Mission Concluding Statement 

Republic of Lithuania: Staff Concluding Statement of the 2024 Article IV Mission

June 7, 2024

Vilnius, Lithuania: Lithuania has experienced fast income convergence over the past two decades and the economy is projected to return to growth this year after a shallow recession. However, positive inflation differentials following the shock triggered by Russia’s invasion of Ukraine have had an impact on competitiveness. Strong fundamentals have allowed the Lithuanian economy to absorb this shock without a significant impact on its growth potential. At the same time, global fragmentation, long-term spending pressures, and long-standing structural challenges in pension, education, healthcare and the labor market could weigh on productivity and growth. Thus, Lithuania needs decisive structural reforms to support sustained productivity growth and ensure higher living standards and continued convergence.

Recent Developments, Outlook, and Risks

After a short and shallow recession, activity started to recover at the end of last year supported by strong disinflation. After recording one of the highest rates of inflation in 2022—at around 20 percent, twice the euro area average—inflation more than halved last year supported by lower energy prices and is now below the euro area average. Core inflation has also moderated but remains elevated due to high energy pass-through, nominal wage growth and services inflation. The strong disinflationary momentum continued in early-2024 and reflects lower commodity prices, tighter monetary conditions, and a contractionary fiscal stance.

Fiscal performance was stronger than expected in 2023 with a structural position that has barely deteriorated compared to the pre-pandemic period. With an overall budget deficit of 0.8 percent of GDP—almost unchanged from 0.7 percent in 2022 but with a larger output gap—the fiscal policy stance was contractionary in 2023, supporting disinflation. This was due to revenue overperformance, the temporary levy on banks, and the faster-than-planned phaseout of energy subsidies. As a result, debt-to-GDP continued its downward trend falling 10 percentage points from the pandemic peak.

The banking system remains very liquid, well capitalized, and highly profitable, despite the temporary levy on banks. With ample liquidity, banks’ profitability benefitted from a faster transmission of higher interest rates on predominantly variable-rate loans than on deposits and higher remuneration on deposits at the European Central Bank (ECB). This, combined with one of the most cost-efficient systems in Europe, led to record high profitability—doubled over 2022—even after paying the levy on banks, which raised about 0.35 percent of GDP in 2023.

With tightening financial conditions and lower real disposable income, the real estate market has partially corrected imbalances built prior to recent shocks. The rapid growth of real estate prices since 2020, largely fueled by accommodative monetary conditions, higher construction prices as a result of supply chain disruptions and the strong post pandemic recovery, eased last year. As real incomes fell with high inflation, affordability deteriorated—a trend that has reversed since real wage growth turned positive last year. This combined with higher borrowing costs resulted in a slowdown of demand and of nominal price growth in the real estate market. Consequently, prices are, so far, orderly moving closer to levels justified by fundamentals.

The economy is projected to recover at a robust pace increasingly supported by domestic demand and the revival in foreign demand. Real GDP growth will accelerate to 2.4 percent in 2024 and stabilize around potential—just above 2 percent—over the medium term. The recovery of real wages and a tight labor market will boost private consumption, while EU funds will support investment. External demand is recovering gradually throughout the year. Headline inflation is projected to fall to around 1 percent this year, with core inflation falling but experiencing larger persistence.

Risks have become more balanced, amid heightened geopolitical tensions and the slow progress in implementing long-overdue structural reforms. Economic growth could be harmed if geopolitical tensions or global fragmentation intensify further. On the upside, risks related to higher inflation have faded and a quicker pickup in external demand could lead to a stronger recovery. The slow progress in implementing politically difficult but needed structural reforms in pensions, education, and healthcare represents a risk.

Policy Priorities

Fiscal policy in 2024 is projected to take a moderately expansionary stance, but less than what the budget would imply. With a mildly negative output gap, the deficit is projected to widen from 0.8 percent of GDP in 2023 to 1.6 percent in 2024—2.9 percent of GDP under the approved budget law with spending buffers and conservative revenue assumptions. Given that under IMF projections, the output gap is small and decreasing as the recovery is gaining strength, a broadly neutral fiscal stance seems appropriate. To that end, any unused spending buffers or revenue overperformance should be saved, particularly if the economy surprises to the upside as is reflected in IMF fiscal projections relative to the macroeconomic projections of the budget.

Lithuania is facing large spending pressures arising from defense needs and higher cost of borrowing in the short term that add to long-term pressures particularly from aging. Notwithstanding the recent stabilization, Lithuania has experienced a rapidly shrinking population—from 3.7 million in 1991 to below 3 million in 2019—due to migration and low fertility rates, a trend that is projected to continue in the future. Altogether, long-term spending pressures over the medium-term could add between 5 and 10 percent of GDP to public spending relative to the 2023 level.

Given the magnitude of the problem, addressing long-term expenditure pressures will require a comprehensive fiscal strategy. The final objective should be to address these pressures without introducing distortions or disincentives that would worsen the growth potential; preserve fiscal sustainability; and maintain a pro-active fiscal policy. There are four elements to this strategy:

• The pension system should be reformed to increase social sustainability while preserving fiscal soundness. Worse demographic projections and recent increases in pensions above what is implied by the sustainability formula have increased medium-term deficits from 1 to above 3 percent of GDP since 2021. Pension reforms should balance inevitable trade-offs between reigning fiscal costs and reducing old-age poverty, and between increasing redistribution and ensuring participation and compliance. First, linking the statutory retirement age to longevity would help absorb spending pressures. Second, applying the personal income tax to pensions would provide budgetary resources to increase non-contributory pensions to help those receiving lower contributory pensions. Third, as it matures over time, the privately-funded component of the pension system will stabilize the replacement ratio—pension received at retirement relative to pre-retirement earnings. Any reform in this area should aim to create a stable environment with strong incentives to participate, ideally making participation compulsory, and strong disincentives for early withdrawals to reduce the pressure on the state-funded pay-as-you-go component.
• Education and healthcare outcomes are worse than in peer economies with comparable spending levels, indicating room for improving spending efficiency. Reforms underway in these areas are steps in the right direction but have been too gradual and not ambitious enough to deliver material changes so far.
• There is scope to increase tax revenues while preserving a competitive tax environment. Lithuania collects less tax revenue, around 9 percent of GDP, than the EU average and the system is heavily tilted towards indirect and labor income taxes. With an aging population that is projected to shrink in the future, the tax burden will increasingly fall on a smaller base of taxpayers, exacerbating economic distortions and causing a further drop in labor force participation. There is scope to rebalance the tax system from consumption and labor towards wealth, capital and environmental taxes that can generate more revenue and improve efficiency.
• Fiscal targets can be set around current levels preserving a strong fiscal position. While overly complex, the current framework imposes a welcome counter-cyclical stance that has helped instill fiscal discipline. Given the relatively low debt and deficits, Lithuania complies with the reference values in the EU economic governance framework and the domestic rule anchors policy as it sets more ambitious targets—a structural fiscal surplus. Hence, targets could be set to a moderate deficit of around 1 percent of GDP in line with this year’s projected outcome, above the deficit resilience safeguard in the EU framework. This would deliver debt below 40 percent of GDP and provide sufficient space to support the economy during downturns without exceeding the 3 percent of GDP deficit reference value in the EU.

Financial Sector Policies

Despite the declining interest margins, banks’ profitability will remain elevated over the next few years. With deposit rates gradually increasing and policy rates expected to continue decreasing in the second half of the year, net interest income is already easing from very high levels. While declining, profitability will remain above historical levels and well above euro area average. The banking system remains liquid and well capitalized providing large buffers to absorb potential losses arising from unexpected shocks. Given the resilience of the labor market and the stabilization and expected gradual recovery of the real estate market, balance sheet risks associated with higher interest rates have not materialized so far. All in all, banks are well placed to support a credit expansion when demand recovers. The public investment agency INVEGA will play an important role intermediating RRF loans. To avoid crowding out lending from private banks and to ensure efficient operations void of political interference, the agency should keep its mandate explicit and narrow, and ensure effective monitoring and transparency.

While the levy on banks—expected to be extended for another year—has not had a material impact on banks’ performance, it should remain truly temporary. By targeting net interest income of existing loans only and given its intended temporary nature, the levy has had little disincentive effects. High profitability allowed banks to pay the levy, increase capitalization and distribute profits. However, the proposal to extend the levy for one more year raises questions about the future taxation of the sector that is already subject to corporate income tax rates 5 percentage points higher than for other corporates. The current levy will deliver decreasing amounts of revenue as profitability declines. Therefore, to raise a meaningful amount of extra revenues from the banking sector going forward, increasingly distortionary forms of taxation would be needed. Thus, the levy should remain temporary, and no other levy should be introduced to avoid being perceived as a tax on foreign investment—the sector is overwhelmingly dominated by foreign banks—and to minimize the negative impact on efficiency that would accrue over time.

Given heightened uncertainty, the emphasis should remain on mitigating non-systemic risks to financial stability. While the real estate market has stabilized recently, there are pockets of vulnerability in the commercial real estate market that warrant vigilance. No new risks have emerged, and the financial cycle is undergoing a soft-landing after the robust performance post-pandemic. Thus, the authorities have adopted an appropriate neutral macroprudential stance with no new measures after those introduced in 2022. If risks materialize, the relaxation of capital-based measures would be appropriate in response to credit supply disruptions while targeted adjustment to borrower-based measures can be used to deal with a disorderly correction of the real estate market to support lending to the real economy.

There has been significant progress in strengthening the AML/CFT supervision framework that needs to continue to reduce heightened ML/TF risks. The authorities have effectively implemented measures including, among others: (i) deepening their understanding of the country’s non-resident ML/TF risks; (ii) increasing BoL’s AML/CFT supervisory resources; (iii) updating AM/FT risk assessment methodology; (iv) strengthening VASPs market entry controls; and (v) strengthening AML/CFT controls to access CENTROlink. These AML/CFT measures have resulted in a stabilization of the number of EMIs and PIs and the revoking of several licenses. The Bank of Lithuania should continue to mitigate ML/TF risks, including continuing preparations to begin supervising VASPs as of the end of 2024 and developing further CENTROlink AML/CFT assessment guidelines.

Structural Challenges

Lithuania experienced fast income convergence until the shock provoked by Russia’s invasion of Ukraine. The strong policy response to the fallout from the global financial crisis in 2008 reinforced external competitiveness and raised income per capita from 40 percent in 2009 to 85 percent of the eurozone average in 2021, leading income convergence among the Baltics. Furthermore, Lithuania exited the pandemic shock with little visible scarring—GDP at end-2021 returned to the pre-pandemic trend. However, income per capita has stagnated over the last two years, on the back of the largest negative terms-of-trade shock in the euro area.

Solid fundamentals have allowed Lithuania to absorb the recent competitiveness shock without a significant impact on its growth potential. The loss in market shares in the last two years was mostly concentrated on re-exported goods, largely driven by sanctions imposed on Russia and Belarus after the war, while export of services has continued to grow strongly. The recent fall in labor productivity is largely cyclical, as employment has been resilient while hours per employee remain low. Lithuania entered the recent shock with an undervalued real effective exchange rate, which helped absorb permanently higher input costs. Furthermore, with negative inflation differentials with main trading partners and labor productivity expected to recover, there should be no further losses of competitiveness in the near-term. However, long-term spending pressures and long-standing structural challenges will weigh on productivity at a time of domestic and global headwinds.

Persistent structural inefficiencies in the labor market should be addressed to reduce mismatches, increase participation, and further enhance flexibility. Lithuania has one of the highest skill mismatches in Europe with a relative shortage of high-skilled workers. Active labor market policies need to be more responsive to cyclical conditions and expand well-designed training programs while employment subsidies should concentrate on the most disadvantaged groups. Education reforms are necessary to foster vocational training, but funding, overwhelmingly reliant on EU funds, is locked in a disproportionately large tertiary education system that does not produce the skills the labor market demands.

Susceptible to risks associated with climate change, Lithuania needs to accelerate the green transition, particularly for adaptation. An introduction of an economy-wide carbon tax on fossil fuels, alongside the EU’s emission trading system, would facilitate faster decarbonization, incentivize renewable investments, and provide resources to protect vulnerable households and strengthen the physical infrastructure against climate change.

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