Public Information Notice No. 09/104

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with the Republic of Lithuania

August 11, 2009

On August 7, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

The Lithuanian economy is undergoing a severe adjustment, after years of rapid economic growth and financial integration. With the global financial crisis, the unwinding of the imbalances accumulated during the boom has led to a sharp economic contraction. Capital inflows came to a halt in late 2008 and reversed in 2009, and the current account deficit turned into a surplus. GDP growth for the first half of the year has been provisionally assessed at -18.1 percent (y/y). Price and wage pressures have quickly abated with inflation going down to 4.2 percent as of June, and wages in the private sector are adjusting rapidly.

Government finances have come under considerable strain with the legacy of a sizable structural deficit built up during the boom and the sharp correction in economic activity. By end-2008, the cyclically adjusted balance had risen to 6½ percent of GDP, notably reflecting generous wage and social benefit increases.

As tax revenues contracted by 28 percent (y/y), the headline central government fiscal deficit widened to 4.6 percent of full-year GDP by end-May 2009. The general government debt burden has risen from very low levels to 23 percent of GDP. The expansion of budget financing needs has been associated with shortening maturities and rising borrowing costs. Faced with a deterioration of the fiscal deficit and debt sustainability, the authorities have responded with a sizeable adjustment. The original budget together with the May and July 2009 supplementary budgets implemented a fiscal adjustment exceeding 7½ percent of GDP through a combination of spending cuts and tax increases but also a temporary reduction in transfers to the second pension pillar. Financial assistance from the European Investment Bank and a successful €500 million eurobond issue in June helped ease immediate fiscal financing needs, and the latter reopened access to international capital markets. The eurobond also helped to boost international reserves: by end-June international reserves stood at €4.45 billion, up from €4.2 billion end-May but still down from end-2008 levels. Although international reserves cover 145 percent of the central bank’s total liabilities in domestic currency, they only cover 3 months of imports and about 46 percent of short-term debt (remaining maturity).

The banking system is in the midst of a pronounced credit contraction reflecting deteriorating asset quality, lower funding, and lack of credit demand. The stock of credit to the private sector has already declined by 4.1 percent in the first six months of 2009. The banking system remains well capitalized overall—with a capital adequacy ratio (CAR) at 13.9 percent as of Q1 2009—but the stock of non performing loans increased rapidly to 8.2 percent while loan loss provisioning increased, albeit, at a lower pace. In October 2008, a deposit run drained 6½ percent of total deposits and while liquidity has since stabilized, deposits have shifted increasingly into foreign currencies. The Bank of Lithuania (BoL) has reacted swiftly to these challenges. Since October 2008 it reduced reserve requirements from 6 to 4 percent to help ease liquidity pressures, and improved internal guidelines for lender of last resort operations (LoLR), while monitoring daily bank-by-bank deposits and liquidity positions. The deposit insurance limit was raised to €100,000 and bank resolution tools are also being enhanced through the Financial Stability Law, which provides for government guarantees of interbank lending, as well as public support for bank recapitalization and asset purchases. The government has also established a financial crisis preparedness committee to enhance coordination.

Executive Board Assessment

Executive Directors noted that the Lithuanian economy is undergoing a painful adjustment from overheating fueled by large capital inflows and expansionary fiscal policy. The reversal in capital flows following the global crisis has led to an unprecedented economic contraction with recovery expected to take hold only in 2011. Directors considered that uncertainty around the outlook remains but with downside risks.

Directors recognized the authorities’ strong commitment to maintain the currency board arrangement, which has served as a useful macroeconomic anchor. They noted the staff’s assessment that the real effective exchange rate is moderately overvalued, while acknowledging the uncertainties surrounding these estimates. Moreover, under the currency board arrangement, the adjustment burden falls directly on domestic policies, in particular sizable fiscal consolidation, and structural reforms to improve the functioning of labor and product markets. Policies to safeguard financial stability are also crucial.

Directors praised the sizable fiscal consolidation implemented since late-2008, including the recent supplementary budgets, and the medium-term fiscal consolidation plans. Notwithstanding the ongoing economic contraction and risks of exacerbating the downturn, they recognized that fiscal adjustment is necessary to offset past expansionary policies and underpin the credibility of the currency board arrangement and the authorities’ Euro adoption strategy. Directors concurred that fiscal adjustment be achieved by front-loaded structural reform. Spending needs to be reduced to more affordable levels, primarily through wage and social benefit reform, and additional revenue measures need to be introduced, including broadening the tax base and improving compliance. Directors encouraged the targeting of social assistance programs to protect the most vulnerable, and considered that institutional reforms, such as multi-year budgeting, could also aid adjustment.

Directors observed that the banking system is well capitalized, but that liquidity and capital buffers could suffer in the recession. They commended steps taken by the authorities to respond to the crisis, including passage of the Financial Stability Law and the increase in the deposit guarantee. Noting the rise in non-performing loans, Directors advocated greater buffers in the financial system, including through accelerated loan-loss provisioning and preemptive increases in bank capital based on stress tests, as well as contingency planning. They encouraged the authorities to seek further explicit commitments from parent banks to provide necessary capital and liquidity support to their subsidiaries. Directors saw scope for closer supervision of banks with costlier funding profiles and the introduction of a purchase and assumption option to enhance bank resolution tools. They also encouraged the speedy restructuring of corporate and household debt to facilitate the recovery.

Directors saw the strength of the recovery and medium-term growth as hinging on improved competitiveness and reorientation of production towards tradables. Private sector wage adjustment, complemented by public wage reductions, is necessary to reduce costs economy-wide. Directors commended recent reforms to enhance labor market flexibility and reduce regulations. They called for further efforts to improve the business environment, including by reducing administrative burdens in business planning and land regulation, and through efficiency gains in the energy sector.