Public Information Notice No. 10/80

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with the Republic of Lithuania

July 8, 2010

On July, 06, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

A determined policy response helped Lithuania weather the crisis. The country experienced a severe output decline in 2009 as a reversal in capital flows led to a collapse of domestic demand and the global recession caused exports to fall. Output dropped by 14.8 percent in 2009 and by 20 percent from peak to trough. The adjustment of the economy has been large and swift. The current account swung from a sizeable double-digit deficit to a surplus of nearly 4 percent of GDP in 2009. Inflation quickly ebbed, with core prices now falling for over a year. Wages have also declined sharply and unemployment rose to very high levels.

A large fiscal consolidation with measures worth about 10 percent of GDP in the 2009–10 budgets contained the fiscal deficit to 8.9 percent of GDP in 2009. The early and sizeable fiscal adjustment was rewarded with access to international bond markets at declining cost. Still, the public debt burden has doubled, reaching 33 percent of GDP at end-March 2010. In the financial sector, capital and liquidity indicators have improved aided by new capital injections. However, asset quality has suffered. The non-performing loan ratio rose almost four-fold from end-2008 to 19.2 percent by end-March 2010. Provisions in the system increased to about 40 percent of the non-performing loan stock but banks are making large losses and credit is contracting.

Lithuania is now benefitting from the global recovery. Recent data are encouraging, with signs that an economic recovery is starting to take hold. In 2010, real GDP is expected to grow by 2 percent on the back of an export-led recovery. Deflation in core CPI is expected to persist, although higher energy and food prices will leave headline inflation close to zero. Over the medium term, domestic demand is likely to remain subdued amid high unemployment, falling incomes, and weak credit prospects. As such, a return to pre-crisis growth rates is unlikely and real GDP is only expected to recover its pre-crisis levels in 2014/15.

Executive Board Assessment

Executive Directors commended the authorities for their decisive fiscal and financial sector policies during the crisis, which helped stabilize the economy and generate a recovery. Notwithstanding encouraging signs, the Lithuanian economy faces important challenges of high fiscal deficits and rapidly growing public debt as well as a high stock of non-performing bank loans. In addition, growth needs to rebalance towards exports. Addressing these challenges will sustain the recovery and facilitate euro adoption.

Directors commended the large fiscal consolidation implemented in the 2009 and 2010 budgets. Nevertheless, further consolidation is critical to maintain confidence, reduce borrowing needs, and place debt on a sustainable path. Directors recommended a timely announcement of a package of specific expenditure and revenue measures so as to underpin the credibility of the consolidation path and ensure that it is achieved in a sustainable, growth-friendly, and equitable manner.

Directors emphasized that far-reaching reform of the social insurance system will be necessary to tackle its large deficit. They saw scope to reduce generous social benefits and restore the viability of the pension system by increasing the retirement age and gradually moving towards a mandatory funded system, while ensuring adequate funding for the minimum basic pension. Expenditure adjustment will need to be complemented with revenue enhancing measures as part of a broad-based package. In particular, it will be important to exploit new, less distortive revenue sources, such as wealth taxes and to strengthen tax compliance.

Directors noted that, overall the financial sector had weathered the crisis well, with both liquidity and capital indicators improving despite rising levels of non-performing loans. They cautioned however that some banks are not as well provisioned and capitalized, and also face pressure on interest rate margins. Directors considered it important that banks be subjected to forward-looking stress tests to ensure their viability. They commended the ongoing efforts to fine-tune the legal framework to facilitate voluntary debt restructuring and cautioned against mandatory moratoriums on debt payments that risk increasing the level of non-performing loans in the banking system.

Directors emphasized that export performance would be key to future growth. They noted that Lithuania’s success in preserving cost competitiveness during the boom was supported also by adjustment and on-going decline in wages. This has contributed to the credibility of the currency board arrangement as an anchor for macroeconomic policy. Directors nevertheless emphasized that continued progress in structural reforms was needed to reorient the economy towards tradeables as a source of growth.

Directors stressed that high and rising levels of unemployment call for decisive action. They supported the plans to enhance labor market flexibility and proposals in parliament to expand fixed-term contracts, ease dismissal requirements, and allow greater flexibility in overtime. Effective use of European Union funds to support job creation will be crucial. Directors also welcomed initiatives to improve the business climate and attract foreign direct investment. These initiatives, coupled with ongoing structural reforms, would enhance medium-term growth prospects.