The Lithuanian economy has continued to enjoy a strong macroeconomic and fiscal performance. The recovery has avoided the large imbalances of the past and places Lithuania in a better position to face future economic downturns. Prudent fiscal policy, a flexible labor market, and proactive macroprudential policies have been critical to preserve stability and should be maintained. However, Lithuania still confronts severe demographic pressures, high social disparities, and external uncertainty. Effective implementation of the authorities’ comprehensive reform agenda, particularly in education and healthcare, along with a continued strong fiscal position, is key to increase productivity and support higher wages.
Boost productivity to sustain high wage growth and reduce social disparities
Despite growing urgency, education and healthcare reforms have so far failed to deliver in key areas. Maintaining large and inefficient networks comes at the cost of lower quality and opportunities. Only comprehensive reform in these areas will allow Lithuania to produce the competitive and well-paid workforce needed to tackle income and social disparities. While the reform agenda rightly identifies the key issues, a lack of buy-in from municipalities has hindered implementation. In this context, planned wage increases in these sectors should be made conditional on progress in network optimization.
Active labor market policies should be strengthened to effectively address skill mismatches and increase labor force participation. Current funding is low and relies excessively on EU funds and its composition inadequately reflects the needs of the labor market. Thus, reliance on employment subsidies should decrease and focus on the most disadvantaged groups only, and the emphasis should shift to well-designed training curricula to upskill the labor force.
Lithuania faces a difficult tradeoff between maintaining a low and competitive tax system and strengthening the social safety net. With discretionary spending already low, further increases in social spending will likely require increases in revenues. At the same time, targeted social spending should be the main tool to reduce poverty and inequality, to ensure the most efficient use of limited resources. In this connection, the design and generosity of child benefits should balance their positive impact on reducing child poverty against the potential disincentives to work, particularly for women.
Fintech brings opportunities and challenges
Fintech provides big opportunities to improve financial services and produce high-skill jobs, but it also brings challenges, particularly related to anti-money laundering. Lithuania is positioning itself as an attractive host of fintech platforms and a gateway to Europe for non-European financial companies. The authorities’ efforts in this area are already delivering results. In a highly concentrated banking sector, strong profitability largely reflects high operational efficiency. However, the exit of one bank and ongoing restructuring of another has lowered the intensity of competition, at least temporarily. In this context, fintech companies will introduce some healthy competition, initially in the payment services segment. However, the larger focus on cross-border transactions could represent a shift in the business model of Lithuania’s financial system that would bring new challenges for supervision, including on AML/CFT. The authorities, aware of these challenges, are stepping up inter-agency coordination and efforts to implement the 2018 MONEYVAL recommendations. However, success in this area will also require adequate resources across all agencies involved.
Preserve macroeconomic and financial stability
The fiscal surplus in 2019 will fall to 0.3 percent of GDP reflecting a moderate loosening of fiscal policy. The continued strong economic performance suggests that a neutral stance along the lines of the last few years would have been preferable. Going forward there are heightened risks to fiscal revenues and increased spending pressures. The budget relies on uncertain gains from combating informality. At the same time, recent revenue gains have a significant cyclical component reflecting low unemployment and high wage growth while the negative revenue impact of the recent tax and pension reforms is uncertain. Thus, projected fiscal revenues over the next few years are subject to increased uncertainty.
Spending pressures are intensifying. The large increase in social spending and public sector wages in 2018 are expected to continue this year and next. Since revenues are not increasing at the same rate, these spending pressures are being accommodated at the expense of other more flexible components of public spending. This trend cannot continue indefinitely. Any additional spending will require an increase in revenues.
Pension and tax reforms go in the right direction but remaining challenges will require future compromises. Tax reform could have been more ambitious in shifting taxes away from labor into capital, wealth, real estate, and environmental taxes. The reduction of tax exemptions and privileged regimes is also needed. On the pension system, reform has ensured the financial, but not social, sustainability of the system. Complementing pay-as-you-go SODRA pensions with a capitalized pillar is necessary given Lithuania’s negative demographic dynamics, projected as among the most severe in Europe. However, low and declining pensions will increase pressures to boost basic pensions, which have been transferred to the budget this year. This represents a fiscal risk over the medium-term.
Macroprudential policy is being used proactively to prevent systemic risks. This reflects the fact that with a more advanced cyclical position than the euro area, the ECB’s monetary policy stance is looser than would be warranted for Lithuania alone. At the same time, the banking system remains sound, with strong capitalization and high asset quality, liquidity and profitability. Signs that moderate cyclical systemic risks are emerging as the pace of growth in credit and house prices remained relatively high and led the Bank of Lithuania to raise the countercyclical buffer to one percent in mid-2018. However, most banks were already above the new capital requirement and have large and rising liquidity buffers given faster deposit growth than credit growth. Though the pace of corporate loans moderated, the growth of mortgages remains relatively high.
Economic Developments and Risks
Economic performance remains strong, exceeding expectations. Strong real growth in 2018, at 3.5 percent, continued into the first quarter of 2019, reaching 4 percent. Supported by resilient export growth, the current account surplus reached its highest level in four years. Strong domestic demand has been supported by high wage and better-than-expected employment growth, which has not yet passed through to inflation, which stood at 2.5 percent in 2018.
Growth is expected to moderate to a more sustainable path in the next few years. Over the medium-term, potential growth is projected to come down to 2-2.5 percent reflecting negative demographics. Domestic demand will continue to be the main engine of growth, but a moderating labor market will also ease consumption growth. Investment in the short-term will be affected by increased external uncertainty and over the medium-term will depend on the effectiveness of reforms to translate into increased productivity.
Low productivity growth is the key risk going forward. In the short-term, risks relate to a weakening external environment reflecting increased uncertainty. As a small open economy in a globalized world, Lithuania is particularly sensitive to external shocks. The current environment of low debt, high liquidity, and strong fiscal and current account positions will mitigate the impact of any negative shocks. In the longer-term, without progress on the reform agenda, notably in education, healthcare, and innovation, productivity growth may remain insufficient to support competitiveness and to compensate for a declining population due to ageing and emigration.
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, and NGOs for constructive and fruitful discussions.
