On May 5, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Lithuania.
The economy has entered a broadly favorable trajectory of healthy and balanced growth, but income convergence with Western Europe has a long way to go. With growth above three percent in each of the past three years and similar prospects, real GDP is set to surpass the peak level of 2008 for the first time this year, but now free of external and internal imbalances. Nonetheless, per capita income remains considerably below Western European levels and structural unemployment is uncomfortably high.
Lithuania targets to adopt the euro next year to further deepen integration with Western Europe. With inflation at historical lows and well-advanced repair of public finances damaged by the 2008/09 crisis, meeting the entry criteria seems on track. The Economic and Financial Affairs Council of the European Union will take a final decision about EMU membership this July, based on convergence reports by the European Commission and the European Central Bank.
A determined multi-year consolidation effort has reduced the fiscal deficit to close to 2 percent of GDP in 2013. Public debt is now on the verge of starting to decline as a ratio to GDP. At around 40 percent of GDP it is relatively low compared to other EU countries.
Financial stability has improved further in 2013, with the capital adequacy ratio exceeding 17 percent and steady progress in reducing non-performing loans. The main challenge is now resuscitating sluggish private sector credit growth, which could undermine investment and the recovery if it continued for much longer.
Executive Directors noted that the pursuit of prudent policies has led to robust balanced growth, falling inflation, and strengthened public finances, thereby placing Lithuania on track for euro adoption in January 2015. Looking ahead, with risks still tilted to the downside, Directors recommended the consolidation of recent macroeconomic gains, and a deepening of structural reforms to provide the impetus for sustainable job-creating growth and income convergence with Western Europe.
Directors commended the strengthening of the public finances in recent years, but noted that expenditure compression is reaching its practical limits after bearing the burden of recent adjustment. They called for further, well-calibrated fiscal consolidation through enhanced revenue mobilization, to help achieve a structural budget balance in the medium term and reduce the public debt-to-GDP ratio. Recurrent taxation of wealth and capital could be improved, the tax base broadened and tax administration strengthened. Directors also considered that a public expenditure review would help promote efficiency and sustainability.
With sound public finances and low inflation, as well as external stability, Directors agreed that the Lithuanian economy is well prepared for euro adoption, which could deliver significant benefits by strengthening financial stability, reducing risk premiums, and fostering further integration with the euro area. Directors recommended strong supporting policy frameworks and macro policy tools to help underpin a successful euro area membership. While Lithuania has demonstrated the ability to deliver economic adjustment when needed, Directors advised strengthening countercyclical tools to rebuild buffers in good economic times. In this regard, they welcomed the impending strengthening of macroprudential powers of the Bank of Lithuania and the planned transposition of the Fiscal Compact. Directors advised improving the accountability and control framework for local government finances and noted that pension reform was needed to enhance fiscal sustainability.
Directors considered that decisive action and effective supervision have improved overall financial sector stability and welcomed efforts to tackle remaining areas of softness, such as in the small credit union sector. They advised that these efforts be sustained, and looked forward to a review of banks’ asset quality. Directors called for a revival of credit growth in support of investment, through further strengthening of insolvency and restructuring frameworks and fostering non-bank sources of finance.
Directors recommended continued implementation of structural reforms to further improve competitiveness and the business climate and tackle high structural unemployment. Wage increases should be aligned with productivity growth, and the management of out-of-work benefits and other key aspects of the labor code strengthened. Reducing Lithuania’s relatively high social security taxes in a fiscally-neutral manner would be desirable, as well as redressing skill mismatches through education reform.
Directors welcomed the emphasis on upgrading energy and transportation infrastructure, and advised that ongoing projects should be embedded in a regional strategy to reduce user costs. They supported reform of state- and municipally-owned enterprises—with many of the former tasked with implementing key infrastructure projects.