Republic of Lithuania: Staff Concluding Statement of the 2024 Article IV Mission
IMF News, June 7, 2024
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- Published: June 7, 2024
Recent developments, outlook, and risks
- Mission date: June 7, 2024.
- Economic performance and inflation:
- Lithuania recorded one of the highest rates of inflation in 2022—at around 20 percent, twice the euro area average.
- Inflation more than halved in 2023 and is now below the euro area average.
- Core inflation has moderated but remains elevated due to high energy pass-through, nominal wage growth and services inflation.
- Strong disinflationary momentum continued in early-2024 reflecting lower commodity prices, tighter monetary conditions, and a contractionary fiscal stance.
- Output and fiscal performance:
- After a short and shallow recession, activity started to recover at the end of last year supported by strong disinflation.
- Overall budget deficit in 2023: 0.8 percent of GDP (almost unchanged from 0.7 percent in 2022 but with a larger output gap).
- Fiscal stance in 2023: contractionary, supporting disinflation (revenue overperformance; temporary levy on banks; faster-than-planned phaseout of energy subsidies).
- Debt-to-GDP continued its downward trend falling 10 percentage points from the pandemic peak.
- Banking and real estate:
- The temporary levy on banks raised about 0.35 percent of GDP in 2023.
- Banking system: very liquid, well capitalized, highly profitable; profitability doubled over 2022 even after paying the levy.
- Real estate market: partial correction of pre-shock imbalances; nominal price growth slowed; prices moving closer to fundamentals as real incomes recover and borrowing costs rose.
- Projections:
- Real GDP growth will accelerate to 2.4 percent in 2024 and stabilize around potential—just above 2 percent—over the medium term.
- Headline inflation is projected to fall to around 1 percent in 2024; core inflation projected to fall but with larger persistence.
- Risks:
- Downside: intensified geopolitical tensions or global fragmentation; slow progress on structural reforms in pensions, education, and healthcare.
- Upside: faded high-inflation risks; quicker pickup in external demand could strengthen the recovery.
Policy priorities and fiscal strategy
- 2024 fiscal stance and recommendations:
- IMF projection: deficit widening from 0.8 percent of GDP in 2023 to 1.6 percent of GDP in 2024.
- Approved budget law projection: deficit of 2.9 percent of GDP in 2024 with spending buffers and conservative revenue assumptions.
- Recommendation: a broadly neutral fiscal stance is appropriate given a mildly negative and decreasing output gap.
- Guidance: any unused spending buffers or revenue overperformance should be saved.
- Long-term spending pressures:
- Demographic change: population fell from 3.7 million in 1991 to below 3 million in 2019; trend projected to continue.
- Medium-term potential increase in public spending due to long-term pressures: between 5 and 10 percent of GDP relative to the 2023 level.
- Comprehensive fiscal strategy—four elements (overview and selected measures):
- Objective: address long-term expenditure pressures while preserving growth potential, fiscal sustainability, and a pro-active fiscal policy.
- Pensions:
- Medium-term deficits increased from 1 to above 3 percent of GDP since 2021 due to worse demographic projections and pension increases above the sustainability formula.
- Reforms recommended:
- Link statutory retirement age to longevity.
- Apply the personal income tax to pensions to provide budgetary resources to increase non-contributory pensions.
- Strengthen privately-funded pension component: aim for compulsory participation, strong disincentives for early withdrawals.
- Education and healthcare:
- Outcomes are worse than peers at comparable spending levels—room to improve spending efficiency.
- Current reforms are steps in the right direction but have been too gradual and not ambitious enough to deliver material changes.
- Tax policy:
- Lithuania collects less tax revenue, around 9 percent of GDP, than the EU average.
- Tax system heavily tilted towards indirect and labor income taxes.
- Recommendation: rebalance from consumption and labor towards wealth, capital and environmental taxes to generate more revenue and improve efficiency.
- Fiscal targets:
- Suggestion: set targets around current levels to preserve a strong fiscal position.
- Proposal: a moderate deficit of around 1 percent of GDP (in line with IMF projected outcome for 2024) would deliver debt below 40 percent of GDP and provide space to support the economy during downturns without exceeding the 3 percent of GDP deficit reference value in the EU.
Financial sector policies
- Banking profitability and outlook:
- Despite declining interest margins, banks’ profitability will remain elevated over the next few years.
- With deposit rates gradually increasing and policy rates expected to continue decreasing in the second half of the year, net interest income is easing from very high levels but profitability will remain above historical levels and well above the euro area average.
- Banking system provides large buffers to absorb potential losses; banks are well placed to support credit expansion when demand recovers.
- Public investment agency (INVEGA):
- Will play an important role intermediating RRF loans.
- Recommendation: keep mandate explicit and narrow; ensure effective monitoring and transparency to avoid crowding out private lending and political interference.
- Levy on banks:
- Levy targeted net interest income of existing loans only, intended temporary, raised about 0.35 percent of GDP in 2023.
- Recommendation: the levy should remain temporary; no other levy should be introduced to avoid perception as a tax on foreign investment and to minimize long-term efficiency costs.
- Concern: sector already subject to corporate income tax rates 5 percentage points higher than for other corporates.
- Macroprudential stance and vulnerabilities:
- Authorities have adopted an appropriate neutral macroprudential stance with no new measures after those introduced in 2022.
- Recommendation: focus on mitigating non-systemic risks; if risks materialize, relax capital-based measures in response to credit supply disruptions and adjust borrower-based measures to address disorderly real estate corrections.
- Watch areas: pockets of vulnerability in the commercial real estate market.
- AML/CFT framework:
- Significant progress in strengthening AML/CFT supervision; implemented measures include:
- Deepening understanding of non-resident ML/TF risks.
- Increasing Bank of Lithuania’s AML/CFT supervisory resources.
- Updating AML/FT risk assessment methodology.
- Strengthening VASPs market entry controls.
- Strengthening AML/CFT controls to access CENTROlink.
- Outcomes: stabilization of the number of EMIs and PIs; revoking of several licenses.
- Next steps: Bank of Lithuania to continue mitigating ML/TF risks, prepare to begin supervising VASPs as of the end of 2024, and develop CENTROlink AML/CFT assessment guidelines.
Structural challenges and reform priorities
- Income convergence and competitiveness:
- Lithuania achieved fast income convergence over two decades (income per capita rose from 40 percent in 2009 to 85 percent of the eurozone average in 2021).
- Income per capita has stagnated over the last two years following the largest negative terms-of-trade shock in the euro area.
- Loss in market shares in last two years was mostly concentrated on re-exported goods (driven by sanctions on Russia and Belarus); export of services continued to grow strongly.
- Lithuania entered the recent shock with an undervalued real effective exchange rate, which helped absorb permanently higher input costs.
- Labor market and skills mismatches:
- Lithuania has one of the highest skill mismatches in Europe with a relative shortage of high-skilled workers.
- Fall in labor productivity largely cyclical: employment resilient while hours per employee remain low.
- Recommendations:
- Make active labor market policies more responsive to cyclical conditions and expand well-designed training programs.
- Concentrate employment subsidies on the most disadvantaged groups.
- Education reforms to foster vocational training; address current funding imbalance where funding is overwhelmingly reliant on EU funds and tertiary system does not produce demanded skills.
- Climate and green transition:
- Lithuania is susceptible to climate-change risks and needs to accelerate the green transition, particularly adaptation.
- Recommendation: introduce an economy-wide carbon tax on fossil fuels alongside the EU’s emission trading system to facilitate decarbonization, incentivize renewable investments, and provide resources to protect vulnerable households and strengthen physical infrastructure.
Republic of Lithuania: Staff Concluding Statement of the 2024 Article IV Mission (June 7, 2024).