Mission Concluding Statement 

Lithuania - December 2008 Staff Visit, Concluding Statement of the IMF Mission

December 16, 2008

The Lithuanian economy faces challenges. The rapid deterioration in the global economic outlook and the continued process of financial deleveraging constitute a serious external shock. The recent period of strong growth in domestic demand has resulted in high inflation and a larger current account imbalance. In this environment, further changes in market sentiment or sharply slowing capital inflows could amplify the impact of the global shock. Addressing the situation will require a combination of bold upfront policy actions and contingency planning to facilitate Lithuania's ability to respond, particularly in the event that the global environment deteriorates further. The currency board arrangement remains central to the policy mix, contributing to macroeconomic stability and providing a bridge to eventual euro adoption. This places the onus on fiscal policy to contribute to the reduction in domestic demand needed to safeguard external sustainability, while the private sector also needs to ensure sufficient wage flexibility and growth in productivity to underpin future competitiveness. This adjustment would need to be complemented by preemptive measures to enhance banks' capacity to weather the economic slowdown. Quick and strong action on all these fronts should bolster confidence and create the preconditions for eventual recovery.

Economic outlook

The economy is entering a downturn. The unexpectedly sharp and prolonged deterioration in the global economy and financial markets-particularly in regional trading partners-will substantially reduce export demand growth and foreign capital inflows. New funding from parent banks is expected to fall from the elevated levels of recent years and credit to the private sector could come to a standstill, if not shrink. Rising unemployment and planned reductions in public sector wages will generate downward pressures on private sector wages. The ongoing correction in real estate and other asset markets will further erode household and firm confidence. The scaling back of corporate and household investment and consumption plans, combined with tighter fiscal policy will contribute to the contraction of domestic demand. Against this backdrop, real GDP, which is estimated to have grown by
4 percent in 2008, would contract by 2 percent in 2009. Continuing the trend already observed in recent data, the external current account deficit would quickly narrow from 12½ percent of GDP in 2008 to 6½-7 percent in 2009. Inflation is projected to be 9¼ percent by end-2008 and to slow to 5¼ percent by end-2009. These projections are subject to high uncertainty, but the risks to the outlook are skewed to the downside: the longer the difficulties in global economy persists, the more severe and prolonged the downturn is likely to be.

Fiscal adjustment

A sizeable upfront fiscal adjustment is necessary. Global financial markets are effectively closed and domestic borrowing options are severely limited by a lack of liquidity- constraining fiscal policy options. The recent surge in domestic demand also needs to be partially unwound in line with external stability requirements: fiscal policy is the most readily available policy tool for this purpose. Upfront fiscal adjustment, supported by a sustainable restructuring of taxes and spending, can signal the government's commitment to macroeconomic stability and thus underpin confidence in the currency board arrangement. For these reasons, Lithuania does not have the scope for fiscal stimulus available to some other countries to counter the downturn.

The fiscal deficit target of 2.1 percent of GDP represents a major policy tightening. This is consistent with an adjustment of nearly 4 percentage points of GDP. Revisions to the draft public budgets for 2009 include a well-crafted package of measures as the basis for adjustment. The increase in the standard VAT rate-and the removal of preferential VAT rates and exemptions-will increase revenues, broaden the tax base, and remove costly distortions. The impact of higher VAT on households will be partly compensated by a reduction in personal income tax rates. Moreover, the delay in the removal of the preferential VAT rate on heating fuel and targeting of the `tax-free' amount under the personal income tax to low-income families will help protect socially vulnerable groups. The increase in excises will complete the convergence to EU requirements in this area. On the expenditure side, the significant adjustment to wage costs will not only generate needed savings, but also will signal the need for downward flexibility in private sector wages, which had increased rapidly-ahead of productivity growth-in recent years. Financial conditions also necessitate some scaling back of the investment program.

Budget financing and revenue performance will require close monitoring. The difficult economic outlook increases the degree of uncertainty surrounding the budget forecasts. The government should plan to review budget implementation mid-year and identify contingency measures that would address any shortfalls in budget resources. These could include further increases in indirect tax rates or additional expenditure cuts. It would be prudent to backload major spending projects until the financing has been secured, and to manage carefully the commitment of expenditure under the treasury plan. If financing becomes available later in the year, it would then be feasible to scale up budget implementation accordingly. Nonetheless, sustainable adjustment in expenditure will require longer-term structural reforms to address the imbalances in the SoDra and health fund finances.

Financial stability

The financial environment has become more challenging. The global financial crisis has reduced liquidity available to banks operating in Lithuania, reducing credit growth and future profitability. In response to the decline in banking system deposits in October, the prompt action by the authorities to increase deposit insurance coverage played a key role in restoring stability. The reduction in the reserve requirements for banks from 6 percent to 4 percent has also eased liquidity pressures, and the authorities are developing further options to enhance their capacity to provide additional liquidity to the system, if needed. There are indications of declining asset quality in banks and the economic downturn is likely to weaken further the quality of banks' assets. Against this backdrop, the Bank of Lithuania has requested that banks increase their capital buffers, including by retaining current-year profits. These measures, together with additional efforts on loan-loss provisioning, should help banks to absorb prospective losses arising from a deterioration in asset quality.

The global financial crisis calls for heightened vigilance and contingency planning. The recent FSAP update for Lithuania found that the regulatory and supervision framework in Lithuania is in line with international standards and that the Bank of Lithuania conducts effective supervision of all banks. The Bank's readiness to respond promptly to problem situations has recently been enhanced by the daily monitoring of bank-by-bank deposits and liquidity positions, as well as the expansion in the list of collateral eligible for use at its liquidity window and the streamlining and updating of associated valuation procedures. The authorities are also well advanced in preparing contingency plans, building on experiences of other countries, to safeguard financial stability.

The package of policies being implemented in the fiscal and financial areas are strong and prudent. They should work to signal the authorities' commitment to macroeconomic stability in a very difficult environment. We thank the authorities for their generous hospitality, productive discussions, and close cooperation with the mission.