OREANDA-NEWS. Lithuania’s economy continues to recover, substantial economic rebalancing has taken place, and vulnerabilities have been reduced significantly. But, the rebuilding of fiscal buffers in ongoing, credit growth is still weak, and unemployment—while falling—remains high. This implies that Lithuania faces three key policy challenges to ensure that the recovery continues and is sustainable: (i) continuing the fiscal adjustment over the medium term; (ii) further strengthening the resilience of the banking system; and (iii) maintaining competitiveness so that growth and job creation are robust over the medium term.

An ongoing recovery

Much has been achieved in Lithuania since the crisis of 2008/09. Significant rebalancing has taken place: a current account deficit of almost 15 percent of GDP has been reduced to close to balance; the fiscal deficit has been brought down from over 9 percent of GDP to an estimated 3 percent of GDP; unit labor costs are well below pre-crisis levels; the tradable sector and exports played a key role in the recovery; and debt has declined across most sectors of the economy. Despite a difficult external environment, the economy expanded strongly in the last two years and unemployment is falling. Locking in these gains to secure and sustain the recovery is the overarching objective for the period ahead.

The recovery is expected to continue in 2013, but at a somewhat slower pace. Growth is projected at about 3 percent this year—down from 3.6 percent in 2012 but still higher than in much of advanced and emerging Europe. Investment growth will likely be spurred by current high levels of capacity utilization, easing financing conditions, and dissipating uncertainty about the external environment. Exports would contribute less to growth in 2013 than in 2012, as the effects of last year’s very good harvest unwind. Inflation is projected to continue to decline, reaching 2.1 percent in 2013, reflecting the lagged impact of lower global commodity prices. Looking farther ahead, growth should gradually rise toward its potential of around 3? percent, but this requires that investment continues to recover in the coming years. The current account deficit is expected to remain relatively contained over the medium term, though at somewhat wider levels than at present.

Risks around this outlook have moderated but remain tilted to the downside. Financial conditions have improved markedly in the past six months, but risks continue to emanate from both external and domestic sources. Renewed financial stress or weak growth in Europe would adversely affect Lithuania through trade and financial channels. A slowdown in other trading partners, such as Russia, would also weigh on Lithuania’s exports. And the projected pickup of investment could fail to materialize—possibly because credit does not recover as anticipated under the baseline—which would reduce growth.

Securing fiscal space

Completing the fiscal adjustment is important to rebuild Lithuania’s fiscal buffers. In light of the limited macroeconomic policy tools available under the currency board arrangement and Lithuania’s vulnerability to external shocks given its size and openness, it is important that the structural fiscal deficit and public debt ratio continue to be reduced. This would bolster fiscal buffers and create space to allow automatic stabilizers to operate during future periods of weak growth. For this reason, achieving a small structural surplus remains appropriate over the medium term.

The 2013 budget appropriately targets a further reduction in the deficit to 2? percent of GDP, but a focus on high quality measures is needed. This deficit target balances the need for further consolidation with supporting the recovery amid slowing growth. Overall, we project a fiscal deficit of 2.6 percent of GDP in 2013. At the same time, the quality of fiscal measures has weakened over time and the consolidation now relies mainly on one-off measures or extensions of temporary measures.

There is significant scope to implement high quality revenue measures to complete the fiscal adjustment in the medium term. So far, most of the fiscal consolidation has taken place on the expenditure side, while Lithuania’s revenue-to-GDP ratio is the lowest in the EU. Capital taxation in Lithuania remains well below the EU average while indirect taxes account for a significantly larger share of total tax revenue than elsewhere in the EU. Therefore, taxation of wealth—notably real estate and motor vehicles—could be expanded to raise additional revenue. These taxes have the added benefits of being less distortionary and more progressive than other taxes. Also, within the current system, there is scope to raise revenue by broadening the bases for corporate income tax and personal income tax. At the same time, it is essential that tax administration be improved, both to ensure that any changes in taxation ultimately bear fruit in terms of revenue generation and to help boost tax compliance more broadly.

Deepening fiscal reforms would be desirable. A simple, clear, and comprehensive fiscal rule, alongside a fiscal council, would strengthen the fiscal framework. Further reform of the pension system to ensure its long-term sustainability is also needed.

Strengthening the financial sector to support growth

Overall, the banking system is profitable, liquid, and well-capitalized, but continued vigilance is needed. The system-wide capital adequacy ratio is nearly 15 percent and liquid assets are about 25 percent of total assets. However, non-performing loans (NPLs)—while declining—remain high and profitability is falling. The intervention of Snoras bank removed a major threat to financial stability, and the recent steps to rapidly address problems in two troubled credit unions underscore the importance of effective financial sector supervision. In this context, the Bank of Lithuania’s (BoL) stepped-up onsite inspections, strict stress testing, and careful monitoring of banks’ loan loss provisions are essential for the continued health of the banking system. The BoL should continue to safeguard financial stability, including by requiring banks to raise capital as needed. Ongoing efforts to strengthen the supervision of credit institutions are welcome.

The financial sector has an essential role to play in supporting a robust and sustainable recovery. While Lithuania has so far been able to continue its economic recovery despite negative private sector credit growth for nearly four years, it is important that credit is not unduly constrained going forward. The weak economic environment and uncertainty about growth prospects both in Lithuania and abroad have no doubt hampered demand for credit by firms and households. At the same time, lending standards have been tight, partly reflecting continued risk aversion of the part of banks, lingering NPLs, and scarcer parent bank funding. NPLs appear to take a longer time to work out in Lithuania than in some regional peers, and a review of obstacles to timely NPL resolution should be considered. In this regard, the new household insolvency regime and recent proposals to modify the corporate insolvency regime are welcome.

Maintaining competitiveness and fostering sustainable growth

Lithuania’s competitiveness has improved substantially since 2008. It will be important that these gains are not eroded as the economy recovers and the output gap closes. This will help ensure that the recovery continues into the medium term and that growth is well-balanced.

Reducing unemployment is a key priority. Although the unemployment rate has been falling, structural unemployment appears to be high and emigration poses additional challenges. This calls for training to reduce skill mismatches and active labor market policies to support job creation, including by deploying EU funds in this area. While the recent large increase in the minimum wage can probably be accommodated given past productivity gains, there is a risk that it will feed into general wages and inflation and erode competitiveness. More generally, it will be important that wage growth does not outpace productivity growth going forward.

Future economic growth will depend critically on boosting investment. With competitiveness gains occurring so far mainly through the labor market, boosting capital formation will become increasingly important. Efforts to improve the business climate by reducing administrative burdens and streamlining territorial planning procedures would help raise investment. Energy sector reforms continue to be important to reduce costs and improve efficiency in this sector.