Mission Concluding Statement 

Republic of Lithuania - Staff Concluding Statement of the 2021 Virtual Article IV Mission

June 14, 2021

Washington, DC: The Lithuanian economy entered the COVID-19 crisis on a solid footing with strong growth and ample buffers, improved private sector financial positions, and a well-capitalized, profitable banking system. These developments reflected years of prudent fiscal and financial sector policies. The strong starting position coupled with the government’s decisive policy response and the benefits of euro area membership, have helped make the Lithuanian economy one of the best performers in Europe last year and have set the stage for a strong recovery. As the recovery quickly gathers pace, policies need to prioritize quality over quantity through more targeted support to the most affected sectors. Going forward, fiscal and macroprudential policies should continue to be used proactively to preserve stability and avoid the reemergence of the imbalances observed prior to the Global Financial Crisis (GFC), particularly if the recovery is stronger than anticipated. Lithuania should confront its long-standing challenges—including high social disparities and demographic pressures—through the decisive implementation of structural reforms. This is the only way to achieve sustained improvements in productivity and high wage growth going forward.

Economic Developments and Risks

Economic performance during the pandemic has been among the best in Europe. With GDP falling by just 0.8 percent versus a euro area average of 6.7 percent, the Lithuanian economy experienced the mildest contraction in Europe last year. Growth momentum has picked up in the first quarter of this year despite lockdown restrictions. A decisive policy response from the government has helped support incomes, mitigate the rise in unemployment, and preserve the financial health of businesses. Exports recovered quickly in the second half of last year. The impact of the pandemic varied across sectors, with a strong recovery in manufacturing but with service sectors being harder hit.

Output has already exceeded its pre-pandemic level in the first quarter of this year. The private sector—households and businesses—entered this crisis without significant imbalances and in a strong financial position that has been preserved by COVID related support measures. This has set the stage for a vigorous recovery in output and employment, led by domestic demand and benefitting from solid external demand. Combined with temporarily higher energy prices, this will result in higher inflation this year. The external position is strong, partly due to temporary factors that will go away with the recovery (such as low consumption and investment as a result of lockdown restrictions). The strength of the external position is also explained by hard fought gains in competitiveness during the recovery that followed the GFC and that have resulted in the strongest increase in exports in the Baltics.

Next Generation EU funds, including Recovery and Resilience Funds (RRF), will support medium-term growth, ameliorating demographic pressures. If efficiently used, these funds will support private and public investment and productivity growth, thereby facilitating sustainable high wage growth. Pressures from aging persist and will intensify going forward despite recent improvements in migration flows—Lithuania experienced a population increase in 2020 for the first time in over 30 years.

Risks are broadly balanced in the short-term, but there is a significant upside growth potential over the next few years. With the recovery accelerating in the second half of this year, and in the absence of future lockdowns as uncertainty dissipates with vaccinations advancing, growth can surprise on the upside and result in higher inflationary pressures. If left unchecked, these dynamics could eventually erode competitiveness in the export sector and lead to the reemergence of macroeconomic and financial imbalances. On the downside, risks include weaker than expected external demand and geopolitical risks.

Actively preserve economic stability and target continued support to those most affected

Unlike the global financial crisis of 2008, the COVID-19 pandemic is expected to have only a temporary negative impact on the Lithuanian economy. The large policy response and strong fundamentals of the economy prevented a severe recession and permanent economic losses. Support via subsidies has helped solidify the financial position of households and businesses. In the labor market, employment was largely preserved, particularly in manufacturing, and the impact on the most affected sectors should be temporary provided a sustained recovery takes hold in the second half of this year.

The unprecedented policy response to the crisis was supportive of activity and incomes, and reasonably targeted. Following years of prudent policies, large fiscal space and lower borrowing costs enabled the government to increase spending to support workers, businesses, and the healthcare system. Macroprudential and monetary policies also provided substantial support. In particular, as a member of the euro area, Lithuania benefited from accommodative policies by the European Central Bank.

The pace of withdrawal of fiscal policy support should be dictated by the strength of the recovery already underway. The government has rightly built up significant buffers in the amended budget for this year to deal with unexpected shocks or a weaker than expected recovery. However, under the most likely macroeconomic scenario, a large share of these buffers will not need to be used. In the absence of temporary COVID-19 related measures and as growth picks up, the fiscal position will improve this year and next, putting debt back in a declining path. As the recovery becomes firmly entrenched, fiscal buffers should gradually be rebuilt to secure Lithuania’s capacity to respond to future economic shocks. If growth is stronger than expected and inflationary pressures intensify, buffers should be rebuilt at a faster pace.

With minimal permanent economic losses expected in aggregate, support should narrowly focus on specific pockets of vulnerability, thereby facilitating a market-led reallocation of resources. Some individual, viable firms in sectors hardest hit by the pandemic may need continued support for longer. Reaching them will require increasingly targeted measures. In this connection, the proposed temporary reduction of the VAT rate for catering services, cultural, and recreation sectors is not well targeted, as it provides less support to companies that suffered a larger shock or face a slower recovery. At the same time, it may complicate the collection efforts of the tax administration inspectorate. Moreover, political pressures to make these temporary tax cuts permanent should be resisted as their envisaged sunset approaches.

Financial sector policies should continue to support the recovery while maintaining the resilience of the system against emerging risks. Banks in Lithuania remain well capitalized, liquid, and more profitable than peers in the euro area. The release of the countercyclical capital buffer (CCyB) and the two private moratoria have supported lending and provided further relief to hard-hit borrowers. Going forward, the banking sector has ample liquidity and capital buffers to support a strong recovery. The positive developments in the housing market so far, particularly residential real estate, are estimated to be in line with fundamentals. However, if in the future signs of elevated risks in particular sectors or overheating of the economy start to emerge, targeted macroprudential tools or reactivation of the CCyB will be necessary.

With a maturing Fintech sector, the focus should continue to be on enhancing supervisory capacity and the AML/CFT framework to reassure markets that risks in this area are contained. To realize the full potential of Fintech in improving financial services and producing high-skill jobs, and as the Fintech industry expands quickly and becomes increasingly sophisticated, the Bank of Lithuania faces new supervisory challenges. The authorities have been proactive in improving the Fintech regulatory framework, for example by establishing the Centre of Excellence in Anti-Money Laundering (AML) and implementing recommendations made in the MONEYVAL evaluation of 2018. Progress in this area will require close multi-agency coordination and more resources but will help consolidate Lithuania’s position as a European Fintech hub. Current efforts to develop a five-year plan in this area should reflect all these challenges and the authorities plans to address them.

Going forward, Lithuania should maintain the proactive policy framework that effectively supported economic stability and convergence prior to the pandemic. As a member of the euro area and given that the economic recovery is projected to be stronger than in much of the euro area, the ECB’s monetary policy stance is expected to be looser than warranted for Lithuania alone. This, combined with significant upside potential for growth and inflation going forward, will require proactive management of risks with the available fiscal and macroprudential policy tools.

Implement reforms that reduce disparities and raise productivity

The new government’s priorities reflect critical yet politically challenging reform areas that enhance private sector productivity and mitigate negative demographic dynamics. Urgently needed reforms in education and health care have failed to deliver in the past, mainly due to lack of buy-in from municipalities. However, given poor outcomes in these areas, improving the large, inefficient, and costly networks and the quality of the services provided is critical. Additional RRF funds could offer the impetus needed to implement challenging reforms.

With rising budget rigidities and age-related spending pressures, further increases in social spending cannot be financed without higher revenues. Reducing regional disparities and high poverty rates, particularly among pensioners, will require larger and more effective social programs. In this connection, the establishment of a working group analyzing potential improvements to the tax policy framework is welcome. Its work should focus on eliminating inefficient loopholes and exemptions, taxing environmental or other externalities, and shifting taxes away from labor towards capital, wealth, and environmental taxes. These efforts should be part of a comprehensive fiscal strategy that complements structural reforms and helps address social disparities while raising the economy’s growth potential.

The combination of a strong recovery, new EU funds, and low funding costs, provides a unique opportunity to galvanize consensus around politically difficult reforms. It also creates an environment where meeting high upfront costs of reforms and higher public investment will not jeopardize the fiscal position. Public investment should aim to strengthen physical and human capital and support social cohesion. Reforms under the Recovery and Resilience Plan rightly focus on these areas and, particularly, on digitalization and climate. The authorities’ goals, which are broadly in line with those of the Next Generation EU initiative, will require ambitious implementation plans that are currently being developed. However, realizing the full benefits of reforms will require progress in all main areas simultaneously given their complementary nature, particularly education and healthcare.

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.