Mission Concluding Statement 

Lithuania--2010 Article IV Consultation Concluding Statement

May 25, 2010

1. The economy is recovering supported by a determined policy response and the global upturn. Confidence in the banking system was maintained thanks to parent bank support and the actions taken by the authorities to lower reserve requirements and increase the deposit insurance coverage. A sizeable fiscal adjustment−the right response to the crisis−was rewarded with renewed access to international capital markets. Ongoing wage adjustment and associated competitiveness gains are helping Lithuania benefit from the global recovery, with higher exports playing a crucial role in stabilizing the economy. However, domestic demand remains subdued amid rising unemployment, falling incomes, and weak credit prospects. Overall, real GDP is expected to grow by 2 percent in 2010, with potential to surprise on the upside given the upturn in global trade. Uncertainty in international financial markets remains a source of risk. Looking ahead, medium term growth is expected to be in the 3½ percent range with real GDP only recovering its pre-crisis levels in 2014/15.

2. While much has been achieved over the past year, the crisis has left three key policy challenges. The fiscal deficit remains high and public debt is growing rapidly, leaving Lithuania reliant on external financing at a time of heightened market sensitivity about fiscal sustainability. While a substantial fiscal retrenchment has been implemented, further effort is needed to consolidate the success already achieved. Enhancing the quality of assets in the banking system will also be important given the legacy of non-performing loans. Beyond these immediate considerations, medium-term growth prospects could disappoint if the economy does not rebalance towards tradeables.

Securing fiscal sustainability

3. Further fiscal consolidation is needed to place deficits and debt on a sustainable path. With the 2010 fiscal deficit estimated at 7¾ percent of GDP and debt service costs rising, the public debt burden would breach the 60 percent Maastricht ceiling as early as 2013 if no new measures are taken. Against this backdrop, Lithuania’s convergence program appropriately targets reducing the deficit to the 3 percent Maastricht criterion by 2012. Extending the 2009-10 measures that expire in 2011 is a necessary start, but not enough. Some 5½ percent of GDP in additional effort−about half the consolidation to date−is required. Economic growth cannot substitute for this. Even in the unlikely event that growth returns to the levels registered pre-crisis, the adjustment need would still amount to some 3 percent to GDP.

4. A consolidation of this size calls for a comprehensive package of both expenditure and revenue measures. Quickly announcing specific proposals will help underpin credibility and market confidence. So far, the adjustment has appropriately relied on wide-ranging expenditure measures. Going forward, there is a need to strike a balance between a broadening of the tax base to yield greater revenues and insuring the sustainability of the social insurance system, as well as finding means to protect the most vulnerable.

5. Reducing Sodra’s deficit will entail tackling high benefit outlays. Sodra’s deficit is forecasted to reach 3½ percent of GDP in 2010, with almost half of this deficit reflecting parental benefits which remain extremely generous by EU standards. Consolidation options could include limiting the duration of these benefits, introducing a benefit cap, lowering the replacement ratio, and eliminating duplicate payments. Tighter certification of other benefits such as sickness and disability could also yield significant savings over time.

6. Restoring the financial viability of the pension system will require a comprehensive approach. Increasing the retirement age and linking it to longevity will help bolster sustainability. To reduce future liabilities and increase the link between contributions and benefits, it will also be necessary to rely more heavily on a mandatory funded system with the basic pension financed by transfers from the state budget. However, these reforms will only yield savings slowly. In the meantime, one option could include aligning the tax treatment of pension income with other income. This would be more equitable than an alternative of cutting pension levels since poorer pensioners would be shielded by the income tax allowance. It would also have the benefit of bringing those with multiple or working pensions under the tax net.

7. Exploiting new revenue sources and closing existing loopholes would help raise revenue in the least distortionary way. Lithuania collects little from wealth taxation. A real estate tax on personal property with a broad enough base, together with an annual registration fee on cars could tap this potential and help minimize the need for rate increases elsewhere in the system. Gradually phasing out tax relief on mortgage interest payments and corporate tax incentives would also help broaden the tax base and reduce the bias towards debt finance. Beyond changes to the tax code, there is substantial scope to bolster revenues through continued strengthening of tax compliance.

8. Reform of the budgetary framework should focus on supporting the on-going adjustment. In particular, a more comprehensive reporting of contingent liabilities and tax expenditures is needed, as is a better monitoring and control of municipal arrears and finances. Formal mid-year budget reviews could also improve the responsiveness of policies. Once the debt burden has been anchored at a sustainable level, changes to the fiscal rule to better prevent pro-cyclical spending rises in good times could further strengthen the framework.

Enhancing the resilience of the banking sector

9. The banking system has weathered the crisis. Capital and liquidity indicators have improved to 15 percent and 45 percent, respectively. Meanwhile, the level of non-performing loans in the banking system is high. The level of non-performing loans has increased almost four-fold since end-2008, reaching 19.2 percent in March 2010. Viewed as a whole, the banking system has sought to enhance its buffers to absorb these losses, with loan loss provisions now covering almost 40 percent of non-performing loans, compared with some 21 percent in December 2008. However, published audited data suggest the pace of this effort has been uneven across the system.

10. Some challenges remain. Interest rate margins have narrowed amid higher interest expenses and deteriorated asset quality. At this stage of the cycle, further asset deterioration cannot be ruled out and a return to rapid loan growth risks adding to non-performing loans. Banks’ capital and capacity to generate cash income may remain under pressure. With changes also anticipated in Basel and EU prudential regulations covering asset valuation and capital, banks will need to raise further capital.

11. Addressing these challenges will require a more forward looking approach. Regulators should continue to closely monitor the sufficiency of banks’ loan loss provisions, and request banks to increase their capital as needed through agreements that set out a clear time frame for new equity injections. Given the challenging economic outlook and to proactively ensure bank viability, the BOL should require from banks a forward-looking business plan under a common set of assumptions, reflecting a stress scenario designed by the supervisory authorities. These plans would show each bank’s capacity to meet minimum prudential standards (including solvency and liquidity), and to generate cash income over a 24-month period. The mission also recommends an independent professional assessment of the consistency of collateral valuation across institutions, especially considering constraints in collateral foreclosure. Moving to a semi-annual audit schedule starting in June 2010, rotating the external auditing teams within audit firms now, and continuing to undertake liquidity stress scenarios at the consolidated group level, would reinforce existing procedures to identify potential vulnerabilities in a timely fashion.

12. To ensure the recovery of viable borrowers and the adequate protection of creditors, effective frameworks that rely on voluntary debt restructuring are key. Efforts underway to strengthen the corporate bankruptcy law, and introduce a personal bankruptcy act are welcome. Corporate debt restructuring procedures could be enhanced by addressing legal and institutional shortcomings for the treatment of fraudulent bankruptcies, clarifying the roles of courts and bankruptcy administrators, training sufficient staff, and granting senior creditor status to new financing. Restructuring efforts should continue to be based on a voluntary approach. Initiatives that seek to introduce mandatory moratoriums on debt payments risk increasing the level of non-performing loans in the banking system and delaying the recovery of solvent borrowers.

13. In line with global initiatives, steps to enhance contingency planning and resolution frameworks should continue. The mission welcomes progress made in this area. Following the passage of the Financial Stability Law, the corresponding by-laws have been drafted and are awaiting approval by the European Commission. It remains important to run regular crisis drills to identify weaknesses and bottlenecks in crisis management, intervention, and resolution procedures.

Generating growth and jobs

14. A sustained recovery hinges on the ability of the economy to rebalance towards tradeables. During the boom years, economic growth was primarily driven by non-tradeable sectors, mainly construction, real estate, and finance. Going forward, these sectors are not expected to make substantial contributions to growth, putting the onus on exports to drive the economy. Despite the rapid run-up in wages and prices in the non-traded sectors, Lithuania was able to contain costs in the export sector and gain world market share during the boom. This, combined with a significant fall in wage costs in the downturn, is supporting competitiveness while reducing estimates of overvaluation to modest levels.

15. The rising level of unemployment, an important social and economic challenge, makes it imperative to advance with structural reforms. Recent packages to support employment generation and SMEs through increased absorption of EU funds should help support the economy and job creation at a time of substantial fiscal adjustment. The new proposals in parliament to further enhance labor market flexibility would, if implemented, encourage hiring earlier in the recovery. Further steps to improve the business climate as well as the performance of state-owned enterprises could help stimulate investment. The government’s efforts to facilitate FDI have already played a role in attracting leading international companies, and programs to support exporters (partly with EU funding) could help raise productivity and exports in high value-added sectors.

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We would like to thank the authorities and all our interlocutors for their excellent cooperation, frank and productive discussions, and warm hospitality.