Mission Concluding Statement 

Lithuania -- International Monetary Fund Staff Visit, Concluding Statement

July 12, 2005

1. Following the adoption of sound policies earlier in the decade and their consistent implementation, Lithuania achieved enviable macroeconomic performance. High economic growth rates and low inflation were the fruits of the policy efforts. Accession to the European Union and entry into ERM-II in mid-2004-as a prelude to euro adoption-have further laid the foundations for catching-up with the more advanced European economies.

2. To maintain the impressive growth rates and, more seriously, to insure against erosion of the long-term growth potential, forward-looking actions are now needed. Beyond ensuring smooth euro adoption, of special importance are increasing the operational efficiency of the government and promoting a business environment that continually responds to new challenges faced by exporters and investors. This requires greater insulation of fiscal decisions from short-term political pressures and the pursuit of a broad range of structural reforms to foster a competitive economy.

Growth Outlook

3. Growth has recently been held up by domestic, especially consumer, demand. GDP growth in 2005 is expected to moderate to about 6½ percent, with downside risks if the ambitious absorption of European Union (EU) funds is delayed until 2006. The Lithuanian consumer has contributed significantly to growth in recent years, while the contribution of exports has declined. Consumer demand is observed in the traditional measure of consumption and also in the demand for investment in residential properties, which has been buoyant. At the same time, export growth has come down from the heady rates in the early years of this decade, though it has remained respectable. Some one-off factors explain the decline in export growth rates; others have helped maintain exports (e.g., subsidies boosted agricultural exports following accession to the EU).

4. Growth, in the medium term, is expected to drift down towards its potential, assessed currently to be in the 5½ to 6 percent a year range. Constraints to growth are evident in the labor market where, despite an unemployment rate of over 10 percent, bottlenecks have led to a significant rise in wages, driven, in part, by public sector wage increases. Constraints are also evident in the property market. The goal must be to raise the economy's potential growth rate, consistent with its catch-up prospects.

Euro Adoption

5. Euro adoption in early 2007 appears well-within reach, but prompt efforts are needed to "insure" against a possible breach of the Maastricht inflation limit. Since supply-side shocks could, under the tight economic conditions, temporarily push the inflation rate above the ceiling, steps are needed to reduce the spillover effects of these shocks, and thus prevent the emergence of self-reinforcing inflationary expectations. To contain the inflation rate, we would discourage administrative and tax measures-which distort economic decisions and do not reduce inflation in a sustainable manner-and would recommend, instead, restraint in public sector wages, pensions, and fiscal expansion. In this context, higher than expected revenues should be saved to achieve a deficit this year below 2 percent of GDP. There may be merit also in curbing fiscal incentives that boost credit (i.e., tax credits on mortgages). These actions would be consistent with the medium-term objective of a balanced structural, or cyclically-adjusted, budget (which, with growth running above potential, is about 3 percent of GDP), creating room for automatic stabilizers. As an added benefit, competitiveness would be strengthened, allowing higher absorption of EU funds and reducing the pressure on the current account.

Fiscal Policy

6. Recent tax reduction initiatives have paid insufficient attention to long-term implications. The planned cuts of the personal income tax rate are appropriate for reducing the effective cost of labor. However, as the authorities recognize, revenues could decline by about 2 percent of GDP when the full measure is implemented in 2008. It is unfortunate that the planned partial compensation for this revenue loss is to occur through the "social tax," effectively a surcharge on the corporate income tax. Ad hoc and temporary changes in tax rates are undesirable and create uncertainty among investors. Instead, a policy of broadening the tax base through scaling back of exemptions plus instituting an ambitious property tax and a vehicle tax would have been a more suitable course. Moreover, with the expiration of the social tax in 2008, the revenue shortfall will reappear. Higher growth and whitening of the gray economy may help bolster revenues, but not unless complementary administrative tax collection measures are taken.

7. Long-term sustainability also requires expenditure discipline, supported by a Fiscal Responsibility Act. To achieve the targeted deficit reduction in the Convergence Program, while accommodating also the revenue losses on account of the tax cuts and the rising pressures on expenditures in line with growing aspirations, it is necessary to achieve greater efficiency in public spending. The need for reforms in, for example, the education and health sectors and for curbing subsidies in agriculture is widely recognized. Reduced government expenditures along with improved supply of services are possible through harnessing private initiative. For example, in the health sector, consideration should be given to a second pillar, based on cofinancing and/or private insurance. Further emphasis is also needed on instituting expenditure controls and more efficient fiscal decentralization. As such, we are disappointed that progress on the development of a Fiscal Responsibility Act has stalled.

Competitiveness

8. To sustain export growth and attract foreign direct investment, renewed and strategic attention is necessary to broad-based measures that improve competitiveness. The real exchange rate on a CPI basis had been appreciating until mid-2004 and then has been stable (or even slightly depreciating). The real exchange rate in terms of unit labor costs has flattened, after declining till early 2003. Lithuania's shares in international trade may have peaked, suggesting that easy gains will no longer be possible. Cheaper imports from Asia are eroding the advantage that Lithuanian exporters have enjoyed in low-technology products. The move up the technology ladder has occurred, but only modestly, and will entail building up significant capabilities, not rendered easy by the migration of high-skilled workers. In light of these trends, further structural reforms are required in the labor market, educational system, and infrastructure delivery to enhance growth and productivity. The effective use of EU funds is crucial in this context. Because competitiveness requires a variety of different initiatives, a strategic view at the highest level is needed to ensure that the objective is not neglected by default.

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Lithuania stands at an important juncture in its economic development. With the first phase of restructuring largely completed and a wave of new international competition, more sophisticated challenges have arisen. Lithuanian entrepreneurs have demonstrated the capability to respond to challenges. Prudent fiscal policies and a strong business climate would provide an environment for continued robust growth. We thank the Lithuanian authorities for their warm hospitality, generous cooperation, and candid discussions during this short visit. We hope to pursue these discussions in greater depth during the proposed 2005 Article IV mission in December.