IMF Executive Board Concludes Article IV Consultation with the Republic of Lithuania
Growth has remained resilient, despite challenges in the external environment. Strong domestic demand growth on the back of improving labor market conditions underpinned real GDP growth of 2.9 percent in 2014. Exports held up reasonably well despite Russian import bans and the incipient recession in the CIS, reflecting a successful diversification drive into new markets and generally strong competitiveness. External factors were responsible for annual inflation of just 0.2 percent, with 12-month inflation rates dipping into negative territory toward year end.
Growth should remain largely unchanged at 2.8 percent from last year in 2015, as positive external factors counterbalance negative ones and domestic demand remains robust. The economic recovery in the euro area and low energy prices are major boons, but the deepening recession in the CIS and geopolitical uncertainty will hold back growth of exports and investment. Risks are moderately tilted to the downside, with deepening geopolitical tensions the main concern, although the effect of lower energy prices could surprise on the upside. Inflation will turn positive again, but average below zero for the year as a whole.
The main policy challenge will be to secure reasonably rapid convergence with living standards in Western Europe going forward. With macoreconomic stability and strong policy frameworks in place, the onus is mainly on structural reforms: fiscal structural reforms to lift spending efficiency and shift the tax burden away from labor; investment and innovation promotion through use of EU funds and better focused policies; and making the most of demographically shrinking labor resources through education reform and a modernization of the labor code.
Executive Board Assessment
In concluding the 2015 Article IV consultation with the Republic of Lithuania, Executive Directors endorsed staff’s appraisal, as follows:
Strong economic fundamentals and recent resilience to adverse external factors bode well for the near-term economic outlook. Legacies from the 2008/09 crisis have been largely worked off, with external and internal balance in place, strong public finances, private-sector balance sheets generally healthy, and policy frameworks strengthened in the context of euro adoption. Good economic performance despite adverse events in the CIS once again underscores the resilience and flexibility of the Lithuanian economy. Risks have moderated but remain tilted to the downside and relate mostly to external factors.
Over the medium term, convergence with living standards in Western Europe will depend critically on advancing the structural reform agenda. Investment needs to increase back to historical norms, labor resources should to be better utilized to mitigate the drag from worsening demographics, and more innovation is required in support of moving up the value chain and remaining competitive as wages converge toward EU levels. Contingent on such reforms, growth could rise to 3? percent over time.
Fiscal consolidation is almost complete but past gains need to be preserved to build more fiscal space over time. Public finances overperformed last year, but it will take measures of 0.4 percent of GDP to keep the fiscal deficit from deteriorating this year. The implied neutral stance is the minimum required under the SGP and broadly appropriate for Lithuania, considering the still slightly negative output gap. Moderate further consolidation of 0.3 percent of GDP next year would deliver the staff-recommended target for the fiscal structural balance of -0.5 percent of GDP, ensuring a steady but gradual decline of the public debt ratio over time, thereby regaining fiscal space needed to be prepared for future adverse shocks.
Fiscal structural reforms could usefully defuse future spending pressures, raise spending quality, and improve tax efficiency. Wealth taxes and tax administration should be strengthened to create room for lightening the labor tax burden, spending programs with subpar results should be reformed, and areas subject to likely future spending pressures should proactively be tackled. Formulating a coherent fiscal structural reform strategy could catalyze progress.
The stability of the largely Nordic-owned banking system has further strengthened, with increased capitalization, lower NPLs, high liquidity, and adequate profitability. Access to ECB liquidity and SSM participation are newly gained additional safeguards. But supervisors need to persevere with efforts to strengthen some smaller domestic banks and credit unions with higher risk profiles and lower capitalization. Plans to fundamentally reform the credit union sector are welcome.
More private sector investment and innovation are needed to securely underpin continued income convergence. The lack of rebound in private investment after the 2008/09 crisis, still sluggish credit developments, and relatively poor innovation performance need to be addressed. Efforts to utilize EU funds and resources under the “Juncker Plan” are welcome, especially to the extent that they benefit SMEs, which have a hard time securing financing from risk averse banks. The effectiveness of innovation policies would benefit from reducing fragmentation in the current setup. An improved outlook for the availability of qualified labor would spur investment and innovation indirectly.
Making the best possible use of available labor resources in the face of adverse demographics is of paramount importance. Proposals for reforming the labor code are an opportunity to modernize labor relations and improve labor utilization. Education reform is of the essence to equip the labor force with a skill mix that better matches companies’ needs.
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