## _cr11326 - Appendix II)

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### CONTEXT — Recent Developments
- GDP contracted by a cumulative 18 percent between the second quarter of 2008 and the last quarter of 2009.
- GDP expanded by 1.4 percent in 2010 and by 6.3 percent in the first half of 2011.
- Export growth was the main driver of the recovery; strong growth in trading partners (including Germany, Poland, and Russia) supported exports.
- Staff estimates that the real exchange rate is now "broadly in line with fundamentals" (Box 1).
- Aggregate operating surplus and mixed income up by some 60 percent since early 2010, and almost back to pre-crisis levels.
- Private sector average gross earnings fell by some 12 percent from late 2008 and then rose by a cumulative 2.5 percent in the last three quarters (as of the report), offset by strong labor productivity growth.
- Gross fixed capital formation rose vigorously after contracting sharply until mid-2010; inventory rebuilding contributed strongly to 2010 growth.
- Oil-related products constitute a third of total imports.
- Current account swung from a 1.5 percent of GDP surplus in 2010 to a 1 percent of full-year GDP deficit in the first half of 2011.
- Headline inflation peaked at 5.0 percent in May 2011; headline inflation was 4.7 percent in September 2011.
- Core inflation was 1.2 percent in September 2011; core prices started rising y/y in April 2011.

### CONTEXT — Near-Term Outlook and Risks
- Q/q growth (s.a.) projected to be about 0.5 percent (annualized) in the second half of 2011.
- Full-year 2011 growth implied as 6.3 percent.
- Annual growth in 2012 projected to be 3½ percent.
- Estimated negative output gap: 2.7 percent in 2011, narrowing to 1.4 percent in 2012 (compared to 6.1 percent in 2010).
- Current account deficit expected to widen a little in 2012; modest current account deficits in 2011 and 2012 to be more than financed by EU capital transfers.
- Financial account: net FDI expected to be strong; repayments of liabilities by domestic bank subsidiaries to their Scandinavian parents expected to decline.
- Unemployment rate projected to fall from 15.5 percent in 2011 (yearly average) to 14 percent in 2012.
- Average nominal gross earnings projected to grow by 3.3 percent in 2011 and 4.1 percent in 2012.
- Consumer price inflation projected to fall to 3.8 percent at end-2011.
- Continuation of trends (low non-core inflation, core inflation rising slowly up to 2 percent) would result in 2.7 percent inflation at end-2012 and an annual average rate of 3.1 percent.
- Downside risks to growth:
  - Heightened uncertainty: Lithuania exports 30 percent of its exports to the euro area.
  - Global financial markets freeze: external borrowing costs could rise; government has some 8 percent of GDP in gross financing needs for next year.
- Banking sector structure: subsidiaries or branches of Scandinavian banks account for three quarters of total assets; parent banks rely on wholesale markets for about half of their total funding.
- Scandinavian authorities described as well prepared to deal with liquidity pressures (sizeable reserves, preparedness to extend range of acceptable collateral, possibility of re-activating swap lines).

### POLICY CHALLENGES — Reducing Government Debt and Financing Needs
- General government deficit (ESA basis) declined from 9.2 percent of GDP in 2009 to 7.1 percent of GDP in 2010.
- First half of 2011 deficit fell by 1 percentage point of GDP compared to first half of 2010.
- Staff projects a fiscal deficit of 5.1 percent of GDP for 2011 as a whole.
- Government’s original 2011 budget target: 5.8 percent of GDP; revised Convergence Program target: 5.3 percent of GDP.
- Expenditure: staff expects total expenditure to fall by 3 percentage points of GDP in 2011, despite higher debt service costs.
- Revenue: VAT and excise duties are growing fast; direct taxes and social contributions lagged behind.
- Government’s 2012 deficit target: 2.8 percent of GDP; medium-term objective: a small surplus.
- Government has fully financed 2011 needs; gross financing needs next year include some 8 percent of GDP, including refinancing euro bonds issued in 2002 and 2006.
- Government debt approaching 40 percent of GDP (up from 15.5 percent of GDP in 2008).
- Population projections: population projected to fall by 20 percent between 2010 and 2060; dependency ratio rising from 1-to-4 to 1-to-2.
- EC Sustainability Report projection: government spending could rise by as much as 6 percent of GDP over the long term due to aging; rising health care costs could add a further 4 percent of GDP to spending.
- Measures worth 1–1¼ percent of GDP needed to reach the 2012 target; consolidation should be sustainable.
- Potential fiscal measures/options:
  - Expand wealth taxation (property and motor vehicles), including non-commercial usage with appropriate thresholds to protect poorer owners.
  - Broaden tax bases: include all earnings categories in social contributions, eliminate CIT exemptions (such as the investment incentive), tax pensions as regular personal income.
  - Protect the most vulnerable and preserve investment levels if further spending cuts are undertaken.
- Contingency planning: draw up a list of saving measures implementable quickly if revenue growth is weaker than expected.
- Medium-term additional adjustment: cumulative adjustment of about 2 percentage points of GDP required in addition to the 2012 effort.
- Structural reforms to support consolidation:
  - Pension reform: Parliament approved gradual increase in pension age to 65 for both men and women (from 62.5 and 60, respectively); expected to deliver at least 1 percent of GDP in annual savings over the long run but insufficient alone; support for guidelines to link future benefits to demographic factors; consider separating basic social pension and financing from general budget.
  - Health care reform: consolidating hospitals and concentrating medical procedures in fewer, higher-volume centers to benefit from economies of scale.
  - State-owned enterprises (SOEs): SOE assets account for some 25 percent of GDP; completed a major inventory of SOE assets; need for rigorous cost-benefit analysis and governance reform (independence and professional experience of boards).
  - Tax compliance: ambitious compliance strategy supported by Fund technical assistance; Commission for Coordination of Cooperation among State Economic and Financial Control Authorities set up; State Tax Inspectorate (STI) focusing resources on a relatively small number of large and medium-size businesses representing about half of total turnover; new training programs for tax inspectors; legislative changes to collect unpaid taxes from enterprises facing bankruptcy; plans to expand use of cash registers, reduce loopholes in business licenses, and step up fight against border smuggling.
- Fiscal framework improvements under consideration:
  - Amendments to tighten rules on the use of Treasury reserves, strengthen independent evaluation in budget planning and execution, and introduce an additional fiscal rule requiring a decline in the headline deficit of at least 0.6 percent of GDP whenever the projected output gap is positive.
  - Staff view: tighter access to fiscal reserves would help discipline spending; independent evaluation should be entrusted to a new body such as a fiscal council.
  - Staff commentary on the additional rule: linking to the sign of the projected output gap is hard to manage effectively and the 0.6 percent of GDP requirement would seem arbitrary; recommend complementing existing expenditure rule with a "debt brake" to bring debt to well below 40 percent of GDP.

### Fiscal stance and 2012 fiscal target
- Authorities committed to the 2012 fiscal deficit target of 2.8 percent of GDP.
- Plan to meet the target (difficulty of introducing new taxes in an election year) by:
  - increasing non-tax revenue and reducing spending;
  - higher dividend receipts from SOEs of about ½ percent point of GDP in 2012 (given strong SOE financial performance in 2011);
  - land sales could yield ¼ percent of GDP;
  - change in valuation method for the land tax (administered by local governments) could yield ¼ percent of GDP;
  - reducing ministries’ spending allocations by 2 percent across the board, saving another ¼ percent of GDP.
- Contingency: consider a supplementary budget should downside risks to revenues materialize.
- Ongoing work on the fiscal rule; authorities will take into account staff’s suggestions.

### Banking system resilience — performance and profitability
- Recovery boosted banking system performance; NPLs stabilized after rising sharply from mid-2008 to end-2009.
- Several banks reduced loan loss provisions after aggressive provisioning earlier.
- Cumulative profits in the four quarters to 2011Q2 reached €188 million, compared with €1 billion in losses in previous four quarters.
- Return on assets improved from negative 4.8 percent at end-2009 to positive 1.3 percent in the most recent four quarters.

### Banking system capitalization and liquidity
- Capital increases in 2009-10 amounted to 3 percent of GDP or 40 percent of bank capital measured at end 2008.
- Prudential ratios (2011Q2):
  - average capital adequacy ratio: 14.8 percent;
  - Tier 1 ratio: 11.4 percent;
  - core Tier 1 ratio: 10.3 percent (above future Basel III requirements).
- Liquid assets:
  - average ratio of liquid assets to current liabilities: slightly above 40 percent (regulatory minimum 30 percent);
  - central bank preliminary calculations: liquidity coverage ratio close to 200 percent;
  - net stable funding ratio slightly below 100 percent (Basel III minima for the latter two are 100 percent).

### Credit growth and supply-demand dynamics
- Low credit growth driven mainly by lack of demand as corporations and households repair balance sheets, not supply constraints.
- Banks tightened lending standards on construction and real estate sectors but not on export sectors.
- Anecdotal evidence of competition among banks to provide credit to good corporate borrowers.

### Stress testing and shock absorption
- Bank of Lithuania (BOL) stress tests: under a 13 percentage point decline in export volumes and a 260–440 basis point spike in interest rates, aggregate and median CARs would still remain above 10 percent.
- Aggregate liquidity ratio would remain above 30 percent with a 10 percent deposit drain and fall only marginally below 30 percent with a 15 percent deposit drain.
- Foreign-owned banks dependent on parent funding; average loan-to-deposit ratio about 150 percent; parents did not curtail funding abruptly in 2009–10.

### Remaining weaknesses and supervisory recommendations
- A few banks (accounting for 15-20 percent of deposits) without liquidity backstops from foreign parents:
  - have set aside lower provisions despite higher NPL ratios;
  - under adverse BOL scenarios did not meet minimum capital requirements.
- Recommended actions:
  - prompt corrective action to address weaknesses;
  - supervisors should enforce conservative risk assessments, require adequate loan loss provisions, and demand capital increases when warranted;
  - law provides authority to take adequate measures if needed;
  - broaden the range of resolution tools (for example, include a purchase and assumption option) in line with European and global initiatives and earlier Fund technical assistance.

### Unification of financial supervision and responsible lending
- Draft law in parliament would unify supervision (and a newly created consumer protection agency) under the BOL; preparations to implement new organizational structure in early 2012 are well under way.
- Important governance point: head of supervision should report directly to the highest governing body of the BOL (draft law currently silent about reporting responsibilities).
- Imminent introduction of responsible lending guidelines (including limits on loan-to-value and debt service-to-income ratios) should help contain systemic risk.

### Insolvency regimes
- Corporate insolvency regime exists but is widely regarded as too slow; law does not provide adequate guidance to judges.
- New personal insolvency law in parliament:
  - broadly in line with Fund advice;
  - areas for improvement: allow creditors (not only debtors) to initiate bankruptcy proceedings; add collective enforcement mechanisms when no plan has been submitted/approved or proceedings have been declared terminated;
  - ensure availability of advisory services to debtors on their rights under the new regime.
- Authorities do not plan to allow creditors to initiate personal bankruptcy proceedings; they consider civil courts provide enough recourse.

### Sustaining medium-term growth — composition and potential
- Need for balanced growth: reallocate resources to tradable sectors to support productivity and minimize external imbalances.
- Contribution of tradable sectors to the recovery about 50 percent, much higher than during the pre-crisis boom.
- No clear evidence yet of stronger employment growth in tradables versus nontradables.
- Investment concerns:
  - investment to GDP ratio fell sharply during the crisis;
  - staff’s central medium-term scenario: lower investment will lead to lower labor productivity growth;
  - staff estimates potential growth of 3½–4 percent, implying slower convergence of living standards to the EU average than before.

### Labor market, employment, and policy recommendations
- To sustain even 4 percent potential output growth amid lower investment and a shrinking labor force, employment ratio needs to rise from around 60 percent to some 65 percent in the medium-term in staff baseline forecasts.
- Recommendations to facilitate labor reallocation and job creation:
  - support plans to make permanent changes to the Labor Code allowing greater use of fixed term contracts for new vacancies;
  - consider extending temporary crisis measures that reduced firing costs on permanent contracts;
  - fully use EU funds for job schemes, training programs, and enhanced labor bureau efficiency.
- Caution on minimum wage increases: proposals to raise the minimum wage should be evaluated carefully since they might slow job creation, reverse competitiveness gains, and increase government spending (wages and benefits tied to the minimum wage).
- Authorities noted potential benefits of raising the minimum wage (enhance labor supply incentives, improve reporting of wages for tax purposes, reduce income inequality) but recognized trade-offs.

### Business environment and competitiveness
- Progress: requirements for starting a business streamlined; need to ensure shorter timetable for obtaining construction permits is implemented.
- New law on business inspections is welcomed (separates policy making from implementation, increases transparency, strengthens coordination).
- Support for proposed law to strengthen the role of the Competition Council to allow more proactive investigations of breaches of competition rules.

### Euro adoption and Maastricht criteria
- Staff supports intention to meet the Maastricht criteria in 2012.
- Exchange rate arrangement: both de facto and de jure currency board pegged to the euro.
- Meeting the 2012 fiscal deficit target of 2.8 percent of GDP is important for the MTO and euro adoption aspirations.
- With regard to the inflation criterion, price controls should not be used to reduce inflation.
- Authorities acknowledged inflation could be above the criterion in 2012 but did not intend to take unorthodox measures to reduce inflation.

### Staff appraisal — summary of policy priorities
- Economy staged an impressive recovery; policy action included sizeable fiscal consolidation, maintenance of confidence in the banking system, and significant wage adjustment.
- With weaker external demand and higher external financing costs, growth will slow sharply in 2012; risks are on the downside.
- Further fiscal consolidation needed to preserve Lithuania’s good fiscal record; some proposed one-off measures (extraordinary SOE dividends and land sales) do not appear sustainable.
- Important to protect the most vulnerable and preserve public investment when implementing spending cuts; expand wealth taxation and broaden tax bases as options; prepare a contingency plan of further measures given downside growth risks.
- Deepen fiscal reforms: pension reform for long-term sustainability; enhance cost-benefit analysis and governance reforms for SOEs; improve tax compliance; expand independent evaluation in budget planning and consider strengthening the existing expenditure rule.
- Banking sector: address remaining pockets of weakness without delay, broaden resolution tools, ensure conservative risk assessment, adequate provisioning, and capital increases where needed.
- Unification of supervision under BOL will strengthen risk identification; head of supervision should report directly to the highest governing body of the central bank; responsible lending guidelines welcome.
- Sustainable medium-term growth depends on increased labor participation, reallocation to tradable sectors, and strong investment; use EU structural funds to address skill mismatches and improve the business environment (new law on business inspections and proposed Competition Council law welcome).
- Proposed timing: hold the next Article IV consultation on the regular 12-month cycle.

### Box 2. Time-Varying Tax Elasticities — Key findings
- VAT revenue accounts for about half of total tax revenue in Lithuania.
- Short-run deviations of tax elasticities from long-run equilibria can be driven by short-changes in the composition of tax bases and cyclical variations in tax compliance.
- Staff analysis finds the elasticity of VAT has fluctuated between 0.5 and 1.5 over the past decade.
- Using a panel of 10 new EU member countries, staff finds robust evidence of the long-run neutrality (i.e. unit elasticity) of VAT revenue with respect to private consumption (tax base).
- VAT revenue deviations dynamics:
  - deviation falls by about 10 percent each quarter (or 60 percent each year).
  - At the peak of the boom, VAT collections exceeded long-run equilibrium by about 20 percent in Latvia and 10 percent in Lithuania and Estonia.
  - In Lithuania, VAT revenue estimated to have been about 5 percent below its long-run value at end-2010.
- Implication: short-run VAT elasticity can be substantially different from long-run elasticity; monitoring cyclical gaps is important.

### Box 4. Medium-Term Growth Prospects — Key quantitative findings
- Medium-term growth projection for Baltic countries: 3¼–4¼ percent.
- Drop relative to 2002–07 boom: 4–5 percentage points.
- Model underprediction in 2002 vs boom outturn: about 2–2½ percentage points.
- Contribution of convergence to decline: about ¾ percentage point.
- Impact of investment at 1998 levels on predicted growth:
  - Latvia: +1 percentage point
  - Lithuania: +1 percentage point
  - Estonia: +1¾ percentage points
- Slower labor productivity growth vs boom years: between 3¼–3¾ percentage points.
- Required policy implication: sustaining 4 percent GDP growth would require large increases in employment ratios.

### Annex 1. Lithuania: External Debt Sustainability Framework, 2006-2016 — Selected baseline series and assumptions
- Public sector debt (Baseline, percent of GDP):
  - 2006: 17.9
  - 2007: 16.8
  - 2008: 15.5
  - 2009: 29.4
  - 2010: 38.0
  - 2011: 37.5
  - 2012: 38.8
  - 2013: 38.7
  - 2014: 38.2
  - 2015: 37.6
  - 2016: 36.8
- Share of foreign-currency denominated public sector debt:
  - 2006: 14.5
  - 2007: 14.0
  - 2008: 12.8
  - 2009: 27.0
  - 2010: 34.2
  - 2011: 32.2
  - 2012: 32.6
  - 2013: 31.8
  - 2014: 30.6
  - 2015: 30.1
  - 2016: 29.4
- Change in public sector debt (percent of GDP):
  - 2006: -0.4
  - 2007: -1.1
  - 2008: -1.3
  - 2009: 13.9
  - 2010: 8.6
  - 2011: -0.5
  - 2012: 1.3
  - 2013: -0.1
  - 2014: -0.5
  - 2015: -0.6
  - 2016: -0.8
- Primary deficit (percent of GDP):
  - 2006: -0.3
  - 2007: 0.3
  - 2008: 2.6
  - 2009: 7.9
  - 2010: 5.2
  - 2011: 3.2
  - 2012: 1.1
  - 2013: 0.6
  - 2014: 0.1
  - 2015: -0.1
  - 2016: -0.3
- Revenue and grants (percent of GDP):
  - 2006: 33.3
  - 2007: 33.8
  - 2008: 34.0
  - 2009: 34.7
  - 2010: 34.3
  - 2011: 33.2
  - 2012: 34.4
  - 2013: 33.9
  - 2014: 33.4
  - 2015: 33.0
  - 2016: 32.7
- Primary (noninterest) expenditure (percent of GDP):
  - 2006: 33.0
  - 2007: 34.1
  - 2008: 36.6
  - 2009: 42.6
  - 2010: 39.5
  - 2011: 36.4
  - 2012: 35.5
  - 2013: 34.5
  - 2014: 33.6
  - 2015: 32.9
  - 2016: 32.4
- Automatic debt dynamics (percent of GDP):
  - 2006: -2.8
  - 2007: -3.5
  - 2008: -0.7
  - 2009: 4.1
  - 2010: 3.7
  - 2011: -2.3
  - 2012: -0.7
  - 2013: -0.7
  - 2014: -0.6
  - 2015: -0.5
  - 2016: -0.5
- Public sector debt-to-revenue ratio:
  - 2006: 54.0
  - 2007: 49.8
  - 2008: 45.6
  - 2009: 84.5
  - 2010: 110.9
  - 2011: 112.9
  - 2012: 112.8
  - 2013: 114.3
  - 2014: 114.3
  - 2015: 114.1
  - 2016: 112.4
- Gross financing need (percent of GDP):
  - 2006: 5.6
  - 2007: 2.8
  - 2008: 4.9
  - 2009: 14.1
  - 2010: 10.1
  - 2011: 9.8
  - 2012: 7.9
  - 2013: 7.8
  - 2014: 6.1
  - 2015: 7.6
  - 2016: 7.5
- Gross financing need in billions of U.S. dollars:
  - 2006: 1.7
  - 2007: 1.1
  - 2008: 2.3
  - 2009: 5.2
  - 2010: 3.7
  - 2011: 4.3
  - 2012: 3.7
  - 2013: 3.8
  - 2014: 3.2
  - 2015: 4.2
  - 2016: 4.4
- Key macro assumptions (selected):
  - Real GDP growth (percent): 2006: 7.8; 2007: 9.8; 2008: 2.9; 2009: -14.8; 2010: 1.4; 2011: 6.3; 2012: 3.5; 2013: 3.7; 2014: 3.8; 2015: 3.8; 2016: 3.8.
  - Average nominal interest rate on public debt (percent): 2006: 4.6; 2007: 4.7; 2008: 4.5; 2009: 6.9; 2010: 6.6; 2011: 5.7; 2012: 5.1; 2013: 5.2; 2014: 5.2; 2015: 5.2; 2016: 5.2.
  - Inflation rate (GDP deflator, percent): 2006: 6.6; 2007: 8.6; 2008: 9.8; 2009: -3.7; 2010: 2.0; 2011: 5.7; 2012: 3.4; 2013: 3.2; 2014: 3.0; 2015: 2.7; 2016: 2.6.
  - Growth of real primary spending (percent): 2006: 8.8; 2007: 13.6; 2008: 10.5; 2009: -0.8; 2010: -6.1; 2011: -2.1; 2012: 1.0; 2013: 0.8; 2014: 1.0; 2015: 1.6; 2016: 2.3.

### Annex 4. Lithuania: Public Debt Sustainability: Bound Tests — Selected outcomes
- Baseline and scenario averages (figures shown in boxes):
  - Historical: 44
  - Baseline: 37
  - Combined shock: 47
  - Combined shock (with 30% depreciation): 52
  - Contingent liabilities shock: 46
- Baseline primary balance: -0.3 (Percent of GDP)
- Scenario primary balance: -1.6 (Percent of GDP)
- Historical primary balance: -1.8 (Percent of GDP)
- Selected general government series referenced:
  - General government gross debt: 2008: 15.5; 2009: 29.4; 2010: 38.0; 2011 projection: 37.5.
  - Foreign currency-denominated public debt: 2008: 12.8; 2009: 27.0; 2010: 34.6; 2011 projection: 32.2.
  - General government balance: 2008: -3.3; 2009: -9.5; 2010: -7.1; 2011 projection: -5.1.

### Financial sector overview and reforms (additional highlights)
- Banking sector growth noted as "11.2 percent over the year."
- Some banks still need to increase loan loss provisioning and strengthen the capital base.
- Banks operating in Lithuania have only limited direct exposure to the sovereign debt of the Southern European countries; spillovers that affect demand for export and conditions for sovereign financing are considered more important risks.
- Regulatory and supervisory reforms advanced in 2011:
  - Consolidation of financial sector supervision under the Bank of Lithuania: transfer insurance and securities sector supervision to the central bank; reformed supervisory authority will report to the designated member of the board of the Bank of Lithuania; financing from market participants’ contributions and central bank resources; legal amendments to be passed by December 2011; operational preparedness for early 2012 implementation.
  - Prudential framework strengthened: Adoption of the Regulations for Responsible Lending with limits on loan-to-value, loan-to-income, loan maturity, and strengthened customer information requirements.
- Cross-border crisis management and cooperation:
  - Signed the Nordic-Baltic cooperation agreement on cross-border financial stability, crisis management, and resolution.
  - Participation in the Nordic-Baltic Cross-Border Stability Group and supervisory colleges.
- Insolvency framework for natural persons:
  - With Fund technical assistance, law on natural persons’ bankruptcy to be adopted by December 2011 to enhance orderly debt restructuring.

*Source: REPUBLIC OF LITHUANIA 2011 ARTICLE IV REPORT — Appendix II).*

### Appendix II).

### _cr11326 - Appendix II)

### CONTEXT — Recent Developments
- Lithuania contracted by a cumulative 18 percent between the second quarter of 2008 and the last quarter of 2009.
- GDP expanded by 1.4 percent in 2010 and by 6.3 percent in the first half of 2011.
- Export growth was the main driver of the recovery; strong growth in trading partners (including Germany, Poland, and Russia) supported exports.
- Staff estimates that the real exchange rate is now "broadly in line with fundamentals" (Box 1).
- Aggregate operating surplus and mixed income up by some 60 percent since early 2010, and almost back to pre-crisis levels.
- Private sector average gross earnings fell by some 12 percent from late 2008 and then rose by a cumulative 2.5 percent in the last three quarters (as of the report), offset by strong labor productivity growth.
- Gross fixed capital formation rose vigorously after contracting sharply until mid-2010; inventory rebuilding contributed strongly to 2010 growth.
- Oil-related products constitute a third of total imports.
- Current account swung from a 1.5 percent of GDP surplus in 2010 to a 1 percent of full-year GDP deficit in the first half of 2011.
- Headline inflation peaked at 5.0 percent in May 2011; headline inflation was 4.7 percent in September 2011.
- Core inflation was 1.2 percent in September 2011; core prices started rising y/y in April 2011.

### CONTEXT — Near-Term Outlook and Risks
- Q/q growth (s.a.) projected to be about 0.5 percent (annualized) in the second half of 2011.
- Full-year 2011 growth implied as 6.3 percent (given the very strong first half).
- Annual growth in 2012 projected to be 3½ percent.
- Estimated negative output gap: 2.7 percent in 2011, narrowing to 1.4 percent in 2012 (compared to 6.1 percent in 2010).
- Current account deficit expected to widen a little in 2012; modest current account deficits in 2011 and 2012 to be more than financed by EU capital transfers.
- Financial account: net FDI expected to be strong; repayments of liabilities by domestic bank subsidiaries to their Scandinavian parents expected to decline.
- Unemployment rate projected to fall from 15.5 percent in 2011 (yearly average) to 14 percent in 2012.
- Average nominal gross earnings projected to grow by 3.3 percent in 2011 and 4.1 percent in 2012.
- Consumer price inflation projected to fall to 3.8 percent at end-2011.
- Continuation of trends (low non-core inflation, core inflation rising slowly up to 2 percent) would result in 2.7 percent inflation at end-2012 and an annual average rate of 3.1 percent.
- Risks to growth (downside):
  - Heightened uncertainty: Lithuania exports 30 percent of its exports to the euro area.
  - Global financial markets freeze: external borrowing costs could rise; government has some 8 percent of GDP in gross financing needs for next year.
- Banking sector structure: subsidiaries or branches of Scandinavian banks account for three quarters of total assets; parent banks rely on wholesale markets for about half of their total funding.
- Scandinavian authorities are described as well prepared to deal with liquidity pressures (sizeable reserves, preparedness to extend range of acceptable collateral, possibility of re-activating swap lines).

### POLICY CHALLENGES — Reducing Government Debt and Financing Needs
- General government deficit (ESA basis) declined from 9.2 percent of GDP in 2009 to 7.1 percent of GDP in 2010.
- First half of 2011 deficit fell by 1 percentage point of GDP compared to first half of 2010.
- Staff projects a fiscal deficit of 5.1 percent of GDP for 2011 as a whole.
- Government’s original 2011 budget target: 5.8 percent of GDP; revised Convergence Program target: 5.3 percent of GDP.
- Expenditure: staff expects total expenditure to fall by 3 percentage points of GDP in 2011, despite higher debt service costs.
- Revenue: VAT and excise duties are growing fast; direct taxes and social contributions lagged behind.
- Government’s 2012 deficit target: 2.8 percent of GDP; medium-term objective: a small surplus.
- Government has fully financed 2011 needs; gross financing needs next year include some 8 percent of GDP, including refinancing euro bonds issued in 2002 and 2006.
- Government debt approaching 40 percent of GDP (up from 15.5 percent of GDP in 2008).
- Population projections: population projected to fall by 20 percent between 2010 and 2060; dependency ratio rising from 1-to-4 to 1-to-2.
- EC Sustainability Report projection: government spending could rise by as much as 6 percent of GDP over the long term due to aging; rising health care costs could add a further 4 percent of GDP to spending.
- Measures worth 1–1¼ percent of GDP needed to reach the 2012 target; consolidation should be sustainable.
- Potential fiscal measures/options:
  - Expand wealth taxation (property and motor vehicles), including non-commercial usage with appropriate thresholds to protect poorer owners.
  - Broaden tax bases: include all earnings categories in social contributions, eliminate CIT exemptions (such as the investment incentive), tax pensions as regular personal income.
  - Protect the most vulnerable and preserve investment levels if further spending cuts are undertaken.
- Contingency planning: draw up a list of saving measures implementable quickly if revenue growth is weaker than expected.
- Medium-term additional adjustment: cumulative adjustment of about 2 percentage points of GDP required in addition to the 2012 effort.
- Structural reforms to support consolidation:
  - Pension reform: Parliament approved gradual increase in pension age to 65 for both men and women (from 62.5 and 60, respectively); expected to deliver at least 1 percent of GDP in annual savings over the long run but insufficient alone; support for guidelines to link future benefits to demographic factors; consider separating basic social pension and financing from general budget.
  - Health care reform: consolidating hospitals and concentrating medical procedures in fewer, higher-volume centers to benefit from economies of scale.
  - State-owned enterprises (SOEs): SOE assets account for some 25 percent of GDP; completed a major inventory of SOE assets; need for rigorous cost-benefit analysis and governance reform (independence and professional experience of boards).
  - Tax compliance: ambitious compliance strategy supported by Fund technical assistance; Commission for Coordination of Cooperation among State Economic and Financial Control Authorities set up; State Tax Inspectorate (STI) focusing resources on a relatively small number of large and medium-size businesses representing about half of total turnover; new training programs for tax inspectors; legislative changes to collect unpaid taxes from enterprises facing bankruptcy; plans to expand use of cash registers, reduce loopholes in business licenses, and step up fight against border smuggling.
- Fiscal framework improvements under consideration:
  - Amendments to tighten rules on the use of Treasury reserves, strengthen independent evaluation in budget planning and execution, and introduce an additional fiscal rule requiring a decline in the headline deficit of at least 0.6 percent of GDP whenever the projected output gap is positive.
  - Staff view: tighter access to fiscal reserves would help discipline spending; independent evaluation should be entrusted to a new body such as a fiscal council.
  - Staff commentary on the additional rule: linking to the sign of the projected output gap is hard to manage effectively and the 0.6 percent of GDP requirement would seem arbitrary; recommend complementing existing expenditure rule with a "debt brake" to bring debt to well below 40 percent of GDP.

*Source: REPUBLIC OF LITHUANIA 2011 ARTICLE IV REPORT — Appendix II).*

### 19.      The authorities underlined their

### _cr11326 - 19.      The authorities underlined their

### Fiscal stance and 2012 fiscal target
- Authorities committed to the 2012 fiscal deficit target of 2.8 percent of GDP.
- Difficulty of introducing new taxes in an election year; plan to meet the target by:
  - increasing non-tax revenue and reducing spending;
  - higher dividend receipts from SOEs of about ½ percent point of GDP in 2012 (given strong SOE financial performance in 2011);
  - land sales could yield ¼ percent of GDP;
  - change in valuation method for the land tax (administered by local governments) could yield ¼ percent of GDP;
  - reducing ministries’ spending allocations by 2 percent across the board, saving another ¼ percent of GDP.
- Contingency: consider a supplementary budget should downside risks to revenues materialize.
- Ongoing work on the fiscal rule; authorities will take into account staff’s suggestions.

### Banking system resilience — performance and profitability
- Recovery boosted banking system performance; NPLs stabilized after rising sharply from mid-2008 to end-2009.
- Several banks reduced loan loss provisions after aggressive provisioning earlier.
- Cumulative profits in the four quarters to 2011Q2 reached €188 million, compared with €1 billion in losses in previous four quarters.
- Return on assets improved from negative 4.8 percent at end-2009 to positive 1.3 percent in the most recent four quarters.

### Banking system capitalization and liquidity
- Capital increases in 2009-10 amounted to 3 percent of GDP or 40 percent of bank capital measured at end 2008.
- Prudential ratios (2011Q2):
  - average capital adequacy ratio: 14.8 percent;
  - Tier 1 ratio: 11.4 percent;
  - core Tier 1 ratio: 10.3 percent (above future Basel III requirements).
- Liquid assets:
  - average ratio of liquid assets to current liabilities: slightly above 40 percent (regulatory minimum 30 percent);
  - central bank preliminary calculations: liquidity coverage ratio close to 200 percent;
  - net stable funding ratio slightly below 100 percent (Basel III minima for the latter two are 100 percent).

### Credit growth and supply-demand dynamics
- Supply factors not seen as main reason for low credit growth; weak stock and flow credit indicators reflect lack of demand as corporations and households repair balance sheets.
- Banks tightened lending standards on construction and real estate sectors but not on export sectors.
- Anecdotal evidence of competition among banks to provide credit to good corporate borrowers.

### Stress testing and shock absorption
- Bank of Lithuania (BOL) stress tests: under a 13 percentage point decline in export volumes and a 260–440 basis point spike in interest rates, aggregate and median CARs would still remain above 10 percent.
- Aggregate liquidity ratio would remain above 30 percent with a 10 percent deposit drain and fall only marginally below 30 percent with a 15 percent deposit drain.
- Foreign-owned banks dependent on parent funding; average loan-to-deposit ratio about 150 percent; parents did not curtail funding abruptly in 2009–10.

### Remaining weaknesses and supervisory recommendations
- A few banks (accounting for 15-20 percent of deposits) without liquidity backstops from foreign parents:
  - have set aside lower provisions despite higher NPL ratios;
  - under adverse BOL scenarios did not meet minimum capital requirements.
- Recommended actions:
  - prompt corrective action to address weaknesses;
  - supervisors should enforce conservative risk assessments, require adequate loan loss provisions, and demand capital increases when warranted;
  - law provides authority to take adequate measures if needed;
  - broaden the range of resolution tools (for example, include a purchase and assumption option) in line with European and global initiatives and earlier Fund technical assistance.

### Unification of financial supervision
- Current structure: central bank supervises banks; insurance and securities companies supervised by separate commissions.
- Draft law in parliament would unify supervision (and a newly created consumer protection agency) under the BOL; preparations to implement new organizational structure in early 2012 are well under way.
- Important governance point: head of supervision should report directly to the highest governing body of the BOL (draft law currently silent about reporting responsibilities).
- Imminent introduction of responsible lending guidelines (including limits on loan-to-value and debt service-to-income ratios) should help contain systemic risk.

### Insolvency regimes
- Corporate insolvency regime exists but is widely regarded as too slow; law does not provide adequate guidance to judges.
- New personal insolvency law in parliament:
  - broadly in line with Fund advice;
  - areas for improvement: allow creditors (not only debtors) to initiate bankruptcy proceedings; add collective enforcement mechanisms when no plan has been submitted/approved or proceedings have been declared terminated;
  - ensure availability of advisory services to debtors on their rights under the new regime.
- Authorities do not plan to allow creditors to initiate personal bankruptcy proceedings; they consider civil courts provide enough recourse.

### Sustaining medium-term growth — composition and potential
- Need for balanced growth: reallocate resources to tradable sectors to support productivity and minimize external imbalances.
- Contribution of tradable sectors to the recovery about 50 percent, much higher than during the pre-crisis boom.
- No clear evidence yet of stronger employment growth in tradables versus nontradables.
- Investment concerns:
  - investment to GDP ratio fell sharply during the crisis;
  - staff’s central medium-term scenario: lower investment will lead to lower labor productivity growth;
  - staff estimates potential growth of 3½–4 percent, implying slower convergence of living standards to the EU average than before.

### Labor market, employment, and policy recommendations
- To sustain even 4 percent potential output growth amid lower investment and a shrinking labor force, employment ratio needs to rise from around 60 percent to some 65 percent in the medium-term in staff baseline forecasts.
- Recommendations to facilitate labor reallocation and job creation:
  - support plans to make permanent changes to the Labor Code allowing greater use of fixed term contracts for new vacancies;
  - consider extending temporary crisis measures that reduced firing costs on permanent contracts;
  - fully use EU funds for job schemes, training programs, and enhanced labor bureau efficiency.
- Caution on minimum wage increases: proposals to raise the minimum wage should be evaluated carefully since they might slow job creation, reverse competitiveness gains, and increase government spending (wages and benefits tied to the minimum wage).
- Authorities noted potential benefits of raising the minimum wage (enhance labor supply incentives, improve reporting of wages for tax purposes, reduce income inequality) but recognized trade-offs.

### Business environment and competitiveness
- Progress: requirements for starting a business streamlined; need to ensure shorter timetable for obtaining construction permits is implemented.
- New law on business inspections is welcomed (separates policy making from implementation, increases transparency, strengthens coordination).
- Support for proposed law to strengthen the role of the Competition Council to allow more proactive investigations of breaches of competition rules.

### Euro adoption and Maastricht criteria
- Staff supports intention to meet the Maastricht criteria in 2012.
- Exchange rate arrangement: both de facto and de jure currency board pegged to the euro.
- Meeting the 2012 fiscal deficit target of 2.8 percent of GDP is important for the MTO and euro adoption aspirations.
- With regard to the inflation criterion, price controls should not be used to reduce inflation.
- Authorities acknowledged inflation could be above the criterion in 2012 but did not intend to take unorthodox measures to reduce inflation.

### Staff appraisal — summary of policy priorities
- Economy staged an impressive recovery; policy action included sizeable fiscal consolidation, maintenance of confidence in the banking system, and significant wage adjustment.
- With weaker external demand and higher external financing costs, growth will slow sharply in 2012; risks are on the downside.
- Further fiscal consolidation needed to preserve Lithuania’s good fiscal record; some proposed one-off measures (extraordinary SOE dividends and land sales) do not appear sustainable.
- Important to protect the most vulnerable and preserve public investment when implementing spending cuts; expand wealth taxation and broaden tax bases as options; prepare a contingency plan of further measures given downside growth risks.
- Deepen fiscal reforms: pension reform for long-term sustainability; enhance cost-benefit analysis and governance reforms for SOEs; improve tax compliance; expand independent evaluation in budget planning and consider strengthening the existing expenditure rule.
- Banking sector: address remaining pockets of weakness without delay, broaden resolution tools, ensure conservative risk assessment, adequate provisioning, and capital increases where needed.
- Unification of supervision under BOL will strengthen risk identification; head of supervision should report directly to the highest governing body of the central bank; responsible lending guidelines welcome.
- Sustainable medium-term growth depends on increased labor participation, reallocation to tradable sectors, and strong investment; use EU structural funds to address skill mismatches and improve the business environment (new law on business inspections and proposed Competition Council law welcome).
- Proposed timing: hold the next Article IV consultation on the regular 12-month cycle.

*Source: _cr11326 - 19.      The authorities underlined their*

### Box 2. Time-Varying Tax Elasticities

### Box 2. Time-Varying Tax Elasticities

### Summary of empirical findings
- VAT revenue accounts for about half of total tax revenue in Lithuania.
- Historical, cross-country evidence suggests tax revenues grow more quickly than their underlying bases during expansions and contract more sharply during recessions.
- Short-run deviations of tax elasticities from long-run equilibria can be driven by short-changes in the composition of tax bases and cyclical variations in tax compliance.
- Staff analysis finds that the elasticity of VAT has fluctuated between 0.5 and 1.5 over the past decade.
- Using a panel of 10 new EU member countries, staff analysis finds robust evidence of the long-run neutrality (i.e. unit elasticity) of VAT revenue with respect to private consumption (tax base).

### Dynamics of short-run deviations
- VAT revenue can and does deviate from its long-run value, with the deviation falling by about 10 percent each quarter (or 60 percent each year).
- According to the analysis, VAT revenues in Baltic countries deviated from their long-run levels during the recent boom and bust:
  - At the peak of the boom, VAT collections exceeded their long-run equilibrium by about 20 percent in Latvia and 10 percent in Lithuania and Estonia.
  - The gap turned negative in the aftermath of the crisis, particularly in Latvia and Lithuania, but is now closing again.
  - In Lithuania, VAT revenue is estimated to have been about 5 percent below its long-run value at end-2010.

### Implications
- Short-run VAT elasticity can be substantially different from the long-run (unit) elasticity, implying that revenue projections based only on long-run elasticities may misstate short-term fiscal dynamics.
- Monitoring cyclical gaps (deviations from long-run VAT equilibrium) is important for understanding revenue swings during booms and busts.

*Source: Box 2, "Time-Varying Tax Elasticities", Selected Issues Paper referenced in the Republic of Lithuania 2011 Article IV Report.*

### Box 4. Medium-Term Growth Prospects

### Box 4. Medium-Term Growth Prospects

### Overview
- Empirical specifications linking growth to initial income, investment, education, institutional quality, and quality of macroeconomic policies suggest medium-term growth rates in the Baltic countries will be in the range of 3¼–4¼ percent.
- This projected medium-term growth is 4–5 percentage points lower than during the 2002–07 boom.

### Reasons for the Lower Medium-Term Growth Projection
- Growth during the boom was unsustainably high.
  - Estimating the same models in 2002 would have predicted growth rates about 2–2½ percentage points below actual growth during the boom.
- Higher income per capita today implies slower conditional convergence.
  - In all three Baltic countries, income per capita was higher in 2010 than in the early 2000s despite the 2008–09 output collapse.
  - Econometric estimates suggest the convergence effect accounts for about ¾ percentage point of the projected decline in growth.
- Investment has fallen sharply and may be slow to recover.
  - Investment ratios were artificially boosted during the boom and were more than fully wiped out by the crisis.
  - Non-construction investment also plummeted and is now about half the level seen over much of the last 15 years.
  - If investment today was at 1998 levels, ceteris paribus, yearly predicted growth would be 1 percentage point higher in Latvia and Lithuania, and 1¾ percentage points in Estonia.
- Labor productivity and labor force dynamics
  - Lower investment will imply slower growth of labor productivity and hence a slower catch-up of living standards with the EU average.
  - Labor productivity is projected to grow between 3¼–3¾ percentage points more slowly than during the boom years.
  - The slowdown in labor productivity will coincide with expectations of a shrinking labor force due to population aging and emigration.
  - Sustaining even 4 percent GDP growth will thus require large increases in employment ratios.

### Models and Evidence Referenced
- Empirical growth models used in the literature that relate economic growth to:
  - initial income
  - investment
  - education
  - institutional quality
  - quality of macroeconomic policies
- Historical model backcasts indicate boom-period growth exceeded model predictions by about 2–2½ percentage points.
- Investment recovery scenarios: comparison to 1998 investment levels yields precise predicted growth uplifts (1 percentage point for Latvia and Lithuania; 1¾ percentage points for Estonia).

### Key Quantitative Findings (as stated)
- Medium-term growth projection for Baltic countries: 3¼–4¼ percent.
- Drop relative to 2002–07 boom: 4–5 percentage points.
- Model underprediction in 2002 vs boom outturn: about 2–2½ percentage points.
- Contribution of convergence to decline: about ¾ percentage point.
- Impact of investment at 1998 levels on predicted growth:
  - Latvia: +1 percentage point
  - Lithuania: +1 percentage point
  - Estonia: +1¾ percentage points
- Slower labor productivity growth vs boom years: between 3¼–3¾ percentage points.
- Required policy implication: sustaining 4 percent GDP growth would require large increases in employment ratios.

### Reference in Source
- See Selected Issues Paper, “How Fast Can the Baltics Grow in the Medium Term?”

*Source: Box 4. Medium-Term Growth Prospects, REPUBLIC OF LITHUANIA 2011 ARTICLE IV REPORT (IMF staff).*

### Annex 1. Lithuania: External Debt Sustainability Framework, 2006-2016

### Annex 1. Lithuania: External Debt Sustainability Framework, 2006-2016

### External debt and stress-test overview
- Charts present baseline and scenario paths for external debt (percent of GDP) over 2006–2016 under shocks:
  - Interest rate shock: shown as percentage series across 2006–2016.
  - Current account (CA) shock.
  - Growth shock (Percent per year).
  - Real depreciation shock: one-time real depreciation of 30 percent occurs in 2011.
  - Combined shock and combined shock (permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance).
- Notes on scenarios:
  - Individual shocks are permanent one-half standard deviation shocks.
  - Figures in boxes represent average projections for the respective variables in the baseline and scenario; ten-year historical average for the variable is also shown.
  - Shaded areas represent actual data.

### Bound tests and scenario averages (illustrative values shown)
- Historical, baseline, and scenario average values are displayed for key variables (examples in figure annotations):
  - Baseline: 3.6; Scenario: 3.8; Historical: 4.1 (context: baseline/historical/growth averages appear in figure captions).
  - Baseline: 4.1; Scenario: 0.5; Historical: 5.3.
  - Baseline: -0.5; Scenario: -3.1; Historical: -4.2.

### Public sector debt projections (Baseline, percent of GDP unless otherwise indicated)
- Public sector debt (coverage note present: indicate coverage of public sector e.g., general government or nonfinancial public sector; net or gross not specified):
  - 2006: 17.9
  - 2007: 16.8
  - 2008: 15.5
  - 2009: 29.4
  - 2010: 38.0
  - 2011: 37.5
  - 2012: 38.8
  - 2013: 38.7
  - 2014: 38.2
  - 2015: 37.6
  - 2016: 36.8
- Share of foreign-currency denominated public sector debt:
  - 2006: 14.5
  - 2007: 14.0
  - 2008: 12.8
  - 2009: 27.0
  - 2010: 34.2
  - 2011: 32.2
  - 2012: 32.6
  - 2013: 31.8
  - 2014: 30.6
  - 2015: 30.1
  - 2016: 29.4

### Change in public sector debt and identified debt-creating flows (percent of GDP)
- Change in public sector debt:
  - 2006: -0.4
  - 2007: -1.1
  - 2008: -1.3
  - 2009: 13.9
  - 2010: 8.6
  - 2011: -0.5
  - 2012: 1.3
  - 2013: -0.1
  - 2014: -0.5
  - 2015: -0.6
  - 2016: -0.8
- Identified debt-creating flows (sum of 4+7+12):
  - 2006: -3.3
  - 2007: -3.4
  - 2008: 1.8
  - 2009: 11.3
  - 2010: 8.9
  - 2011: 0.9
  - 2012: 0.4
  - 2013: -0.1
  - 2014: -0.5
  - 2015: -0.6
  - 2016: -0.8

### Primary deficit, revenue, and primary expenditure (percent of GDP)
- Primary deficit:
  - 2006: -0.3
  - 2007: 0.3
  - 2008: 2.6
  - 2009: 7.9
  - 2010: 5.2
  - 2011: 3.2
  - 2012: 1.1
  - 2013: 0.6
  - 2014: 0.1
  - 2015: -0.1
  - 2016: -0.3
- Revenue and grants:
  - 2006: 33.3
  - 2007: 33.8
  - 2008: 34.0
  - 2009: 34.7
  - 2010: 34.3
  - 2011: 33.2
  - 2012: 34.4
  - 2013: 33.9
  - 2014: 33.4
  - 2015: 33.0
  - 2016: 32.7
- Primary (noninterest) expenditure:
  - 2006: 33.0
  - 2007: 34.1
  - 2008: 36.6
  - 2009: 42.6
  - 2010: 39.5
  - 2011: 36.4
  - 2012: 35.5
  - 2013: 34.5
  - 2014: 33.6
  - 2015: 32.9
  - 2016: 32.4

### Automatic debt dynamics and contributions (percent of GDP)
- Automatic debt dynamics:
  - 2006: -2.8
  - 2007: -3.5
  - 2008: -0.7
  - 2009: 4.1
  - 2010: 3.7
  - 2011: -2.3
  - 2012: -0.7
  - 2013: -0.7
  - 2014: -0.6
  - 2015: -0.5
  - 2016: -0.5
- Contribution from interest rate/growth differential:
  - 2006: -1.7
  - 2007: -2.2
  - 2008: -1.3
  - 2009: 4.7
  - 2010: 0.9
  - 2011: -2.3
  - 2012: -0.7
  - 2013: -0.7
  - 2014: -0.6
  - 2015: -0.5
  - 2016: -0.5
- Of which contribution from real interest rate:
  - 2006: -0.4
  - 2007: -0.7
  - 2008: -0.8
  - 2009: 1.9
  - 2010: 1.3
  - 2011: -0.1
  - 2012: 0.6
  - 2013: 0.7
  - 2014: 0.7
  - 2015: 0.8
  - 2016: 0.9
- Of which contribution from real GDP growth:
  - 2006: -1.2
  - 2007: -1.5
  - 2008: -0.4
  - 2009: 2.8
  - 2010: -0.4
  - 2011: -2.1
  - 2012: -1.2
  - 2013: -1.3
  - 2014: -1.4
  - 2015: -1.4
  - 2016: -1.4
- Contribution from exchange rate depreciation:
  - 2006: -1.1
  - 2007: -1.3
  - 2008: 0.5
  - 2009: -0.6
  - 2010: 2.8
  - 2011: ... (ellipsis in source)

### Other identified flows and residuals
- Other identified debt-creating flows:
  - 2006: -0.2
  - 2007: -0.2
  - 2008: -0.1
  - 2009: -0.8
  - 2010: -0.1
  - 2011: 0.0
  - 2012: 0.0
  - 2013: 0.0
  - 2014: 0.0
  - 2015: 0.0
  - 2016: 0.0
- Privatization receipts (negative):
  - 2006: -0.2
  - 2007: -0.2
  - 2008: -0.1
  - 2009: -0.8
  - 2010: -0.1
  - 2011–2016: 0.0 (each year)
- Recognition of implicit or contingent liabilities:
  - 2006–2016: 0.0 (each year)
- Other (e.g., bank recapitalization):
  - 2006–2016: 0.0 (each year)
- Residual, including asset changes (2-3):
  - 2006: 2.9
  - 2007: 2.3
  - 2008: -3.1
  - 2009: 2.6
  - 2010: -0.3
  - 2011: -1.9
  - 2012: 1.0
  - 2013–2016: 0.0 (each year)

### Ratios and gross financing need
- Public sector debt-to-revenue ratio:
  - 2006: 54.0
  - 2007: 49.8
  - 2008: 45.6
  - 2009: 84.5
  - 2010: 110.9
  - 2011: 112.9
  - 2012: 112.8
  - 2013: 114.3
  - 2014: 114.3
  - 2015: 114.1
  - 2016: 112.4
- Gross financing need (percent of GDP):
  - 2006: 5.6
  - 2007: 2.8
  - 2008: 4.9
  - 2009: 14.1
  - 2010: 10.1
  - 2011: 9.8
  - 2012: 7.9
  - 2013: 7.8
  - 2014: 6.1
  - 2015: 7.6
  - 2016: 7.5
- Gross financing need in billions of U.S. dollars:
  - 2006: 1.7
  - 2007: 1.1
  - 2008: 2.3
  - 2009: 5.2
  - 2010: 3.7
  - 2011: 4.3
  - 2012: 3.7
  - 2013: 3.8
  - 2014: 3.2
  - 2015: 4.2
  - 2016: 4.4

### Alternative scenarios (brief)
- Scenario with key variables at their historical averages (real GDP growth; real interest rate; and primary balance in percent of GDP):
  - 2011: 37.5
  - 2012: 39.5
  - 2013: 40.6
  - 2014: 41.6
  - 2015: 42.7
  - 2016: 43.7
  - Debt-stabilizing primary balance (footnote 9): -0.6 (appears associated with scenario)
- Scenario with no policy change (constant primary balance) in 2011–2016:
  - 2011: 37.5
  - 2012: 40.9
  - 2013: 43.4
  - 2014: 45.9
  - 2015: 48.5
  - 2016: 51.1
  - Debt-stabilizing primary balance (footnote 9): -0.3

### Key macroeconomic and fiscal assumptions underlying baseline
- Real GDP growth (in percent):
  - 2006: 7.8
  - 2007: 9.8
  - 2008: 2.9
  - 2009: -14.8
  - 2010: 1.4
  - 2011: 6.3
  - 2012: 3.5
  - 2013: 3.7
  - 2014: 3.8
  - 2015: 3.8
  - 2016: 3.8
- Average nominal interest rate on public debt (in percent):
  - 2006: 4.6
  - 2007: 4.7
  - 2008: 4.5
  - 2009: 6.9
  - 2010: 6.6
  - 2011: 5.7
  - 2012: 5.1
  - 2013: 5.2
  - 2014: 5.2
  - 2015: 5.2
  - 2016: 5.2
- Average real interest rate (nominal rate minus change in GDP deflator, in percent):
  - 2006: -2.0
  - 2007: -3.9
  - 2008: -5.2
  - 2009: 10.6
  - 2010: 4.6
  - 2011: 0.0
  - 2012: 1.7
  - 2013: 2.0
  - 2014: 2.1
  - 2015: 2.5
  - 2016: 2.6
- Nominal appreciation (increase in US dollar value of local currency, in percent):
  - 2006: 10.6
  - 2007: 11.6
  - 2008: -3.8
  - 2009: 3.6
  - 2010: -9.5
  - 2011: ... (ellipsis in source)
- Inflation rate (GDP deflator, in percent):
  - 2006: 6.6
  - 2007: 8.6
  - 2008: 9.8
  - 2009: -3.7
  - 2010: 2.0
  - 2011: 5.7
  - 2012: 3.4
  - 2013: 3.2
  - 2014: 3.0
  - 2015: 2.7
  - 2016: 2.6
- Growth of real primary spending (deflated by GDP deflator, in percent):
  - 2006: 8.8
  - 2007: 13.6
  - 2008: 10.5
  - 2009: -0.8
  - 2010: -6.1
  - 2011: -2.1
  - 2012: 1.0
  - 2013: 0.8
  - 2014: 1.0
  - 2015: 1.6
  - 2016: 2.3

### Methodological footnotes (selected)
- Automatic debt dynamics derived as: [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
- Real interest rate contribution derived from denominator in footnote 2/ as r - π(1+g) and real growth contribution as -g.
- Exchange rate contribution derived from numerator in footnote 2/ as ae(1+r).
- Residual line (for projections) includes exchange rate changes.
- Gross financing need defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.
- Key variables for the historical-average scenario: real GDP growth; real interest rate; and primary balance in percent of GDP.
- Average nominal interest rate on public debt derived as nominal interest expenditure divided by previous period debt stock.
- Debt-stabilizing primary balance assumes key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

_International Monetary Fund. Annex 1. Lithuania: External Debt Sustainability Framework, 2006-2016._

### Annex 4. Lithuania: Public Debt Sustainability:  Bound Tests  1/ 2/

### Annex 4. Lithuania: Public Debt Sustainability: Bound Tests 1/ 2/

### Public debt scenarios and shocks
- Public debt is presented as "Public debt in percent of GDP."
- Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks.
- Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.
- For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.
- The growth shock is noted as extreme, modeled in part on the 2008-10 GDP collapse.
- Permanent 1/4 standard deviation shocks applied to:
  - real interest rate,
  - growth rate,
  - primary balance.
- One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2010, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

### Baseline and scenario averages (figures shown in boxes)
- Historical: 44
- Baseline: 37
- Combined shock: 47
- Combined shock (with 30% depreciation): 52
- Contingent liabilities shock: 46

### Gross financing needs and primary balance scenarios
- Baseline primary balance: -0.3 (Percent of GDP)
- Scenario primary balance: -1.6 (Percent of GDP)
- Historical primary balance: -1.8 (Percent of GDP)
- Baseline: 3.7
- Scenario: 0.0
- Historical: 4.6
- Baseline: 2.2
- Scenario: 4.9
- Historical: 2.6
- Gross financing need under baseline shown on right scale in figures (no additional numeric series provided in text).

### Key methodological notes relevant for interpretation
- Real depreciation measured as nominal depreciation minus domestic inflation (GDP deflator).
- Contingent liabilities shock specified as 10 percent of GDP occurring in 2010.
- Shocks include both one-time events (real depreciation, contingent liabilities) and permanent stochastic shocks (1/2 and 1/4 standard deviation specifications described).

### Selected complementary findings and projections from surrounding annex material
- General government gross debt:
  - 2008: 15.5 (In percent of GDP)
  - 2009: 29.4 (In percent of GDP)
  - 2010: 38.0 (In percent of GDP)
  - 2011 projection: 37.5 (In percent of GDP)
- Foreign currency-denominated public debt:
  - 2008: 12.8 (In percent of GDP)
  - 2009: 27.0 (In percent of GDP)
  - 2010: 34.6 (In percent of GDP)
  - 2011 projection: 32.2 (In percent of GDP)
- General government balance:
  - 2008: -3.3 (In percent of GDP)
  - 2009: -9.5 (In percent of GDP)
  - 2010: -7.1 (In percent of GDP)
  - 2011 projection: -5.1 (In percent of GDP)

*Source: IMF staff report annex material contained in the provided PDF content.*

### 11.2 percent over the year. However, some banks still need to increase loan loss provisioning

### _cr11326 - 11.2 percent over the year. However, some banks still need to increase loan loss provisioning

### Financial sector overview and risks
- Banking sector growth noted as "11.2 percent over the year."
- Some banks still need to increase loan loss provisioning and strengthen the capital base.
- Banks operating in Lithuania have only limited direct exposure to the sovereign debt of the Southern European countries.
- Spillovers that affect demand for export and the conditions for sovereign financing are considered a more important risk.

### Regulatory and supervisory reforms advanced in 2011
- Consolidation of financial sector supervision under the Bank of Lithuania:
  - Objective: achieve economies of scope in supervising Lithuania’s bank-based financial system and ensure better coordination and systemic risk management.
  - Reform foresees transferring the insurance and securities sector supervision function to the central bank, which will also assume responsibility to provide consumer financial protection services.
  - The reformed supervisory authority will report to the designated member of the board of the Bank of Lithuania.
  - The financial supervision function will be financed from market participants’ contributions and the central bank’s resources.
  - The reform will enhance the institutional, political, operational, and financial independence in carrying out the financial sector supervision.
  - Necessary legal amendments have been presented to the Parliament and should be passed into law by December 2011.
  - Operational preparedness to implement the foreseen reforms from the beginning of 2012 is well advanced.

- Prudential framework strengthened:
  - Adoption of the Regulations for Responsible Lending that established clear limits on loan-to-value, loan-to-income, loan maturity, and strengthened the requirements for banks to inform customers about the borrowing risks.

### Cross-border crisis management and cooperation
- Progress on operational preparedness for cross-border crisis management:
  - Lithuanian authorities signed the Nordic-Baltic cooperation agreement on cross-border financial stability, crisis management, and resolution.
  - Participation in the Nordic-Baltic Cross-Border Stability Group, established to implement the provisions of the agreement.
  - Continued participation in the supervisory colleges established to supervise the cross-border banking groups.

### Insolvency framework for natural persons
- With the help of the Fund’s technical assistance, the authorities prepared the law on natural persons’ bankruptcy that should be adopted by December 2011.
- The law will enhance the insolvency regime by providing opportunities for orderly natural persons’ debt restructuring.

*Source: _cr11326 - 11.2 percent over the year. However, some banks still need to increase loan loss provisioning*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11326.pdf_