Republic of Lithuania: Staff Concluding Statement of the 2023 Article IV Mission
IMF News, June 12, 2023
Source details
- Canonical URL
- Republic of Lithuania: Staff Concluding Statement of the 2023 Article IV Mission
Other formats
Bibliographic details
- Published: June 12, 2023
Executive summary
- 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.
- High inflation and rising interest rates amid weakening external demand have resulted in a contraction of economic activity.
- Persistently higher inflation than the eurozone average—beyond what is consistent with the convergence process—is the most important short-term risk.
- With monetary conditions that are still too loose for Lithuania, the onus to fight inflation is on fiscal policy.
- Short-term policy priority: reduce inflationary pressures and preserve financial stability.
- Medium-term policy priority: implement long-overdue structural reforms to support productivity gains and higher living standards.
Recent developments, outlook, and risks
- Inflation:
- 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.
- Level of inflation remains significantly above the eurozone average even as lower energy prices are expected to decrease inflation rates rapidly over the next few months.
- Economic activity:
- High inflation and rising interest rates weakened disposable income and, combined with weak external demand, resulted in a contraction of economic activity at the end of last year that intensified at the beginning of this year.
- Non-energy net exports improved, suggesting competitive strength has not deteriorated to date.
- Fiscal performance:
- Fiscal performance was significantly better-than-expected, supported by a resilient economy, windfall revenues from high inflation, and lower-than-planned spending on energy subsidies.
- The fiscal policy stance was moderately counter-cyclical in 2022, marginally contributing to contain inflationary pressures.
- Banking sector and policy responses:
- Higher lending rates and a slow increase in deposit rates given ample liquidity have led to unprecedented profitability in the banking system.
- Government measures include an increase in the corporate tax rate for big banks from 15 to 20 percent in 2019 (made permanent last year) and a temporary windfall levy on banks.
- The temporary windfall levy 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.
- Outlook:
- Activity is weak in the first half of the year due to softening domestic and external demand; the labor market has weakened but remains broadly resilient.
- Real wage growth is expected to become increasingly positive as inflation cools.
- Further support to activity is expected from a significant increase in investment supported by European funds and recovery in external demand.
- Trade deficit expected to largely reverse last year’s deterioration as commodity prices decline.
- Risks:
- Downside risks: further escalation of the war, volatile financial markets triggering a disorderly correction in the real estate market, and persistently higher inflation than in the euro area beyond what is consistent with the convergence process.
- Upside risk: the economy could prove more resilient than projected given strong underlying fundamentals.
Macroeconomic policy priorities
- Fiscal policy role:
- Fiscal policy should be used proactively to reduce inflationary pressures given that ECB monetary tightening came late for Lithuania and has not gone far enough for domestic conditions.
- To mitigate high and persistent inflation, 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.
- Fiscal rule and medium-term consolidation:
- 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.
- Discussions to modify the EU fiscal framework provide an opportunity to finetune Lithuania’s fiscal rule while preserving a strong counter-cyclical stance.
- Wages and minimum wage policy:
- Setting moderate minimum and public sector wages 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.
- 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.
- Revenue and tax structure:
- Accommodating new and pre-existing spending pressures will likely require new revenues under the existing fiscal targets.
- Rebalancing the tax system from labor towards wealth, capital, and environmental taxes can generate more revenue and improve efficiency.
- 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.
- Other tax proposals 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.
Financial sector policies
- Bank levy and tax design:
- The levy on banks should remain temporary to avoid being perceived as a tax on foreign investment and minimize negative impacts on efficiency.
- Permanent sector-specific taxes on excess profits tend to have a distortionary impact over time.
- Banking sector resilience:
- A weakening economy and higher interest rates bring risks to the banking sector but should remain manageable given high liquidity, capitalization, and profitability.
- The correction in property prices is bringing valuations closer to fundamentals in an orderly fashion so far.
- Vulnerabilities require close monitoring, especially if additional shocks result in even higher interest rates and weaker economic activity.
- If a sharp downturn causes credit supply disruptions or a disorderly correction in the real estate market, the central bank should consider a relaxation of capital-based macroprudential and, potentially, borrower-based measures.
- AML/CFT and fintech/VASP supervision:
- Progress has been made in addressing ML/FT risks responding to fintech challenges.
- The Bank of Lithuania (BoL) has increased ML/TF supervisory resources and risk assessment of new and existing clients of BoL’s payment system CENTROLink.
- Number of fintech companies: 263 this year vs 265 last year, after seven years of significant growth (55 in 2014).
- BoL should develop a robust risk assessment methodology with experts in the newly formed CENTROLink committee.
- Progress in the VASP sector includes upgrading the regulatory framework and introducing a sectoral risk assessment conducted by the Financial Intelligence Unit.
- 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 passing the draft amendments to the AML/CFT law.
Structural challenges and climate/energy policy
- Structural reform priorities:
- Preserve flexibility of the economy and advance long-overdue structural reforms to support further productivity gains and higher living standards.
- Accelerate reforms in education and healthcare and close gaps in transportation infrastructure to enhance private sector-led growth and mitigate negative demographic dynamics.
- The recently approved civil service reform aimed at increasing flexibility, efficiency and accountability in the public sector is a step in the right direction.
- Energy transition and climate mitigation:
- 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.
- Current pace of reduction in emissions is not consistent with the country’s climate objective.
- Policy tools recommended include 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 CO2 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.
Republic of Lithuania: Staff Concluding Statement of the 2023 Article IV Mission — June 12, 2023