Mission Concluding Statement 

June 22, 2009

1. The Lithuanian economy is undergoing a sharp adjustment. After several years of rapid growth and widening macroeconomic imbalances in the context of the boom, the reversal in capital flows in the wake of the global financial crisis has triggered a severe contraction in the domestic economy. This shock has been compounded by the decline in export demand reflecting the on-going recession in most trading partners.

2. The contraction in economic activity is expected to be deep. The economy is forecast to shrink by 16 percent in 2009 and a further 3¾ percent in 2010 but there is a considerable range of uncertainty around these forecasts. However, they suggest from peak to trough a cumulative real decline in GDP in excess of 20 percent. The key drivers in this contraction are the retrenchment in domestic demand and the fall in exports. Private sector investment and consumption are being severely impacted by the rise in unemployment, fall in wages, tightened credit conditions and standards, and declining asset values. These trends will continue through 2010 and be compounded by the closure of Ignalina Nuclear Power Plant at end-2009. Against this backdrop, the current account has returned to balance and overall prices are declining in nominal terms. The current baseline scenario for the projections envisages the recovery starting in the second half of 2010. However, the strength and pace of the recovery will be heavily dependent on the ability of the economy to nimbly restructure itself, and on the outlook in key trading partners.

3. Courageous and skillful management of policies by the authorities since the onset of the downturn has been crucial to maintaining stability in this challenging environment. The original and May 2009 supplementary budgets implemented measures worth about 7 percent of GDP to contain the deterioration in the budget deficit in line with available financing. A successful Eurobond issue has also signaled investors’ confidence in the current stance of policies. The increase in deposit insurance coverage, reduction in reserve requirements, and support of parent banks, has preserved depositors’ confidence and eased liquidity constraints.

4. In this challenging environment, ensuring a sustainable path to Euro adoption will require a continued remarkable effort. Addressing the challenges within the currency board arrangement will need concerted action on several fronts including through:

• A sizeable consolidation in the fiscal sector: the budget deficit has risen as the revenues associated with the boom have dissipated but the legacy of unsustainable social and wage spending remain.

• The building of additional buffers in the financial system: the private sector will face increasing financial stress with implications for asset quality in the banks.

• Further wage adjustment and structural reforms: recent wage declines have only begun to unwind the imbalances accumulated over several years of wage growth in excess of productivity.

5. However, there are risks on the road ahead. While balance of payments pressures due to the adjustment in the current account have decreased, external buffers to deal with tail risks are low. A deflationary environment could increase the size of the adjustment needed in the public and private sectors and prolong the process of deleveraging.

Returning the Fiscal Deficit to a Sustainable Path

6. A prolonged period of sizeable fiscal consolidation is needed to safeguard fiscal sustainability. If deficits continue at current trends, Lithuania risks a sustained increase in its borrowing needs and costs, and a rising debt burden. Notwithstanding the substantial measures taken and proposed so far, there is an additional need for consolidation in the medium-term of about 7 percent of GDP to pave the way for euro adoption.

7. The fiscal consolidation should be guided by the need to secure a permanent improvement in the structure and effectiveness of government spending. The plans to prepare a comprehensive package of reforms to be implemented with the 2010 budget are welcome. Steps to reduce costs in the public administration and ensure the viability of the social security system should be granted high priority. Such measures are critical to bringing spending to more affordable levels by unwinding the unsustainable increases granted in recent years. In addition, it would also allow the full-restoration of transfers to the second pillar of the pension system. There is also ample scope to improve efficiency through public sector consolidation as proposed by the Sunset Committee, and effectiveness of health and education outlays. However, given the magnitude of the adjustment required, it would also be prudent to bolster revenue by taking steps to strengthen tax administration and broaden the tax base, including by streamlining tax incentives. In the current environment, there is little scope for tax cuts. Although challenging in the context of large scale adjustment, it will also be important to provide space for social safety nets to protect the most vulnerable.

8. Frontloading some of the fiscal structural reform to 2009 is important not only to address financing needs but also to anchor a strong commitment to reform. The package of measures recently proposed to parliament strikes a good balance between structural measures that realign high public sector costs with the rest of the economy and revenue measures that alleviate pressing financing needs. If approved, these measures could help bring the 2009 budget deficit to a level that should be fully financeable. Moreover, the full-year impact of these measures could be approximately Litas 1.5 billion.

9. There is also room to strengthen fiscal institutions and promote fiscal discipline. Contingent liabilities associated with government guarantees should be closely monitored, managed, and integrated into fiscal policy analysis. And looking at the medium-term, the fiscal framework needs to be revamped to promote discipline and savings in good times, and ultimately create a greater cushion for future downturns. Grounding the annual budget in a multi-year framework and formulating budget targets in cyclically adjusted terms would help to achieve this goal.

Safeguarding Financial Sector Stability

10. The banking system, largely owned by international banks, shows broadly a good level of capitalization, but it faces some challenges ahead. Non performing loans (NPLs) are on the rise and reached 8.2 percent of total loans in March 2009 (up from 4.6 percent in December 2008), covered with partial loan loss provision of about 20 percent. Unprovisioned NPLs represent a significant share of bank equity capital. Bank profitability was negative in the first quarter of 2009. Furthermore, asset quality may deteriorate further due to the sharp economic downturn. These two factors will put a significant burden on bank capital (13.9 percent of risk weighted assets). Although aggregate liquidity has recovered and stabilized compared with the last quarter of 2008, it remains vulnerable to potential shocks.

11. The Bank of Lithuania (BoL) is taking steps to increase buffers in the banking system. At the request of the BoL, banks increased their capital buffers at end-2008, by retaining current-year profits. Banks are also being urged to hold sufficient capital to address potential bank losses. Additionally, the early identification of potential problems has been enhanced by well-targeted on site examinations to help ensure that banks build up timely loan loss provisioning, and the daily monitoring of bank-by-bank deposits and liquidity positions. The BoL also expanded the list of collateral eligible for use at its liquidity window and improved associated valuation procedures. These policies could be complemented by some additional steps including accelerated loan loss provisioning, timely bank recapitalization, full semi-annual audits, and preemptive increases in capital based on enhanced stress tests exercises.

12. In line with international trends, precautionary measures are also being adopted to ensure the safety and soundness of the banking system. Temporary protection of depositors up to €100,000 by the deposit insurance corporation is being made permanent, in line with EU guidelines. To safeguard the deposit insurance scheme, the BoL should enhance supervision of banks with shorter and significantly costlier funding profiles. The draft Financial Stability Law currently before Parliament, introduces tools, such as partial and full bank capitalization by the state, for swiftly addressing banks that may face difficulties. In such situations, speed is critical to contain possible contagion within the system and maintain confidence. Under existing contingency planning procedures, drill crisis exercises should be run to identify potential weak areas in existing crisis preparedness frameworks—notably with respect to triggers and coordinating procedures. Existing stress tests could be complemented with new tests that further capture downside risks to the liquidity of banks’ assets.

13. Implementing regulations for the Law on Financial Stability should be prepared for immediate passage after the law’s enactment. It is very important to incorporate measures in it to protect the state from losses in the event the government has to participate in a bank recapitalization. Options include early receivership, which would help avoid nationalizing banks’ hidden or contingent liabilities, as well as strict procedures for valuing bank shares and assets. In this context of a demanding agenda for financial sector supervision, proposals to overhaul the supervisory framework and merge financial supervisory agencies are premature.

14. The legal framework for the resolution of corporate debt is adequate but its implementation will be tested in this downturn. The restructuring law provides a legal framework for rehabilitation of financially distressed but viable enterprises and public establishments, for both in-court and out-of-court restructuring procedures. Expedited training programs in commercial issues should also be established to better equip the judiciary to effectively and quickly process commercial claims.

Structural Reforms to Boost Growth Potential

15. Beyond the immediate demands imposed by the downturn, Lithuania needs to improve its structural competitiveness. Recent declines in private sector wages are a important step for improving cost competitiveness. The budget proposal to reduce public sector wages would complement this adjustment by helping reduce costs economy-wide. The front-loading of EU-funds and their effective absorption should help alleviate the impact of a sharp recession. It provides the resources for further developing infrastructure and promoting the development of small and medium-sized enterprises and exporters.

16. Yet in the drive to improve competitiveness, steps to improve the business environment are also key. In this sense, recent plans to amend the Labor Code with the aim of allowing greater flexibility in working hours or dismissal arrangements are welcome. Similarly, ongoing efforts to reduce administrative burdens and bottlenecks in the areas of business planning, land regulation, and public procurement will facilitate investment.

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The mission is grateful to the authorities for their generous and warm hospitality, productive discussions, and close cooperation.