Mission Concluding Statement 

Republic of Lithuania: Staff Concluding Statement of the 2023 Article IV Mission

June 12, 2023

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.