Mission Concluding Statement 

Republic of Lithuania: Staff Concluding Statement of the 2016 Article IV Consultation Mission

March 16, 2016

Economic activity is poised for a pickup this year as the drag from the unfavorable external environment diminishes. Thanks to many years of fiscal effort, the budget deficit now stands at an appropriate level, and over the medium term the focus should be on avoiding any deterioration in structural terms. Sustainably advancing Lithuania’s living standards now depends on making determined progress with structural reforms, which ideally should be bound together in a comprehensive and coherent package to provide strategic direction. There are several priorities: better developing and utilizing human resources; supporting the modernization of firms; further improving the business climate; and ensuring that the structure of taxation and public spending is efficient, pro-growth, and equitable. Many of these reforms are complex, including those considered under the “New Social Model.” The implications of their design need to be carefully and fully considered before moving ahead. Competitiveness of Lithuanian exports is adequate, but could come under pressure if current wage and productivity trends persist. In this context, efforts to upgrade enterprises should be redoubled and it would be prudent to consider a pause in minimum wage hikes until they can be justified by productivity and competitiveness gains.

An improving near-term economic outlook with downside risks

1. Growth should reach 2.7 percent in 2016 and strengthen further in the outer years. As last year, the drivers will be solid private consumption on the back of robust wage growth together with strong investment, reflecting pent-up demand, high capacity utilization, and reviving bank lending. Furthermore, the drag from low exports is set to diminish compared to 2015, primarily due to the easing of recession and currency depreciation in Russia and the CIS, giving GDP growth an upward jolt. Over the medium term, growth is expected to inch up further to around 3½ percent, but this is contingent on further reforms.

2. Risks to this outlook are mainly on the downside. Considering Lithuania’s high degree of economic openness, predominately downside risks to the global growth outlook could spill over to the domestic economy through trade channels. Volatile financial conditions abroad could affect Lithuania indirectly via the foreign banks that dominate its financial system, primarily through credit supply channels. Domestic risks relate to future competiveness developments. On the upside, lower-than-projected global energy prices could boost purchasing power further. A credible reform package would send a welcome positive signal and provide improved strategic direction.

Public finances have reached a milestone worth safeguarding

3. The structural fiscal deficit fell to an estimated ½ percent of GDP last year—a level that ensures a reliable rebuilding of fiscal buffers if maintained over time. Expenditure restraint, revenues from buoyant wage and consumption growth, and incipient gains from improved tax administration delivered the final consolidation stretch. If maintained at this level over the medium term, the structural balance would reliably put the public debt ratio on a downward path, after its sharp rise since 2009. As a result, fiscal buffers would be rebuilt to better deal with future shocks and to cushion the rise of age-related spending to some extent. While the 2016 budget falls somewhat short of achieving a structural deficit of ½ percent of GDP, the gap seems small enough to be bridged by careful budget execution. But there is no room for costly new initiatives this year.

4. Policy makers can now squarely focus on fiscal structural reforms. The emphasis should be on measures that promote growth and reduce income inequality, which is among the highest in the EU—not only a social concern but also the source of important macroeconomic implications. For example, it can hinder people from developing their full potential or adequately recover from setbacks. Spending more on social protection and active labor market programs, as well as adjusting the tax system, can help, but any measures need to be cost effective. In addition, resources could be mobilized by rationalizing expenditure associated with Lithuania’s oversized education and health infrastructures. On the revenue side, wealth taxation remains underdeveloped, tax administration improvements have a long way to go, and the addition of an upper bracket to the personal income tax could also be considered. The overall reform package would need to be budget neutral to preserve hard won fiscal gains.

The banking sector is stable and lending again

5. There are no immediate risks to financial stability. Lithuania’s predominantly Nordic-owned banking sector boasts impressive financial soundness indicators, with capital adequacy and liquidity ratios rising further in 2015 from already strong levels. Access to ECB liquidity since joining the euro area also reduced vulnerabilities. Thanks to cost cuts, bank profitability has so far proven resilient despite revenue losses from euro adoption and the low interest rate environment. Some smaller banks and credit unions still need close monitoring but are not systemic. The advancement of the credit union reform legislation in parliament is welcome and should be brought to a swift conclusion.

6. Bank lending firmly returned to positive growth last year, ending the extensive deleveraging that started in 2008/09. However, new bank lending to the SME segment remains exploratory at best. This underscores the need for continued support for SME and startup financing under the various schemes implemented with EU funds. It will be important that the transition of existing programs between Multiannual Financial Frameworks is managed smoothly. Welcome efforts are now underway to develop a framework that would facilitate alternative financing.

7. There are no signs of financial excesses developing and tools are in place to address them should they arise. At around 5 percent private sector credit growth is moderate, housing prices are still substantially undervalued, and household and corporate balance sheets are strong. Despite the overhauled regulatory regime and a full-fledged macro-prudential tool kit, close cooperation with home-country authorities remains important to add traction to domestic policy tools and better deal with any unforeseen circumstances.

External competitiveness remains intact but needs monitoring going forward

8. As of now, price competitiveness is not a concern but could soon become one if current trends persist. Wage growth has exceeded productivity gains in the past few years, but the critical tradable sector had some cushions from earlier years and its profitability also benefitted from lower prices for raw materials. However, these cushions are now mostly used up. If real wages remain on their current trajectory for much longer, price competitiveness could be materially hurt. While all the stops should be pulled out to boost productivity growth, relief should also come from the cost side. Minimum wages have been rising rapidly since mid-2012. They feed into general wage growth and their high ratio relative to average wages puts formal job prospects for the low-skilled and those working in marginal firms at risk. It would be prudent to pause minimum wage hikes, depoliticize the process of setting them, and start addressing legitimate concerns about income inequality through other means.

9. More attention should be paid to developments in non-price competitiveness, i.e., exporters’ ability to upgrade to more sophisticated products. While exporters have demonstrated nimbleness in maneuvering a difficult external environment, Lithuania’s export market shares have started to stagnate in the past few years. This may reflect an erosion of the edge that Lithuanian exporters used to have over their competitors in creating higher value added products, which command higher prices.

Productivity growth for competitiveness, equity, and higher living standards

10. Productivity growth is the ultimate foundation for improving living standards. Supporting policies in Lithuania fall into three broad categories. They can be designed to particularly target those at the lower end of the income distribution thus reducing income inequality. They could be a powerful tool to chart a hopeful path forward when tied together in a comprehensive and coherent package of concrete measures with periodic monitoring of progress.

• Employability of labor. Structural unemployment remains high and labor market mismatches abound. Lithuania’s large wedge between labor costs and take-home pay should be lowered in a cost effective way, for example by introducing a basic exemption for social security contributions, along the lines of the mechanism that is already in place for the personal income tax, or other in-work benefits. Lithuania’s limited active labor market programs should be ramped up, spending more per individual, while ensuring quality, and better covering those at risk of job loss. A program for life-long learning should be put in place, with labor legislation fostering participation. Job mismatches should be addressed by improving vocational training and raising its profile. In higher education, financial incentives should be strengthened for students to enroll in fields that are highly demanded in the labor market. Mandatory orientation, building on the recently launched “job barometer,” could be considered before students embark on post-secondary education. To alleviate critical labor shortages, “labor market test” requirements should be dropped for immigrants with pertinent skills.
• Company upgrading. Lithuania scores relatively poorly on innovation indicators, not only on those measuring cutting edge scientific achievements, but also broader ones, such as the upgrading of product lineups, internal processes, or marketing. While supporting programs are in place, these remain limited in terms of size and scope. Resources could be freed up by reforming existing innovation policies that are fragmented, favor physical infrastructure, and overemphasize scientific advancements that are difficult to commercialize.
• Business environment. Lithuania’s business environment rightly earns high marks. Nevertheless, tackling outdated labor legislation, inefficient bankruptcy procedures, and overly strict immigration rules would bring further improvement. The recent review of the regulatory environment is commendable, but some of the identified unnecessary requirements have yet to be removed. Finally, the agenda for bringing the shadow economy into the formal sector should be pushed forward aggressively.

Getting the most out of the “New Social Model”

11. The “New Social Model” is a bold reform initiative with the right thrust. Unveiled about a year ago, its aim is to modernize labor relations, upgrade social benefits, and reform social security. With significant changes envisaged in each of these areas, the economic, financial, and social implications need to be carefully considered.

• The new labor code has already been discussed extensively. It would help facilitate job creation, attract foreign investors, and improve labor relations. However, it will be important to ensure that the original proposal is not overly diluted. In particular, amendments that raise labor taxation should be avoided considering Lithuania’s already high labor tax wedge.
• Social benefit reform is closely linked to the overhaul of the labor code and should thus be implemented at the same time. The envisaged improvements in unemployment benefits would allow for better job search and mitigate reductions in severance pay.
• Social security reform involves profound changes, including a new pension formula, an indexation mechanism, and a partial shift of pension expenditure from the State Social Insurance Fund to the State Budget. It is bound to have far-reaching implications for the social and financial sustainability of the system for decades to come. Deliberations should allow sufficient time to carefully consider all the ramifications, even if this entails social security reform moving ahead more slowly that the other elements of the “New Social Model.” Any agreed new arrangement should be subjected to expert and actuary scrutiny before it takes effect.

The IMF team is grateful for the generous hospitality of the Lithuanian authorities and would like to thank all interlocutors in government, the Bank of Lithuania, the private sector, and NGOs for constructive and fruitful discussions.