Washington, DC:
The Lithuanian economy entered the COVID-19 crisis on a solid footing
with strong growth and ample buffers, improved private sector financial
positions, and a well-capitalized, profitable banking system. These
developments reflected years of prudent fiscal and financial sector
policies. The strong starting position coupled with the government’s
decisive policy response and the benefits of euro area membership, have
helped make the Lithuanian economy one of the best performers in Europe
last year and have set the stage for a strong recovery. As the recovery
quickly gathers pace, policies need to prioritize quality over quantity
through more targeted support to the most affected sectors. Going
forward, fiscal and macroprudential policies should continue to be used
proactively to preserve stability and avoid the reemergence of the
imbalances observed prior to the Global Financial Crisis (GFC),
particularly if the recovery is stronger than anticipated. Lithuania
should confront its long-standing challenges—including high social
disparities and demographic pressures—through the decisive
implementation of structural reforms. This is the only way to achieve
sustained improvements in productivity and high wage growth going
forward.
Economic Developments and Risks
Economic performance during the pandemic has been among the best in
Europe.
With GDP falling by just 0.8 percent versus a euro area average of 6.7
percent, the Lithuanian economy experienced the mildest contraction in
Europe last year. Growth momentum has picked up in the first quarter of
this year despite lockdown restrictions. A decisive policy response from
the government has helped support incomes, mitigate the rise in
unemployment, and preserve the financial health of businesses. Exports
recovered quickly in the second half of last year. The impact of the
pandemic varied across sectors, with a strong recovery in manufacturing but
with service sectors being harder hit.
Output has already exceeded its pre-pandemic level in the first quarter
of this year.
The private sector—households and businesses—entered this crisis without
significant imbalances and in a strong financial position that has been
preserved by COVID related support measures. This has set the stage for a
vigorous recovery in output and employment, led by domestic demand and
benefitting from solid external demand. Combined with temporarily higher
energy prices, this will result in higher inflation this year. The external
position is strong, partly due to temporary factors that will go away with
the recovery (such as low consumption and investment as a result of
lockdown restrictions). The strength of the external position is also
explained by hard fought gains in competitiveness during the recovery that
followed the GFC and that have resulted in the strongest increase in
exports in the Baltics.
Next Generation EU funds, including Recovery and Resilience Funds
(RRF), will support medium-term growth, ameliorating demographic
pressures.
If efficiently used, these funds will support private and public investment
and productivity growth, thereby facilitating sustainable high wage growth.
Pressures from aging persist and will intensify going forward despite
recent improvements in migration flows—Lithuania experienced a population
increase in 2020 for the first time in over 30 years.
Risks are broadly balanced in the short-term, but there is a
significant upside growth potential over the next few years.
With the recovery accelerating in the second half of this year, and in the
absence of future lockdowns as uncertainty dissipates with vaccinations
advancing, growth can surprise on the upside and result in higher
inflationary pressures. If left unchecked, these dynamics could eventually
erode competitiveness in the export sector and lead to the reemergence of
macroeconomic and financial imbalances. On the downside, risks include
weaker than expected external demand and geopolitical risks.
Actively preserve economic stability and target continued support
to those most affected
Unlike the global financial crisis of 2008, the COVID-19 pandemic is
expected to have only a temporary negative impact on the Lithuanian
economy.
The large policy response and strong fundamentals of the economy prevented
a severe recession and permanent economic losses. Support via subsidies has
helped solidify the financial position of households and businesses. In the
labor market, employment was largely preserved, particularly in
manufacturing, and the impact on the most affected sectors should be
temporary provided a sustained recovery takes hold in the second half of
this year.
The unprecedented policy response to the crisis was supportive of
activity and incomes, and reasonably targeted.
Following years of prudent policies, large fiscal space and lower borrowing
costs enabled the government to increase spending to support workers,
businesses, and the healthcare system. Macroprudential and monetary
policies also provided substantial support. In particular, as a member of
the euro area, Lithuania benefited from accommodative policies by the
European Central Bank.
The pace of withdrawal of fiscal policy support should be dictated by
the strength of the recovery already underway.
The government has rightly built up significant buffers in the amended
budget for this year to deal with unexpected shocks or a weaker than
expected recovery. However, under the most likely macroeconomic scenario, a
large share of these buffers will not need to be used. In the absence of
temporary COVID-19 related measures and as growth picks up, the fiscal
position will improve this year and next, putting debt back in a declining
path. As the recovery becomes firmly entrenched, fiscal buffers should
gradually be rebuilt to secure Lithuania’s capacity to respond to future
economic shocks. If growth is stronger than expected and inflationary
pressures intensify, buffers should be rebuilt at a faster pace.
With minimal permanent economic losses expected in aggregate, support
should narrowly focus on specific pockets of vulnerability, thereby
facilitating a market-led reallocation of resources.
Some individual, viable firms in sectors hardest hit by the pandemic may
need continued support for longer. Reaching them will require increasingly
targeted measures. In this connection, the proposed temporary reduction of
the VAT rate for catering services, cultural, and recreation sectors is not
well targeted, as it provides less support to companies that suffered a
larger shock or face a slower recovery. At the same time, it may complicate
the collection efforts of the tax administration inspectorate. Moreover,
political pressures to make these temporary tax cuts permanent should be
resisted as their envisaged sunset approaches.
Financial sector policies should continue to support the recovery while
maintaining the resilience of the system against emerging risks.
Banks in Lithuania remain well capitalized, liquid, and more profitable
than peers in the euro area. The release of the countercyclical capital
buffer (CCyB) and the two private moratoria have supported lending and
provided further relief to hard-hit borrowers. Going forward, the banking
sector has ample liquidity and capital buffers to support a strong
recovery. The positive developments in the housing market so far,
particularly residential real estate, are estimated to be in line with
fundamentals. However, if in the future signs of elevated risks in
particular sectors or overheating of the economy start to emerge, targeted
macroprudential tools or reactivation of the CCyB will be necessary.
With a maturing Fintech sector, the focus should continue to be on
enhancing supervisory capacity and the AML/CFT framework to reassure
markets that risks in this area are contained.
To realize the full potential of Fintech in improving financial services
and producing high-skill jobs, and as the Fintech industry expands quickly
and becomes increasingly sophisticated, the Bank of Lithuania faces new
supervisory challenges. The authorities have been proactive in improving
the Fintech regulatory framework, for example by establishing the Centre of
Excellence in Anti-Money Laundering (AML) and implementing recommendations
made in the MONEYVAL evaluation of 2018. Progress in this area will require
close multi-agency coordination and more resources but will help
consolidate Lithuania’s position as a European Fintech hub. Current efforts
to develop a five-year plan in this area should reflect all these
challenges and the authorities plans to address them.
Going forward, Lithuania should maintain the proactive policy framework
that effectively supported economic stability and convergence prior to
the pandemic.
As a member of the euro area and given that the economic recovery is
projected to be stronger than in much of the euro area, the ECB’s monetary
policy stance is expected to be looser than warranted for Lithuania alone.
This, combined with significant upside potential for growth and inflation
going forward, will require proactive management of risks with the
available fiscal and macroprudential policy tools.
Implement reforms that reduce disparities and raise productivity
The new government’s priorities reflect critical yet politically
challenging reform areas that enhance private sector productivity and
mitigate negative demographic dynamics.
Urgently needed reforms in education and health care have failed to deliver
in the past, mainly due to lack of buy-in from municipalities. However,
given poor outcomes in these areas, improving the large, inefficient, and
costly networks and the quality of the services provided is critical.
Additional RRF funds could offer the impetus needed to implement
challenging reforms.
With rising budget rigidities and age-related spending pressures,
further increases in social spending cannot be financed without higher
revenues.
Reducing regional disparities and high poverty rates, particularly among
pensioners, will require larger and more effective social programs. In this
connection, the establishment of a working group analyzing potential
improvements to the tax policy framework is welcome. Its work should focus
on eliminating inefficient loopholes and exemptions, taxing environmental
or other externalities, and shifting taxes away from labor towards capital,
wealth, and environmental taxes. These efforts should be part of a comprehensive fiscal strategy that complements
structural reforms and helps address social disparities while raising the
economy’s growth potential.
The combination of a strong recovery, new EU funds, and low funding
costs, provides a unique opportunity to galvanize consensus around
politically difficult reforms.
It also creates an environment where meeting high upfront costs of reforms
and higher public investment will not jeopardize the fiscal position.
Public investment should aim to strengthen physical and human capital and
support social cohesion. Reforms under the Recovery and Resilience Plan
rightly focus on these areas and, particularly, on digitalization and
climate. The authorities’ goals, which are broadly in line with those of
the Next Generation EU initiative, will require ambitious implementation
plans that are currently being developed. However, realizing the full
benefits of reforms will require progress in all main areas simultaneously
given their complementary nature, particularly education and healthcare.
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Lithuania Macroeconomic Outlook
|
|
|
2019
|
2020
|
2021
|
2022
|
2023
|
|
GDP growth
|
4.3
|
-0.8
|
4.4
|
4.1
|
3.1
|
|
Inflation
|
2.2
|
1.1
|
3.2
|
2.8
|
2.7
|
|
Core inflation
|
2.3
|
2.6
|
2.8
|
3.0
|
2.6
|
|
Output gap
(percent of potential GDP)
|
0.8
|
-0.9
|
0.3
|
0.9
|
0.6
|
|
Overall fiscal balance
(percent of GDP)
|
0.5
|
-7.4
|
-5.5
|
-2.9
|
-1.5
|
|
Structural balance
(percent of potential GDP)
|
0.6
|
-6.3
|
-5.0
|
-2.8
|
-1.4
|
|
Public gross debt
(percent of GDP)
|
35.9
|
47.1
|
47.8
|
45.9
|
44.3
|
|
Nominal GDP
(billions of euros)
|
48.8
|
48.9
|
52.4
|
56.0
|
59.2
|
|
Source: IMF staff projections starting 2021
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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.