Vilnius, Lithuania:
Lithuania weathered multiple shocks, including the pandemic and an
unprecedented deterioration in the terms-of-trade following Russia’s
invasion of Ukraine, with remarkable resilience. However, the impact of
high inflation and rising interest rates amid weakening external demand
has caught up and resulted in a contraction. Persistently higher
inflation than the eurozone average—beyond what is consistent with the
convergence process—is the most important short-term risk facing
Lithuania as it would erode competitiveness and slow down the
successful convergence process. With monetary conditions that are still
too loose for Lithuania, the onus to fight inflation is on fiscal
policy. In the short-term, policies should aim at reducing inflationary
pressures and preserving financial stability. Over the medium-term,
policies should focus on implementing long-overdue structural reforms
that remain key to support further productivity gains and higher living
standards.
Recent Developments, Outlook, and Risks
The Lithuanian economy remained resilient to the negative
terms-of-trade shock until recently.
Inflation increased to an average of 19 percent in 2022—one of the highest
in the eurozone—with elevated core inflation reflecting broad-based
inflationary pressures. High inflation and rising interest rates weakened
disposable income which, combined with weak external demand, eventually
resulted in a contraction of economic activity at the end of last year that
intensified at the beginning of this year. At the same time, while lower
energy prices are expected to continue to decrease inflation rates rapidly
over the next few months, the level of inflation remains significantly
above the eurozone average. The large deterioration in the trade balance
last year was mainly driven by the commodity price shock. However,
non-energy net exports improved suggesting that, to date, the competitive
strength of the economy has not deteriorated.
The fiscal policy stance was moderately counter-cyclical in 2022,
marginally contributing to contain inflationary pressures.
Fiscal performance was, once again, significantly better-than-expected
supported by a resilient economy, windfall revenues from high inflation,
and lower-than-planned spending on energy subsidies.
Higher lending rates and a slow increase in deposit rates given ample
liquidity have led to unprecedented profitability in the banking
system.
Banks are benefiting from higher interest rates on new loans and the
repricing of variable-rate mortgages that account for the great majority of
that portfolio. The low stock of mortgages, the large share of real estate
transactions in cash and the relatively low average loan-to-value ratio
suggest that the quantitative impact on households will be limited and the
monetary transmission weaker than could have been expected.
Given the high profitability of the banking system, the government has
introduced a temporary windfall levy
. This is on top of the increase in the corporate tax rate
for big banks from 15 to 20 percent in 2019 made permanent last year. The
so-called ‘solidarity contribution’ is imposed on all credit institutions
and existing loans—new loans are excluded—and applies to the net interest
income that exceeds the average of the previous four years by more than 50
percent.
The economy is in the midst of a contraction, but a recovery is
projected later in the year.
Activity is weak in the first half of the year due to softening domestic
and external demand. The labor market has also weakened, but remains
broadly resilient. Going forward, real wage growth is expected to become
increasingly positive as inflation cools, increasing domestic demand.
Further support to economic activity will come from a significant increase
in investment supported by European funds and the expected recovery in
external demand. The trade deficit will largely reverse last year’s
deterioration as commodity prices decline. Notwithstanding lower global
energy and food prices and the recent slowdown in momentum, a weakening but
still tight labor market and second round effects may result in more
persistent inflation.
This baseline scenario is highly uncertain with risks tilted to the
downside
. External risks emanate from a further escalation of the war and uncertain
and volatile financial markets that could trigger a disorderly correction
in the real estate market. On the domestic front, the biggest risk is
persistently higher inflation than in the euro area beyond what is
consistent with the convergence process. Deviations of wages from
productivity over the last year can be accommodated as long as they are
transitory. However, if inflation remains stubbornly higher for longer,
inflation expectations might adjust upwards, perpetuating higher rates of
price and wage growth going forward. This would eventually erode
competitiveness and slow income convergence. On the upside, the economy
could prove more resilient than projected given strong underlying
fundamentals.
Macroeconomic Policy Priorities
Fiscal policy has an important role to play in containing the risks
from too high and persistent inflation.
External factors tend to be the dominant driver of inflation in Lithuania,
but domestic factors play an important role as well. The monetary
tightening by the European Central Bank (ECB)—aimed at bringing inflation
back to target in the euro area as a whole—came late for Lithuania and have
not gone far enough given domestic economic conditions. Thus, fiscal policy
is the main macro-stabilization tool available, and it should be used
proactively to reduce inflationary pressures.
The fiscal stance is expected to become moderately expansionary this
year, adding to inflationary pressures.
To mitigate the risks of high and persistent inflation and notwithstanding
weaker economic activity, a fiscal contraction this year would actively
contribute to lower inflation. At a minimum, any revenue over-performance
and unspent energy subsidies should be saved in line with the Stability
Program. Over the next few years, Lithuania’s fiscal rule will be
reactivated requiring a tightening of at least 0.5 percent of GDP per year,
which will help contain inflationary risks.
Setting moderate minimum and public sector wages to mitigate the risk
of a wage-price spiral helps anchor inflation expectations in the
private sector.
The proposal by unions and businesses to increase the minimum wage by 10
percent in 2024 stays below the current rate of inflation. Future increases
will need to be prudent not to add to inflation persistence. Furthermore,
the targeted range—45-50 percent of the average wage—negatively affects
low-skilled and young workers in rural areas whose wages are well below the
national average reflecting lower productivity.
Accommodating new and pre-existing spending pressures will likely
require new revenues under the existing fiscal targets.
Spending pressures stem from ageing, higher military spending, and
increasing interest payments on debt due to tighter financial conditions.
In addition, reducing poverty and social disparities, especially at the
regional level, will require better social programs.
Rebalancing the tax system from labor towards wealth, capital,
and environmental taxes can generate more revenue and improve
efficiency.
The recent reform of excise taxes incorporating an environmental component
is welcome but will not be enough to achieve the country’s strategy for
climate change (see below). Other tax proposals currently under
consideration will reduce distortions and increase the minimum nontaxable
income improving efficiency and equity but will largely reverse revenue
gains from the increase in excises. All in all, these reforms are a step in
the right direction but will generate limited additional revenue.
Discussions to modify the EU fiscal framework provide an opportunity to
finetune Lithuania’s fiscal rule while preserving its strong
counter-cyclical stance.
Lithuania has a history of prudent fiscal policymaking, with a fiscal rule
targeting a structural balance—more than required by the EU framework.
Marginal changes can be introduced to make the fiscal rule simpler and
accommodate some structural spending pressures, such as the permanent
increase in defense spending. Any modification should preserve ample fiscal
buffers—low deficits and debt—necessary to ensure an effective
counter-cyclical stance.
Financial Sector Policies
The levy on banks should remain temporary to avoid being perceived as a
tax on foreign investment and minimize the potential negative impact on
efficiency
. While the levy has been carefully designed to avoid
disincentivizing banks’ lending in the short-run, permanent sector-specific
taxes on excess profits tend to have a distortionary impact over time. This
is particularly the case in a banking system where, so far, efficiency,
rather than concentration, has been the main explanation for healthy levels
of profitability. Furthermore, in the current volatile environment in
international financial markets, preserving financial stability is a key
priority. Frequent ad hoc tax changes in sectors with significant foreign
investment risk weakening Lithuania’s hard-fought reputation as a stable,
predictable, and competitive tax destination.
A weakening economy and higher interest rates bring risks to the
banking sector but should remain manageable given the high liquidity,
capitalization, and profitability.
The correction in property prices is bringing valuations closer to
fundamentals in an orderly fashion so far. The negative impact of higher
interest rates and weaker economic activity on banks should be contained
given large capital buffers and profitability that are able to absorb
potential losses from a likely deterioration of the lending portfolio.
However, vulnerabilities will require close monitoring, especially if
additional shocks result in even higher interest rates and weaker
economic activity.
The authorities have proactively used macroprudential policy to build
buffers and address risks particularly from the real estate market due to
higher interest rates. A sharp downturn could cause credit supply
disruptions or a disorderly correction in the real estate market. In such a
scenario, the central bank should consider a relaxation of capital-based
macroprudential and, potentially, borrower-based measures.
There has been progress in addressing money laundering and terrorist
financing (ML/FT) risks in the financial sector responding to the
challenges coming from the fintech sector.
The Bank of Lithuania (BoL) has initiated a series of actions including
increasing ML/TF supervisory resources and in the area of risk assessment
of new and existing clients of BoL’s payment system CENTROLink. Following
these steps, the number of fintech companies has stabilized this year (263
this year vs 265 last year) after seven years of significant growth (55 in
2014). The BoL should develop a robust risk assessment methodology with the
presence of experts in the newly formed CENTROLink committee. Progress has
also been made in the virtual asset service provider (VASP) sector by
upgrading the regulatory framework and introducing a sectoral risk
assessment conducted by the Financial Intelligence Unit. Going forward
emphasis should be placed on supporting risk-based supervision and
increasing supervisory powers and market entry controls. Regarding the wider
AML/CFT framework, some deficiencies identified in the country’s 2018
MONEYVAL Mutual Evaluation report in the areas of transparency and
beneficial ownership of legal persons and cash couriers have been
addressed. Further progress is needed on addressing remaining risks in the
VASP sector and on regulation and supervision of designated non-financial
businesses and professions, through the passing of the draft amendments to
the AML/CFT law.
Structural Challenges
Preserving the flexibility of the economy and advancing long-overdue
structural reforms will be needed to support further productivity gains
and higher living standards.
The economy has remained on a balanced high-productivity growth path since
the global financial crisis with wages intricately linked to productivity.
This has been supported by a flexible labor market that is able to absorb
shocks. In this connection, the recently approved civil service reform
aimed at increasing flexibility, efficiency and accountability in the
public sector is a step in the right direction. To further improve
productivity going forward and avoid the “middle-income trap,” it is
critical to accelerate ongoing reforms in education and healthcare and close
gaps in the transportation infrastructure among others that would enhance
private sector-led growth and mitigate or even reverse negative demographic
dynamics.
Developing renewable sources of energy and improving energy efficiency
are necessary for climate change mitigation and energy security.
The new energy matrix and the transition towards it should be carefully
calibrated to avoid hampering long-term growth. Moving away from fossil
fuels and increasing energy efficiency are necessary to enhance energy
security and reduce CO2emissions in line with the country’s
pledges for climate change mitigation. However, the current pace of
reduction in emissions is not consistent with that objective. This will
require the application of a carbon tax in sectors not covered by the
Emissions Trading Scheme (ETS)—set to gradually increase to EUR60 per
metric ton of CO 2 emissions on all types of fossil fuel by
2030—and other measures including “feebates” on fossil-fuel consumption to
incentivize energy conservation and more investment in renewable energy.
The IMF team is grateful for the generous hospitality of the Lithuanian
authorities and would like to thank all its interlocutors in
government, the Bank of Lithuania, the European Central Bank, the
private sector, unions, and business associations for constructive and
fruitful discussions.