, Annex VI).
- Other priority areas for structural reform: closing gaps in transport infrastructure, human capital, and access to financing for SMEs.
- Financial support from the EU presents an opportunity to address these structural impediments.

### Labor market flexibility, wages, and competitiveness
- Labor code reform in 2017 deregulated temporary contracts and working-time arrangements, increasing labor-market flexibility.
- Reform effects: provided more flexibility for hiring and dismissal of permanent and temporary workers; potential cost of increasing labor market duality.
- Compensating measures: increased benefits and duration of unemployment insurance.
- Minimum wage developments: unchanged in the years following the global financial crisis, then increased significantly in the last decade at an average annual rate of 12 percent, the second fastest in the EU.
- Labor shortages arising from population aging and low net immigration; inflow of skilled workers and refugees from Ukraine could help alleviate shortages in specific sectors such as hospitality.
- Tradeable sector: high productivity has driven convergence since the global financial crisis, preserved competitiveness, and supported wage growth.
- Wages and productivity: recent high real wage growth in the tradeable sector has been, on average, in line with productivity; wage equalization across sectors has seen productivity growth broadly in line with wage growth for non-tradeables as well.
- Wage setting largely occurs at the firm level, making wages sensitive to unemployment and providing a self-correction mechanism if deviations between wages and productivity become entrenched.

### Greening growth and ensuring energy security
- Baltics face increasing vulnerability to climate change; geopolitical tensions have highlighted energy security risks.
- Lithuania’s CO2 emission reduction has been slower than the EU average, due to continuing increases in emissions in agriculture, transportation, services, and buildings.
- Lithuania’s commitments and targets (from source content):
  - Committed to cut its emissions by 80 percent—by increasing the share of renewables to 45 percent and improving energy efficiency—and sequester 20 percent in order to achieve carbon neutrality by 2050.
- Policy measures and goals:
  - Increase the share of renewables and other non-hydrocarbon energy and improve energy efficiency to reduce emissions and imported energy.
  - Lithuania has eliminated all energy-related imports from Russia.
  - Introduction of a national economy-wide carbon tax set to gradually increase to EUR50 per metric ton of CO2 emissions by 2030 is identified as needed to reach Lithuania’s emission target by 2030.
- Complementary actions required: reducing fossil fuels, investing in low-emission transportation, and raising energy efficiency.
- Recognition that long-term climate risks require strengthening physical, financial, institutional, and social resilience.

### Fiscal policy response and short-term tradeoffs
- Authorities’ response to the energy crisis aims to limit economic disruptions, provide targeted support to the vulnerable, and allow for market price signals.
- Early 2022 support was less aligned with best practices; more recent decisions to allow significant pass-through of energy prices and reflect subsidies transparently in the budget are welcomed.
- Targeted programs: pre-existing programs to subsidize heating for vulnerable households were enhanced; the VAT rate on district heating for households was temporarily reduced to zero at a modest fiscal cost.
- Recommended path: phase out broad energy tariff subsidies gradually, with the bulk of support provided in a targeted manner to the more vulnerable.
- Higher revenues from inflation allow the budget to accommodate pressures for higher social and defense spending in the short-term, but permanent spending commitments risk turning short-term measures into structural problems.
- With discretionary spending low and lack of consensus on significant tax reform, further increases in spending could result in a moderate deficit over the medium-term instead of the authorities’ goal of a balanced budget; public debt would still be on a declining path.
- Policy recommendations:
  - Focus on improving the quality of spending while broadening environmental and housing-related taxes; government proposal for revamping real estate taxation seen as a step in the right direction.
  - Fiscal policy should be decisively countercyclical going forward given the risk of persistently high inflation and the lack of independent monetary policy.
  - The moderately procyclical stance in 2022 was an appropriate response to heightened uncertainty; half of the fiscal stimulus is on additional military spending on mostly imported equipment with little impact on domestic demand.
  - A tightening of fiscal policy next year in line with the national fiscal rule will help minimize risks of persistently high inflation.
  - Increases in public sector wages and the minimum wage over the next few years should be consistent with expected inflation and productivity gains to avoid a wage-price spiral.

### Financial sector resilience and AML/CFT risks
- Banking system has ample capital and liquidity buffers to withstand a weakening economic environment or greater shocks.
- Emergence of a large financial institution with a non-resident base business model will require prompt action by national and supranational authorities to ensure effective supervision under existing European arrangements.
- Money laundering risks:
  - Further efforts needed to mitigate money laundering risks, particularly from the dynamic and growing fintech sector.
  - Fast-growing non-resident activity in the fintech sector presents regulatory and supervisory challenges and cross-border risks to the integrity of the AML/CFT framework.
  - Policy actions recommended:
    - Shift focus from growth to consolidation of the fintech sector to mitigate risks.
    - Implement more effective controls for access to the BoL’s payment system (SEPA/RTGS link).
    - For virtual asset service providers, the Ministry of Interior and the Financial Intelligence Unit should develop risk-based supervision, stronger supervisory powers, and market entry controls.
    - Substantially strengthen the AML/CFT supervisory capacity of the Bank of Lithuania (BoL); this will require time, significant new resources, and greater coordination with other jurisdictions.

### External position and overall appraisal
- External position: moderately stronger than implied by fundamentals; current account surplus decreased to pre-pandemic levels.
- National savings remained buoyant reflecting temporary factors rather than a long-term misalignment.
- Staff appraisal summary:
  - Structural reforms are necessary to ensure continued income convergence; accelerate reforms in education and healthcare, close transportation infrastructure gaps, and reduce information asymmetries limiting SME financing.
  - Ample fiscal space and European funds imply upfront reform costs can be met without jeopardizing the fiscal position.
  - A comprehensive carbon tax is likely necessary to achieve the authorities’ emission reduction objectives for 2030; introduction of an economy-wide carbon tax set to gradually increase to EUR50 per metric ton of CO2 emissions by 2030 would help achieve these goals.

*Source: 1ltuea2022001 - 24.      Lithuania has strong institutions, good governance, and a robust policy framework*

### 39.      The next Article IV Consultation is expected  to be completed on the standard 12-

### 1ltuea2022001 - 39.      The next Article IV Consultation is expected  to be completed on the standard 12-

### COVID Developments
- Recent developments have been in line with countries in the region, although the overall cumulative death from COVID is high.
- Mobility and policy:
  - With relatively lower mobility restrictions than other countries, the impact on mobility was lower.
- Vaccination and epidemiology:
  - The vaccination campaign has been effective; COVID follows seasonal patterns.
- Sources cited for figures: Bloomberg Finance L.P.; ECDC; Our World in Data; Worldometers; Google; IMF, WEO; and IMF staff calculations.

### Inflation Developments
- The ECB monetary policy stance is characterized in the source as "too loose for Lithuania."
- Inflation expectations have picked up.
- Decomposition and distribution:
  - Eurozone inflation mainly reflects higher energy prices; in Lithuania inflation is broad-based.
  - Spending on energy and food is higher than in the euro area, reinforcing the impact on low-income households.
- Sources cited for figures: European Central Bank; Consensus Forecast; Eurostat; and IMF staff calculations.

### Macroeconomic Developments
- Pre-war performance:
  - Before the war, Lithuania was on a strong recovery path, outpacing most euro area peers; the rebound was broad-based and accompanied by a declining trade surplus.
- Post-war / recent developments:
  - With the start of the war, industrial production has not been significantly affected yet, while inflation has picked up further.
- Sources for charts: Haver Analytics; Statistics Lithuania; Bank of Lithuania; and IMF staff calculations.

### Labor Market Developments
- Unemployment has been persistent although declining; employment growth accelerated.
- Wage and minimum wage:
  - Wage growth has been strong for a few years; recent increases of the minimum wage have also been significant.
- Participation and demographics:
  - Participation rate has trended upward, helping to make the pension system more sustainable.
- Sources: Haver Analytics; Eurostat; Statistics Lithuania; and IMF staff calculations.

### Banking Sector Developments
- Credit and deposits:
  - Credit growth has accelerated, with banks increasing exposure to corporates and households, funded by a continued increase in deposits.
- Real estate and balance sheets:
  - Buoyant economy and stronger household/corporate balance sheets have supported a strong housing market; real estate indicators remain around historic levels.
- Capital and profitability:
  - Banks continue to have significant capital buffers and their profitability remains strong.
- Sources: Bank of Lithuania; BIS; European Central Bank; Haver Analytics; and IMF staff calculations.

### Fiscal Developments
- Budget and debt:
  - Strong revenue growth and lower (pandemic-related) spending narrowed the budget deficit.
  - Better fiscal performance and higher nominal GDP growth lowered the debt-to-GDP ratio.
  - Lithuania’s government debt is among the lowest in the region.
- Interest costs and spreads:
  - The interest bill is projected to remain low, partly due to the decline in government debt and improving credit quality as measured by bond spreads.
- Wages:
  - Wage growth is key to inflation and competitiveness, and the public sector will play a critical role.
- Sources: Ministry of Finance; Statistics Lithuania; Haver Analytics; and IMF staff calculations.

### Energy Imports and Diversification (1990–2020)
- Natural gas:
  - Efforts to diversify away from Russian gas started after Russia’s annexation of Crimea, replacing it with liquified gas from Norway and the United States.
- Crude oil and solid fuels:
  - Diversification of crude oil and solid fuels has been more limited as they are global markets.
- Electricity:
  - Electricity imports from Russia and Belarus remain large; gaining access to the European network will allow for a prompt decline in dependency.
- Source: Eurostat; IMF staff calculations.

### Evolving ML/FT Threats
- Fintech and cross-border activity:
  - Success in attracting Fintech has led to a significant increase in non-resident cross-border activity, with a large rise in cross-border flows in recent years, particularly to financial centers.
  - Outliers among outflows have intensified exponentially; CENTROlink fostered these flows, and its controls are key to safeguard the European payment system integrity.
- Sources: Invest Lithuania, 2021; Swift; and IMF staff calculations.

### Competitiveness Developments
- Wages and productivity:
  - High overall wage growth above productivity has resulted in increasing real unit labor costs (ULC).
  - Wage developments in exporting sectors have been consistent with productivity; wages have equalized across the nontradables sector where productivity is lower.
- Outcomes:
  - Export shares have increased more than peers in the region; the wage share is at historic highs.
- Sources: Statistics Lithuania; IMF Direction of Trade Statistics; Eurostat; IFS; and IMF staff calculations.

### Key Socioeconomic and Projection Highlights (excerpted from Table 1)
- Demographics and social indicators:
  - Life expectancy at birth (2020): 80 years (women), 70.1 years (men)
  - Quota (current, % of total): SDR 441.6 million, 0.09 percent
  - Per capita GDP (2021):19,760€
  - Literacy rate (2015):99.8%
  - At-risk-of-poverty (after transfers), share of population (2020):20.9%
  - Key export markets: Russia, Latvia, Poland, Germany, U.S.
- Real GDP growth (annual percentage change), 2018–27:
  - 2018: 4.0
  - 2019: 4.6
  - 2020: -0.1
  - 2021: 5.0
  - 2022: 1.8
  - 2023: 2.3
  - 2024: 3.0
  - 2025: 2.8
  - 2026: 2.6
  - 2027: 2.3
- HICP, period average (annual percentage change), selected years:
  - 2018: 2.5
  - 2019: 2.2
  - 2020: 1.1
  - 2021: 4.6
  - 2022: 17.9
  - 2023: 8.5
  - 2024: 3.0
  - 2025: 2.4
  - 2026: 2.4
  - 2027: 2.3
- General government debt (percent of GDP), 2018–27:
  - 2018: 33.7
  - 2019: 35.9
  - 2020: 46.6
  - 2021: 44.7
  - 2022: 42.1
  - 2023: 38.3
  - 2024: 36.5
  - 2025: 35.2
  - 2026: 34.1
  - 2027: 33.1
- Current account balance (percent of GDP), 2018–27:
  - 2018: 0.3
  - 2019: 3.5
  - 2020: 7.3
  - 2021: 1.4
  - 2022: -1.5
  - 2023: -1.5
  - 2024: -1.0
  - 2025: -0.5
  - 2026: -0.2
  - 2027: 0.1
- Nominal GDP (in billions of euro), 2018–27:
  - 2018: 45.5
  - 2019: 48.8
  - 2020: 49.5
  - 2021: 55.4
  - 2022: 64.6
  - 2023: 72.4
  - 2024: 77.5
  - 2025: 82.1
  - 2026: 86.5
  - 2027: 90.8
- Note: Data are presented on ESA2010 and BPM6 manuals basis. Projections and sources: Lithuanian authorities; World Bank; Eurostat; and IMF staff estimates and projections.

### Fiscal Operations (excerpted from Table 2)
- Revenue and expenditure (percent of GDP):
  - Revenue (2018–27): 34.5, 35.2, 35.7, 37.7, 38.3, 37.2, 36.7, 36.4, 36.2, 36.2
  - Expenditure (2018–27): 34.0, 34.8, 42.9, 38.7, 40.2, 38.5, 37.9, 37.6, 37.4, 37.2
- Net Lending (+) / Borrowing (-) (percent of GDP):
  - 2018: 0.5
  - 2019: 0.5
  - 2020: -7.3
  - 2021: -1.0
  - 2022: -2.0
  - 2023: -1.3
  - 2024: -1.2
  - 2025: -1.2
  - 2026: -1.2
  - 2027: -1.0
- Memorandum: GDP (in millions of euros) 2018–27:
  - 2018: 45,515
  - 2019: 48,860
  - 2020: 49,507
  - 2021: 55,383
  - 2022: 64,583
  - 2023: 72,410
  - 2024: 77,469
  - 2025: 82,073
  - 2026: 86,531
  - 2027: 90,809
- Note: Projections incorporate only announced budgetary measures; passive projections from 2022 onward.
- Sources: Ministry of Finance; Ministry of Social Security; and IMF staff estimates.

### Balance of Payments Highlights (excerpted from Table 3)
- Current Account Balance (billions of euros), 2018–27:
  - 2018: 0.1
  - 2019: 1.7
  - 2020: 3.6
  - 2021: 0.8
  - 2022: -0.9
  - 2023: -1.1
  - 2024: -0.8
  - 2025: -0.4
  - 2026: -0.2
  - 2027: 0.1
- Exports (f.o.b.) and Imports (f.o.b.), selected years (billions of euros):
  - Exports (2018–27): 24.6, 26.0, 25.5, 31.7, 38.4, 40.8, 42.0, 43.4, 44.8, 46.4
  - Imports (2018–27): 27.3, 28.3, 25.9, 34.5, 43.8, 46.2, 47.5, 49.0, 50.5, 52.4
- Gross external debt (percent of GDP), 2018–27:
  - 2018: 78.1
  - 2019: 66.4
  - 2020: 70.6
  - 2021: 70.8
  - 2022: 61.0
  - 2023: 55.6
  - 2024: 51.9
  - 2025: 48.7
  - 2026: 46.1
  - 2027: 43.7
- Sources: Data provided by the Lithuanian authorities; IMF International Financial and Trade Statistics; and IMF staff estimates and projections.

### Monetary and Financial Soundness Indicators (selected)
- Broad money (yearly percent change), 2012–21 (end value shown):
  - 2021: 45.7 (broad money, percent)
- Reserve money (yearly percent change), 2012–21 (end value shown):
  - 2021: 20.5 (reserve money, percent)
- Banking sector (Table 5, selected indicators):
  - Regulatory capital to risk-weighted assets (Dec-21): 23.5
  - Return on Equity (RoE) (Dec-21): 10.3
  - Nonperforming loans to total (non-interbank) loans (Dec-21): 0.7
  - Residential real estate loans to total (non-interbank) loans (Dec-21): 24.5
- Sources: Bank of Lithuania; and IMF staff estimates and projections.

*Source: IMF staff calculations; Lithuanian authorities; and figures and tables in the provided document.*

### Annex I. Implementation of Past IMF Recommendations

### Annex I. Implementation of Past IMF Recommendations

### 2021 Article IV Recommendations — Fiscal Policy
- Fiscal policy stance: Maintain targeted policy support in the short-term and proactively manage risks by maintaining countercyclical fiscal and macroprudential policies as the recovery strengthens. Ensure policies remain countercyclical, particularly if growth exceeds expectations, within the existing policy framework that has served Lithuania so well.
- Policy action taken: The authorities continued to provide targeted support for post-pandemic recovery, while reducing the overall budget deficit by 6.3 percentage points to 1 percent of GDP consistent with staff advice.

### 2021 Article IV Recommendations — Financial Sector Policy
- AML/CFT: Complement the implementation of the 2018 MONEYVAL report recommendations and ensure inter-agency coordination with adequate resources for all agencies involved.
- Policy action taken: The authorities approved the establishment of the Centre of Excellence in Anti-Money Laundering in collaboration with the private sector.

### 2021 Article IV Recommendations — Structural Reforms (Education and Health)
- Education:
  - Recommendation: Address overcapacities (reduce number of teachers and consolidate school and university infrastructure). Review nexus between universities, financial incentives, and quality standards. Planned wage increases should be made conditional on progress in network optimization.
  - Policy action taken: Since approved reforms in 2018 in line with past recommendations, implementation has been slow, yet planned wage increases have continued. COVID-19 has delayed reforms, but the government is preparing its plan to resume implementation efforts.
- Health:
  - Recommendation: Continue reorganizing and rationalizing the hospital sector, improve out-patient and long-term care, and expand role of primary care. Develop a copayments system to incentivize cost efficiency. Strengthen accountability, particularly at municipal level. Planned wage increases should be made conditional on progress in network optimization.
  - Policy action taken: The authorities have diverted more financial resources, including wage increases, to the health sector in response to COVID-19. Consultations with the European Commission on best practices in inter-hospital communication and coordination occurred in 2020. The government is renewing implementation efforts, including by introducing legal changes to allow for joint ownership of hospitals with municipalities.

### 2021 Article IV Recommendations — Tax Policy
- Recommendation: Reduce social security contributions for low wage earners. Rebalance tax system from indirect and labor taxes towards wealth and capital (e.g., environmental and property). Continue tax administration reform. Reduce tax exemptions and privileged regimes.
- Policy actions taken:
  - The authorities slightly reduced labor tax wedge by raising PIT rates, lowering social contributions and increasing the non-taxable income threshold in 2019.
  - They have introduced an ambitious overhaul of environmental taxes, but the war in Ukraine has delayed the parliamentary process.

### 2021 Article IV Recommendations — Social Assistance and Labor Market
- Social assistance:
  - Recommendation: Given limited resources, social protection should increase reliance on means-tested programs. Design should avoid welfare dependency and disincentives to work (e.g., in-work benefits to reduce inequality and increase employment).
  - Policy action taken: In response to the pandemic, large temporary increases in social assistance were provided in 2020 and into 2021, including both targeted and universal measures.
- Labor market:
  - Recommendation: Reduce reliance on employment subsidies and focus on most disadvantaged groups only. Shift emphasis to well-designed training curricula to upskill workforce. Strengthen ALMPs, including life-long learning and apprenticeships, and increase its funding.
  - Policy action taken: As a response to the pandemic, large temporary wage subsidies were provided to firms to support employment and incomes. The government plans to resume focus on pre-existing issues including skills gaps and ALMPs.

### 2021 Article IV Recommendations — Pensions and Innovation
- Pensions:
  - Recommendation: Link retirement age to life expectancy and tighten early retirement. Raise gross pensions (to at least preserve replacement ratios) and scale back incidence of disability pensions.
  - Policy action taken: One-off increases in pension benefits outside of the indexation formula were introduced again at the beginning of 2022, which could undermine the system’s actuarial sustainability especially in view of temporary deferrals of social security contributions during the pandemic.
- Innovation:
  - Recommendation: Consolidate a highly fragmented system and improve coordination.
  - Policy action taken: The authorities have recently consolidated innovation agencies and continue the promotion of innovation in its new program.

*Source: IMF staff.*

### 3.      In contrast to other countries in Europe, inflation is driven not just by external factors

### 1ltuea2022001 - 3.      In contrast to other countries in Europe, inflation is driven not just by external factors

### Drivers of recent HICP inflation (Models and contributions)
- Model 1 specification: overall import price inflation and the output gap (output gap interpolated from annual WEO data using observed variation in real GDP). Coefficients on past HICP inflation and on expected inflation (from the Consensus Forecast) are restricted to one to ensure long-term neutrality.
- Model 1 findings:
  - The recent spike in HICP inflation is driven by increasing contributions from lagged inflation and imported prices.
  - Contribution from inflation expectations is relatively stable.
  - The output gap plays a negligible role.
- Model 2 specification: replaces the output gap with the job vacancy rate and replaces import price inflation with energy prices.
- Model 2 findings:
  - Contributions from inflation expectations are increasing, capturing expected impact of high commodity prices on future inflation.
  - The role of domestic pressures is more pronounced (vacancy rate, lagged inflation).
- Average contributions (2020q1 to 2022q1) to HICP inflation:
  - about a third explained by past inflation
  - another third by the vacancy rate
  - a fifth by expected inflation
  - the remainder by energy prices (which had had a negative contribution in 2020)

### Inflation persistence and city-level evidence
- Rolling window estimates of Model 2 (not reported) suggest an increasing coefficient on the sum of backward-looking and forward-looking inflation, implying increased inflation persistence after the pandemic.
- Supporting evidence from other studies:
  - Cevik (2022a): Using monthly CPI data for five major Lithuanian cities, finds that despite lack of persistence in headline inflation rate, most consumption categories exhibit significant persistence.
  - Cevik (2022b): Reports significant increases in the degree of synchronization across city-level inflation rates, reflecting major external shocks including the COVID-19 pandemic.

### Inflation–wage correlation
- There is an increasingly positive correlation between inflation and private sector wage growth, particularly in manufacturing.
- The 12-quarters rolling contemporaneous correlations of HICP and wage inflation have recently increased.
- The increase is driven by the private sector; correlation has been higher since 2019.
- Wages in manufacturing have shown a positive, large, and stable correlation with inflation since 2020q2.

### Heterogeneity of inflation across households and distributional impact
- Inflation rates vary across household groups due to heterogeneity in expenditure consumption patterns.
- Lithuania uses 2016 Household Budget Survey cash expenditure weights for 12 COICOP categories; weights are constant over 2016-2022.
- Until the recent increase in inflation (since 2016), deviations of inflation among income quantiles or employment status fluctuated around zero and were not persistent.
- Recent sharp increase in inflation has disproportionately affected low-income groups and pensioners:
  - Lower income groups and pensioners exhibit increasing inflation rates because their consumption is more heavily biased towards energy and food.
  - The gap in inflation experienced increases with the level of inflation.

### Lithuania’s energy markets (structure and recent policy response)
- Energy market structure and dependency:
  - Lithuania is highly dependent on foreign sources of energy after decommissioning of the nuclear power plant (which had covered 70 percent of electricity consumed).
  - Domestically produced electricity accounts for a third of total consumption and originates predominantly from renewable sources and fossils.
  - Steps taken to reduce energy dependency on Russia include integration into Nordic/Baltic and Western European electricity markets.
  - Gas and electricity market for businesses largely liberalized; liberalization of customer segment of household electricity market initiated in 2020 and foreseen to be completed by end-2022.
  - For regulated segments, the National Energy Regulatory Council (NERC) sets prices and price caps, approves methodologies, and monitors wholesale and retail markets.
- Natural gas market specifics:
  - No domestic production and no imports from Russia; dependence on imports through the NLG terminal at Klaipeda and a pipeline to Poland.
  - Industrial natural gas consumption is about two-thirds of total consumption; one fertilizer producer accounts for half of total consumption and imports gas on its own.
  - Ignitis (state-owned energy company) supplies about a third of the rest of the business market share.
  - Residential consumption is relatively limited and predominantly used for cooking.
  - The state company supplies all consumers in the residential segment; regulator adjusts prices bi-annually to reflect transmission, distribution, storage, regasification, and supply costs. No liberalization plans envisaged for this segment.
- Electricity market specifics:
  - Non-household retail market fully liberalized in 2013.
  - Household market liberalization initiated in 2020 and foreseen to be completed by end-2022.
  - All regulated households are serviced by Ignitis.
  - Regulated prices adjusted bi-annually; regulated household electricity prices are among the lowest in the EU.
- District heating:
  - Heating is supplied by a large district heating network with generation largely dependent on biomass.
  - Heat generation has shifted from natural gas to biomass.
  - End-consumer heat prices are calculated monthly based on prices of fuel and heat purchased from independent producers; prices reflect depreciation, maintenance, personnel costs, and return on investment (adjusted annually).

### Authorities’ multi-pronged policy response to the energy crisis
- Objectives: limit economic disruption, provide targeted support, and allow for market price signals.
- Untargeted subsidies (initial response) and price developments:
  - Regulated natural gas increased between 25 and 35 percent at the beginning of the year, and between 27 and 40 percent in July.
  - Respective increases for regulated electricity prices amounted to 10 and 46 percent respectively.
  - The initial untargeted subsidies allowed a significant rise in prices; the regulator was empowered (November 2021 legal amendments) to limit gas and electricity price increases for households if such increases were to exceed 40 percent and to spread the associated cost over 5 years with future tariffs compensating suppliers for postponed income including interests.
  - Under the initial scheme, a regulated price significantly below market was set for gas and electricity during the first half of 2022, implying that Ignitis had to cover the cost of the subsidy from its balance sheet.
  - Consumers already in the liberalized market (businesses and a few households) did not benefit from the initial scheme.
- Second package (revamped approach in May):
  - Rationale: high energy prices proved persistent; concern about Ignitis balance sheet, investment plans, and governance.
  - Approach: provide support explicitly through the budget and compensate Ignitis for past losses.
  - Expected cost of subsidies: 690 million (1¼ percent of GDP).
  - Parliamentary approval: 570 million in funding to cover previous subsidies—the difference between the regulated and market price during 2021 and the first half of 2022—and to cover envisaged subsidies for households for the second half of 2022.
  - Additional 120 million approved to support businesses; exact means not yet determined and will likely depend on finding a scheme consistent with European rules on state aid.
  - Policy improvements from the new scheme:
    - Improved transparency by making subsidies explicit in the budget.
    - Supports liberalization of the electricity market by covering unregulated households and placing regulated and unregulated households on level footing, reducing incentives for delays in liberalization.
- Targeted measures and other adjustments:
  - Enhanced targeted subsidies for heating of vulnerable households.
  - Temporary reduction to zero of VAT on district heating for households from January to April (modest cost).
- Fiscal transparency and market signals:
  - Subsidy design: seeks to set a price ceiling for each household customer so the amount of support depends on the difference between such ceiling and the contracted price; contracted prices tending to be variable or set for short duration implies such differences should dissipate over time.

### Key fiscal and market numeric values and dates (preserved exactly)
- Average contributions to HICP inflation (2020q1 to 2022q1): about a third from past inflation; another third from vacancy rate; a fifth from expected inflation; remainder from energy prices (negative in 2020).
- Wages–inflation correlation increase since 2019; manufacturing wages positive, large, and stable correlation with inflation since 2020q2.
- Household Budget Survey weights used: 2016 cash expenditure weights for 12 COICOP categories, constant over 2016-2022.
- Regulated natural gas price increases: between 25 and 35 percent (beginning of the year); between 27 and 40 percent (in July).
- Regulated electricity price increases: 10 percent and 46 percent (respective increases).
- Cost of subsidies under second package: 690 million (1¼ percent of GDP).
- Parliamentary funding approved: 570 million for previous subsidies and envisaged household subsidies for second half of 2022; additional 120 million approved to support businesses.
- Household electricity market liberalization initiated in 2020 and foreseen to be completed by end-2022.
- Nuclear power plant had covered 70 percent of the electricity consumed prior to its decommissioning in 2009.
- Domestic electricity production accounts for a third of total consumption.

*Source: IMF staff summary of the provided content.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1ltuea2022001.pdf_