OREANDA-NEWS.  On 21 February 2008 was announced, that  Lithuania's economic performance over much of the past decade has been impressive, reflecting in part broad macroeconomic stability. Real GDP growth has been rapid, inflation has been low, and unemployment has fallen. These favorable developments have been supported by EU accession, rapid financial integration, and generally sound macroeconomic policies, including the currency board arrangement, the low and declining level of public debt, and relatively flexible labor and product markets.

However, the recent rise in external and internal imbalances is a concern. The external current account deficit appears to be somewhat larger than can be explained by economic fundamentals, though large uncertainties surround this assessment. The associated deterioration in the net external asset position represents a risk to external stability. Inflation is well above the level in the euro area and an obstacle to euro adoption. Although the level of the real effective exchange rate is still broadly appropriate (given strong productivity growth in earlier years), continued rapid wage growth could erode competitiveness. These imbalances reflect an excess of aggregate demand over the economy's supply potential.

Against this background, the key policy objective is to promote macroeconomic stability by supporting a soft landing and being prepared for a hard landing. First, additional fiscal consolidation is needed to reduce demand pressures and increase fiscal cushions. Second, continued vigilant financial supervision should help ensure a measured pace of credit growth and strong bank asset quality; further increases in banks' capital buffers would be advisable to mitigate the risks associated with low-probability extreme events. Third, greater economic flexibility would support a soft landing by easing supply bottlenecks and facilitate the reallocation of resources in the event of a hard landing.

Economic outlook

The economy's momentum is strong, but the tightening of financing conditions is likely to lead to an orderly easing of imbalances (a soft landing). Reflecting concerns about rapid credit growth, the Bank of Lithuania (BOL) and the parent banks of major Lithuanian banks have encouraged a tightening of lending standards. Global financial market turbulence has reinforced concerns about asset quality. As a result, following several years of rapid house price appreciation, the housing market is now cooling. Looking forward, property-related investment will likely fall, though strong profitability in export-oriented sectors and the elimination of the social tax will support overall private investment, and public investment will remain strong. Similarly, purchases of consumer durables will likely ease, though the low unemployment rate and the cut in the personal income tax rate will underpin continued robust after-tax wage growth and thus consumption of non-durables. Moreover, slowing GDP growth in all main export markets will dampen external demand growth. In this scenario, real GDP growth would moderate to 7 percent in 2008 and 6 percent in 2009; the external current account deficit would narrow to 11 percent in 2008 and 9Ѕ percent in 2009; and inflation would decline to 7 percent by end-2008 and 4Ѕ percent by end-2009.

While a soft landing is likely, large uncertainties surround the outlook and there is a risk of a hard landing. The experience in other countries shows that rapid house price increases are sometimes followed by abrupt house price declines. In addition, Lithuania's reliance on external financing makes it vulnerable to a sharper scaling back of new lending by parent banks. If these risks materialize, domestic demand growth could slow sharply (a hard landing). Conversely, it is possible—though less likely—that property market sentiment could recover or that competition for market share among banks could interfere with a moderation in credit growth. In this situation, domestic demand growth could remain strong and imbalances could continue to rise (no landing).

Fiscal policy

The stance of fiscal policy in 2008 is helpful but more fiscal contraction is needed to support a soft landing. Last year, the fiscal stance (including restitution payments) added to aggregate demand, which was counter-productive given the economy's cyclical position. This year, the fiscal deficit (excluding restitution payments) is projected to narrow to ѕ percent of GDP, which will reduce demand pressures. However, given the magnitude of inflationary pressures, additional fiscal contraction of Ѕ percent of GDP would be advisable. Greater fiscal contraction would not only have a direct impact on aggregate demand, but also provide a credible signal of the government's commitment to macroeconomic stability, helping to boost investor confidence and to focus expectations on the need for slower growth going forward. In addition, given that the cyclically-adjusted fiscal deficit is not far from 3 percent of GDP, it would be prudent to take advantage of the current favorable economic situation to increase fiscal cushions. Additional fiscal contraction could be achieved by postponing restitution payments and accelerating the planned increase in excise taxes. In any event, the government should resist pressures to cut tax rates, introduce new exemptions or tax credits, or raise spending in the run up to the October 2008 elections.

Further fiscal consolidation is likely to be needed in 2009 to reduce demand pressures and increase fiscal cushions. Given that excess demand is expected to remain significant, fiscal policy should continue to support a soft landing by aiming for cyclically-adjusted balance by 2010. On current projections, this would imply a fiscal surplus (excluding restitution payments) of just over ј percent of GDP, which could be achieved by restraining the growth of current spending and removing exemptions on VAT, PIT, and social security taxes. Given the urgency of improving infrastructure, we would caution against abrupt cuts in the nationally-financed public investment program. If GDP growth does not ease as projected, then greater fiscal contraction would be desirable. Conversely, if the economic slowdown is considerably sharper than projected, then fiscal policy should not exacerbate the downturn. In the unlikely event of excess supply, discretionary stimulus should be considered. More generally, in light of the need to enhance the medium-term spending framework, the recent scrutiny of government ministries' expenditure planning by an external audit firm is welcome. We support the audit's recommendation to improve evaluation criteria, and would also suggest better integration of strategic expenditure planning and budgeting.

The new fiscal responsibility law is welcome, but the legal framework could be further improved. The law appropriately prohibits mid-year budgets, requires that windfall revenues be saved, and stipulates that the government budget aim for balance or better, subject to escape clauses intended to avoid procyclical policy in an economic downturn. We welcome the government's plans to enhance transparency by showing how a proposed budget conforms to the fiscal target in the law, and to reduce the risk of procyclicality in an economic upturn by providing an explicit assessment of whether the budget is inflationary. In this context, independent scrutiny of the economy's cyclical position would be desirable. In addition, independent scrutiny of some key revenue assumptions should be considered.

Financial stability

Indicators of the banking system's soundness are generally satisfactory and are expected to remain so under the soft landing scenario. Profitability is high, nonperforming loans are low, and capital adequacy has increased over the past couple of years. Looking ahead, the cooling of the housing market and the expected easing of credit growth will likely dampen profitability somewhat.

Continued vigilant financial supervision—aimed at maintaining high lending standards and strong risk management in banks—is needed to help reduce the build-up of balance sheet vulnerabilities. In recent years, the BOL has strengthened banks' capital bases by raising the effective risk weight on residential mortgages, restricting the amount of current-year profits that count toward regulatory capital, and asking banks to fully retain profits. The BOL has also encouraged strong risk management by urging banks to pay due attention to loan-to-value ratios and debt-service-to-income ratios, and to conduct stress tests on borrowers' debt service capabilities under different interest rate scenarios. More generally, the regulatory and supervisory framework for banks is in line with international standards, and the BOL conducts effective supervision of all banks operating in Lithuania. As regards the non-bank financial sector, improved supervision is needed given the rapid growth of assets and the increasing sophistication of financial institutions.

Given the potential impact of low-probability extreme events on the banking system, it would be advisable to raise banks' capital buffers now to mitigate those risks. Stress tests suggest that—if property prices fall sharply and interest rates rise sharply, leading to a steep drop in GDP growth—the average capital adequacy ratio may eventually fall below the 8 percent minimum, so a further increase in banks' capital buffers would be advisable. Specifically, in the upcoming process of validating internal risk-based models, the BOL could encourage banks to fully capture the risk characteristics of their loan portfolios; otherwise, these risks could be covered by bank-specific capital surcharges under Pillar 2. Similarly, liquidity stress tests suggest that liquidity would be broadly adequate under individual liquidity stress scenarios, but may not be sufficient under a combination of severe events. Although the probability of a combination of severe events is low, the BOL could further discuss with banks their contingency plans, including the availability of credit lines.

Economic flexibility

Greater economic flexibility would support a soft landing by easing supply bottlenecks and facilitate the reallocation of resources in the event of a hard landing. In the labor market, restrictions on working hours reduce labor market flexibility. Obstacles to immigration, including time-consuming procedures for residency and work permits, as well as restrictions on family members, inhibit an easing of labor market pressures. Though improving, land planning processes remain cumbersome. The proliferation of regulatory standards associated with the large number of regulatory bodies and required licenses also creates barriers to redeploying resources.