OREANDA-NEWS. October 13, 2011. 1. The economy has staged an impressive recovery, based on a supportive global environment and determined policy adjustment. After contracting sharply in 2008-09, economic activity grew by 1 percent in 2010 and a robust 6 percent in the first half of 2011. The export-led recovery broadened to domestic demand and employment growth accelerated. The recovery reflected both the global upturn and strong policy action, including sizeable fiscal consolidation, the maintenance of confidence in the banking system, and significant wage adjustment that underpinned gains in competitiveness.

2. With external conditions now worsening, it is important to further strengthen policies. The key policy challenges are as follows:

• Fiscal policy: additional measures are needed to achieve a further reduction in the fiscal deficit to 2.8 percent of GDP in 2012.

• Financial stability: the banking system as a whole is well-positioned to withstand adverse shocks, but it is crucial to assess risks conservatively across all institutions, to make appropriate loan loss provisions, and to increase capital if necessary.

• Sustainable growth: enhancing labor participation, facilitating labor reallocation, and improving the business environment are key to sustainable growth.

Economic outlook

3. With falling economic growth and deteriorating financial conditions in Europe, growth in Lithuania will slow. Weaker demand from the euro area will dampen Lithuania’s export growth, and higher external financing costs are likely to be passed on to bank lending in Lithuania. As a result, real GDP is expected to grow by about 3 percent in 2012. With domestic demand slowing less quickly than external demand, the current account deficit is expected to widen a little to 1 percent of GDP in 2012. Given broadly stable food and energy prices, inflation is projected to ease, yielding an average annual rate of about 3 percent in 2012.

4. Risks to the economic outlook in Lithuania are clearly on the downside. An intensification of financial strains in Europe could lead to even weaker external demand and jeopardize funding. As in other European countries, Lithuania’s sovereign CDS spread has risen in recent months and the government has large gross financing needs in 2012. While the foreign parent banks of Lithuanian banks could face funding pressures, they have very limited direct exposure to southern European assets and the Scandinavian authorities are well prepared to deal with liquidity pressures on their banks.

Fiscal policy

5. A further reduction in the fiscal deficit to 2.8 percent of GDP in 2012 and towards a small surplus in the medium term is essential to put debt on a downward path and reduce vulnerability to financing shocks. As a small open economy that is highly exposed to external shocks, Lithuania needs the fiscal space to allow automatic stabilizers to operate during downturns. This implies that government debt should be reduced to well below its current level of about 40 percent of GDP. It is also important to lower the government’s large gross financing needs, which constitute an important vulnerability.

6. Additional fiscal measures of about 1 percent of GDP will be needed to achieve the 2012 fiscal target. The government has announced plans to continue the spending freeze on the wage bill and goods and services, and to return pension benefits to the pre-crisis level. On this basis, the fiscal deficit would fall to about 4 percent of GDP next year. Therefore, achieving the target would require additional measures of about 1 percent of GDP. Moreover, given the upside risk to the fiscal deficit (stemming from the downside risk to economic growth), a contingency plan consisting of further measures should be prepared. Beyond 2012, on announced policies, the fiscal deficit is projected to fall to about 2 percent of GDP over five years, implying a cumulative adjustment need of some 2 percent of GDP to achieve the government’s medium-term objective of a small budget surplus.

7. The additional fiscal measures should be high-quality and sustainable. While the composition of adjustment is of course at the discretion of the government, the following considerations are important. To date, almost all of the adjustment has been on the spending side. Since wealth taxes in Lithuania are relatively low, and such taxes are progressive and less distortive than other taxes, the taxation of real estate and automobiles could be expanded. The bases for corporate income tax, personal income tax, and social contributions could be broadened by reducing exemptions. If the government chooses to reduce spending, it will be important to protect the most vulnerable people and preserve the level of public investment.

8. Important reforms already underway should be deepened over the medium term. Given long-term pressures from age-related spending, the enactment of a gradual increase in the pension age to 65 is welcome. Further reform of the pension system is needed, including linking future changes in benefits and the pension age to demographic factors, and separating the basic social pension so that it is financed from the state budget. On state-owned enterprises, the improvement in transparency regarding assets is welcome; looking forward, we recommend strengthening the cost-benefit analysis of SOEs’ social functions and developing governance reforms. On tax compliance, we welcome plans to limit the use of business certificates, extend the use of cash registers, and strengthen anti-smuggling efforts.

9. A strengthening of the fiscal framework would be desirable. Plans to tighten rules on the use of Treasury reserves are welcome. The role of independent evaluation in budget planning and execution could be expanded by establishing a new independent body, such as a fiscal council. The existing expenditure rule provides sensible targets, at least for the forecast horizon. The proposed additional rule provides a welcome focus on counter-cyclicality, but is complicated and difficult to implement. The government could consider adding a “debt brake” to the existing expenditure rule, in line with the objective of reducing debt to well below 40 percent of GDP.

Financial stability

10. The strong recovery has boosted banks’ performance. Nonperforming loans have stabilized, allowing some banks to reverse earlier loan loss provisions, and net interest margins have risen. As a result, banking system profitability has returned to close to pre-crisis levels. Substantial increases in bank capital have boosted the banking system’s capital adequacy ratio to about 15 percent in June 2011, well above the pre-crisis level. At the same time, banks have increased liquidity: the average ratio of liquid assets to current liabilities was about 40 percent at end-August 2011.

11. The banking system as a whole is well-positioned to withstand adverse shocks. Recent stress tests by the central bank show that, even with sharply negative export growth and a spike in interest rates, the banking system’s median capital adequacy ratio would remain well above 8 percent (the regulatory minimum). Even with a sharp deposit drain, the banking system’s median liquidity ratio would fall only slightly below 30 percent (the regulatory minimum).

12. Notwithstanding generally encouraging developments, some pockets of weakness remain. Some banks have made lower loan loss provisions than other banks, despite having higher NPL ratios. In these banks, it will be necessary to assess risks conservatively, to make appropriate loan loss provisions, and to increase capital if necessary. If the need arises, existing law provides the necessary authority to take adequate measures. In line with European and global initiatives, the range of resolution tools should be broadened.

13. The planned unification of financial supervision will strengthen the authorities’ ability to identify and address risks to the financial system. Given economies of scope in financial activities, the unification of bank, insurance, and securities supervision, as well as consumer protection, under the central bank makes sense. Responsibility for financial supervision should be clearly allocated to the board of the central bank. In addition, the imminent introduction of responsible lending guidelines to contain systemic risk, which include limits on loan-to-value and debt service-to-income ratios, is welcome.

14. To ensure that viable individual borrowers can recover and that creditors have adequate protection, an effective personal insolvency regime is needed. The proposed law is broadly in line with international best practice, though it could be strengthened in a few areas.

Sustainable growth

15. Enhancing labor participation and facilitating labor reallocation to tradable sectors will be key to sustainable growth. We are concerned that raising the minimum wage at this juncture could slow job creation, reverse recent competitiveness gains, and increase government spending. We support plans to make permanent the changes to the Labor Code that provide more opportunities to use fixed-term contracts for new vacancies. To overcome skill mismatches, full use should be made of EU structural funds to support job schemes, expand training programs, and improve matching through enhanced labor bureaus.

16. Efforts to improve the business environment are welcome and should continue. Requirements for starting a business have been streamlined; it will be important to ensure that the shorter timetable for obtaining a construction permit is implemented. The new law on business inspections is welcome, as it separates policy making from policy implementation, increases transparency, and enhances coordination between inspectorates. We support the proposed law on strengthening the role of the Competition Council, including by giving it the authority to pro-actively check compliance with competition rules.

Euro adoption

17. We support the authorities’ intention to meet the Maastricht criteria as soon as possible. Meeting the fiscal deficit target for 2012 of 2.8 percent of GDP would preserve euro adoption aspirations.