Mission Concluding Statement 

Republic of Lithuania: Concluding Statement of the 2015 Article IV Mission

April 1, 2015

1. Lithuania’s economic comeback over the last five years has been impressive, turning the page with its entry into the euro area this January. Growth has been among the strongest in the EU, real GDP now exceeds previous peak levels, and per-capita income reached 73 percent of the EU average (in purchasing-power-parity terms). The current account is balanced, the fiscal deficit is much reduced, and private-sector balance sheets are healthy. Euro introduction was smooth and accompanied by important upgrades in policy frameworks. Even tighter economic integration with Europe than before and access to ECB liquidity are important boons to the Lithuanian economy.

2. Looking ahead, the onus to deliver strong and sustained income convergence with Western Europe will be above all on structural reforms. Key areas, such as education, labor relations, pensions, fiscal structural improvements in spending efficiency and tax composition, and innovation policies are often complex and may take time to develop and implement. But they remain essential to ready workers, public finances, and the business environment for the next stage of catching-up with living standards in Western Europe.

Economic outlook—recent resiliency augurs well for the future

3. Growth is projected at 2.8 percent this year—little changed from 2014. Domestic demand will remain the main driver. Improving prospects for the euro area should largely counterbalance the drag from the recession in CIS trading partners—exporters have already proven their high adaptability by reorienting to new markets. Continued external uncertainties are likely to inject a degree of caution into investment, but the effect on growth should be largely offset by the boost from low energy prices. Inflation is set to veer slightly into negative territory because of energy prices. Real wage growth will likely remain robust as the post-2009 catching-up of wages with productivity enters its finishing stretch.

4. Growth is set to pick up to 3.2 percent next year and to 3¾ percent in the longer term. With a gradually improving external environment the near term driver, long-term performance would remain contingent on structural reforms, investment, and innovation policies that minimize the drag from population aging and help sustain catching-up as the income gap narrows.

Fiscal policy—strategic vision to chart the way forward

5. Further progress with fiscal consolidation achieved in 2014 is commendable. The deficit declined to an estimated 1.3 percent of GDP (excl. DIF and pension compensation), corresponding to a higher-than-planned improvement in the structural fiscal balance by almost 1 percent of GDP.¹ But the public debt ratio has not yet materially declined after the large run-up since 2009, potentially constraining fiscal space to maneuver in future downturns and to deal with the fiscal challenges from population aging.

6. Public finances will continue to face various pressures in the years ahead. Apart from looming aging costs in pensions and health, committed increases in defense spending and labor taxation reductions in support of job creation will need to be offset elsewhere. Pressures to unwind some of the expenditure compression undertaken since 2009 could mount. Moreover, to reliably put the public debt ratio on a downward trend, a medium-term objective for the (structural) fiscal balance of -½ percent of GDP should be targeted, implying a need for some further consolidation.

7. Fiscal backsliding in 2015 should be avoided, to ensure that meeting the medium-term objective remains on track while giving credit for last year’s overperformance. Sticking to the originally budgeted deficit would indeed largely steer clear of a deteriorating (structural) fiscal balance. But measures of at least 0.3 percent of GDP are required to meet it, because the budget was based on more favorable macroeconomic assumptions in terms of growth, inflation, and wage developments than are projected now. A strengthening of wealth taxation and targeted expenditure cuts should be considered. Paring back discretionary spending in line with lower inflation could also make a limited contribution.

8. To provide a road map for short-term policy steps and reduce uncertainty for the general public, a clearly articulated medium-term fiscal policy strategy would be helpful. Key planks could comprise the following: systematic strengthening of underdeveloped tax bases; relieving the tax burden on labor as other taxes develop and as ongoing efforts to improve tax administration bear fruit; pension reform to improve fiscal and social sustainability; scaling back over-sized infrastructure in education and health, attuning public employment to the reality of a shrinking working-age population; and readying fiscal relations with local governments for application of the new constitutional fiscal rule. Reform proposals under the just unveiled “New Social Model” cover some of these aspects and go in the right direction, such as linking the retirement age to life expectancy and putting the need for a reduction of labor taxation firmly on the agenda for the future. However, a careful costing of the pension reform is needed, considering the powerful impact of changes to benefit formulas and contribution rates on public finances.

Financial sector—stable overall but continued vigilance important

9. The largely Nordic-owned banking sector is liquid and well capitalized. The largest banks, now directly supervised by the ECB, comfortably passed the AQR and EBA stress tests. A further decline in NPL ratios to 6.5 percent and solid profitability for four years running are positives. New arrangements under the Single Supervisory Mechanism require close cooperation between home, host, and European authorities. Vigilance is called for in monitoring and dealing with potential side-effects from global financial conditions. Supervisors should continue to proactively work with smaller banks with higher risk profiles to ensure sufficient capital buffers, especially as tighter EU-wide regulatory requirements come into effect.

10. Credit unions are only a very small part of Lithuania’s financial sector but entrenched performance issues warrant their fundamental overhaul. A determined reform push along the lines of the Bank of Lithuania’s blueprint is needed and could transform the sector into a valuable source of funding for SMEs over the medium term. In the interim, supervisors should step up existing measures to ensure that risk taking is commensurate with credit unions’ ability to bear it.

Investment and innovation—extra support for underserved segments needed

11. To sustain rapid income convergence, private investment will have to recover more fully from the setback in 2009. The experience from the boom-bust cycle has left companies and banks averse to risk and external uncertainty weighs on the willingness to invest in the near term. Credit is essentially flat. Prospects for investment to pick up when external uncertainty eases are relatively good for larger companies with established relations to banks—capacity utilization is high and access to financing is not an issue. But SMEs face a harder time to secure funding in the climate of risk aversion. And all firms’ medium-term investment appetite will also depend on structural reforms in other areas such as labor and education (see below).

12. Plans to boost investment in the nearer term and support SMEs are welcome. The government is pushing ahead with preparations to tap resources under the “Juncker Plan,” which is designed to spur private investment through risk sharing with the public sector at the European level. EU structural funds and “Juncker Plan” resources will also widen the pool of financial resources available to SMEs. Greater reliance on financial instruments instead of grant distribution is planned to enhance the economic impact of EU structural funds.

13. Innovation is equally important for income convergence. Backward-looking indicators suggest a deficit of Lithuania in this area relative to EU countries. Efforts are being made under the new “Smart Specialization Strategy” to advance, but fragmentation and lack of critical size in implementation and oversight of innovation promotion remain important challenges.

Other structural reforms—making the most of labor resources

14. The importance of making the best possible use of available labor resources in the face of adverse demographics can hardly be overstated. To sustain productivity growth and to attract investment despite the pronounced projected decline in the working-age population over the next decades make it imperative that workers’ skills match labor market needs and labor resources do not go underutilized, either in the informal sector or through unemployment.

15. The new labor code proposed under the “New Social Model” is an opportunity to modernize labor relations. Lithuania scores well on a range of labor market flexibility indicators, but this is partly because the overly rigid labor code is poorly applied, ultimately to the detriment of workers and employers alike. More balanced arrangements for working time, form of contracts, notification periods, severance pay, and dispute resolution would be better enforceable, would put labor relations on a sound and predictable footing, and would appeal to investors, especially from abroad.

16. The education system should aim at better equipping Lithuania’s labor force with the skill mix needed by labor markets. Attainment rates in tertiary education are at record highs but a large share of graduates ends up working in fields other than the one of their study or needing further training. The nexus between the large number of universities, financial incentives, quality standards, and guidance for future students needs in-depth review. Efforts to make vocational training more attractive and shifting from a school-based model to a dual education system with apprenticeship should be accelerated and intensified.

17. Continuing the reform of public enterprises remains important, especially considering their central role in a range of key ongoing energy projects. Encouraging progress has already been made—accounting has been separated between commercial activities and public-service obligations and recent legal reform requires independent board members on a broader set of state and municipal entities. More progress is still needed though toward the ultimate objective of cost-efficient service delivery and meeting set return-on-equity targets.

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The IMF team is grateful for the generous hospitality of the Lithuanian authorities and would like to thank all interlocutors in government, the Bank of Lithuania, the private sector, and in NGOs for constructive and fruitful discussions.

¹ The fiscal structural balance excludes one-off effects and the influence of the business cycle on public finances.