Public Information Notice No. 08/47

Public Information Notice: IMF Concludes 2008 Article IV Consultation with the Republic of Lithuania

April 22, 2008

On April 16, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

Economic performance over much of the past decade has been very strong, reflecting in part broad macroeconomic stability. The growth rate of real GDP per capita has been one of the highest among emerging market countries, inflation one of the lowest, and the unemployment rate has declined. These favorable developments have been supported by EU accession, rapid financial integration, and generally sound macroeconomic policies, including the currency board arrangement, the low and declining level of public debt, and relatively flexible labor and product markets.

However, external and internal imbalances increased in 2007. The external current account deficit widened to an estimated 13 percent of GDP and end-year Consumer Price Index (CPI) inflation rose to 8¼ percent. House prices continued to increase, accompanied by a rising share of property-related investment in GDP and rapid credit growth. Rapid wage growth led to an appreciation of the real effective exchange rate.

Public finances are generally sound, but fiscal policy turned procyclical in 2007. General government debt fell from 24 percent of GDP to 18 percent of GDP between 2000-06, reflecting small fiscal deficits and rapid GDP growth. However, in 2007, the fiscal deficit (including restitution payments) widened to 2 percent of GDP, giving rise to a fiscal stimulus of ½ percent of GDP. A fiscal responsibility law was enacted in November 2007. The law prohibits mid-year budgets, requires that revenue over performance be saved, and stipulates that the government budget aim for balance or better, subject to escape clauses intended to avoid procyclical policy in an economic downturn.

Indicators of the banking system's soundness are generally satisfactory. Profitability is high and nonperforming loans are low, and capital adequacy has increased in recent years. Foreign-owned banks account for about 85 percent of the banking system's assets. In recent years, the Bank of Lithuania (BOL) has strengthened banks' capital bases by raising the effective risk weight on residential mortgages, restricting the amount of current-year profits that count toward regulatory capital, and asking banks to fully retain profits. The BOL has also urged banks to pay due attention to loan-to-value ratios and debt-service-to-income-ratios, and to conduct stress tests on borrowers' debt service capabilities under different interest rate scenarios. In the non-bank financial sector, assets have grown rapidly and financial institutions are becoming increasingly sophisticated.

Executive Board Assessment

Executive Directors commended Lithuania's impressive economic performance over much of the past decade—in particular, rapid economic growth and rising employment rates—that reflected EU accession, rapid financial integration, and generally sound macroeconomic policies under the currency board arrangement.

However, Directors raised concerns about the recent rise in external and internal imbalances, characterized by an unsustainable current account deficit and an increase in domestic inflationary pressures, resulting from excess domestic demand. Directors observed that these imbalances will need to be reduced significantly over the medium term in order to contain external vulnerabilities. They also noted that, although the level of the real effective exchange rate is still broadly appropriate, continued rapid wage growth could erode competitiveness. Given the currency board arrangement, Directors stressed that fiscal and structural policies hold the key to stabilization and growth.

Looking ahead, Directors considered that tightening financing conditions would lead to an orderly easing of imbalances in 2008-09, and concurred that a soft landing of the economy is the most likely scenario. Given tighter bank lending standards and the cooling of the housing market, a substantial slowdown in credit growth is likely. Therefore, while the economy's underlying momentum remains strong, Directors expected domestic demand growth to slow, leading to a narrowing of the current account deficit and an easing of inflationary pressures. However, Directors were concerned about the risk of a hard landing. They cited the experience of other countries where rapid house price increases were sometimes followed by abrupt house price declines. Directors cautioned that Lithuania's reliance on external financing makes it vulnerable to a sharper scaling back of new lending by parent banks. If these risks materialize, domestic demand growth could slow quickly.

Directors welcomed the planned tightening of fiscal policy in 2008, and suggested additional fiscal contraction to support a soft landing. They recommended that the government start preparing for further fiscal consolidation in 2009, with the goal of achieving cyclically-adjusted balance by 2010. Directors urged the government to resist pressures to cut taxes, introduce new exemptions or tax credits, or raise spending in the run up to the October 2008 elections. They welcomed the new fiscal responsibility law, and supported the government's plans to further enhance transparency and reduce the risk of procyclicality in an economic upturn. They also encouraged the authorities to give priority to increasing government efficiency within the context of a medium term fiscal strategy.

Directors emphasized that the priorities for bank supervision are to maintain high lending standards and strong risk management and to increase capital buffers. They welcomed the findings of the Financial Sector Assessment Program (FSAP) update, namely that indicators of the banking system's soundness are generally satisfactory and are expected to remain so under the soft landing scenario. Directors observed that the regulatory and supervisory framework for banks is in line with international standards, and that the Bank of Lithuania conducts effective supervision of all banks operating in Lithuania. They welcomed the Bank of Lithuania's measures in recent years to strengthen banks' capital bases and encourage strong risk management. Directors noted that the dominance of reputable foreign banks supports the banking system's resilience but also exposes Lithuania to the risk of financial contagion. Nevertheless, given the potential impact of low-probability extreme events on the banking system, Directors recommended that banks' capital buffers be raised and that contingency plans, including credit lines, in the event of liquidity shocks be further discussed with banks, parent banks, and home country authorities. As regards the non-bank financial sector, Directors urged the authorities to improve supervision given the rapid growth of assets and the increasing sophistication of financial institutions.

Directors observed that greater economic flexibility and productivity-enhancing reforms would support a soft landing by easing supply bottlenecks and would facilitate the reallocation of resources in the event of a hard landing. Priorities include easing restrictions on working hours, removing obstacles to immigration, improving the education system and encouraging investment in science and technology, and streamlining the assessment of firms' compliance with regulatory standards.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.