Public Information Notice No. 06/51

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of Lithuania

May 4, 2006

On May 1, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Lithuania.¹

Background

Following exceptional economic progress, based on macro stability and economic flexibility, imbalances and cautionary signals have emerged. Centered around nontraded goods production, GDP grew 7.5 percent in 2005. Most indicators suggest a tightening of resource use: a declining unemployment rate, high capacity utilization, and buoyant asset prices. Through external price shocks, adjustment of administered prices, and domestic demand pressures, inflation has been on the rise, creating the risk that the Maastricht inflation reference rate will be exceeded and euro adoption delayed beyond the targeted January 1, 2007.

The economy has continued to receive stimulus from the combination of fiscal and European Union (EU) expenditures. The stimulus in 2005 would have been greater absent some unexpected, one-off revenue gains, especially for the value added tax (VAT) and profit tax revenues. The reorganization of tax administration in late 2004 yielded further revenue gains. Fiscal pressures, however, are set to increase as expenditure pressures will arise from aging and public sector wage increases to discourage emigration, and as the elimination of the social tax reduces revenues from 2008. To offset these fiscal pressures, a widening of the tax base and expenditure rationalization will be needed.

The current account deficit has remained sizable, with significant reliance on bank and market-based financing to cover it. External indebtedness, however, is among the lowest in the new Central and Eastern European members of the EU (the CEE-8). The accumulating short-term debt is composed of trade credits and lending by parent banks to the Lithuanian subsidiaries. As such, while the reserve cover of short-term debt is lower than conventionally accepted threshold values, the sound reputation of the foreign banks and their long-term relationships with the Lithuanian banking system mitigate the rollover risk.

Rapid credit growth has supported growing household appetite for mortgages and corporate demands in non-traded sectors. While financial sector earnings and liquidity ratios held steady, asset quality and capital adequacy indicators deteriorated somewhat in 2005. The competition among banks to satisfy the demand for credit has led to more aggressive lending practices, as seen in narrow interest margins and increasing loan-to-value and debt-to-income ratios of new loans.

Increased use of EU funds has revealed the need to harness them carefully to ensure that they improve competitiveness. The real exchange rate appears fairly valued and export growth has been sound. Lithuania has also made significant advances in improving its business climate. Nevertheless, export growth faces new challenges as capacity constraints are reached in the oil refining industry and international competition in labor-intensive goods increases. In per capita terms, Lithuania is to receive substantial EU funds and their absorption is expected to rise steeply in the next few years. Effective use of these funds for developing public goods, without distorting market competition, will help maintain competitiveness.

Executive Board Assessment

Directors welcomed the continued rapid growth with low inflation, and observed that Lithuania's performance over the past five years ranks among the best within the European Union (EU). Directors attributed this impressive outcome to strong macroeconomic policies, firmly supported by the currency board arrangement that has served the economy well, the implementation of wide-ranging structural reforms, and integration with the EU. They noted that generally flexible product and labor markets, as well as the strong international trade and financial links, have laid the foundation for Lithuania's success in the euro zone with sustained, productivity-based growth.

Directors cautioned, however, that imbalances are emerging and that longer-term challenges have to be addressed. Consumption as well as investment in the property and construction sectors have grown rapidly, contributing to inflation and new financial vulnerabilities. Longer-term challenges are also likely to arise from international tax competition, the demand for public goods, emigration, and pressures on international competitiveness.

Most Directors noted that external shocks, administered price changes, and domestic demand pressures had caused the inflation rate to pick up in 2005, and rise above the Maastricht reference value. A few Directors pointed out that the rise in price levels could also reflect changes in relative prices related to EU integration. It remains a close call whether the inflation rate will fall below the Maastricht reference value in time for the euro to be adopted in January 2007. In this context, a number of Directors considered that the rise in inflation may delay euro adoption. Directors agreed that a year's delay is unlikely to concern financial markets: the currency board, fiscal policy, and the process of trade and financial integration with Europe could be expected to stay on course. More generally, Directors encouraged the authorities to ensure that the right policies are in place to achieve early euro adoption, in order to benefit further from trade and financial ties with the rest of Europe.

Most Directors stressed that a more ambitious fiscal goal would help contain the rise in the price level. They noted that the fiscal stance envisaged for 2006 is procyclical and suggested reducing the projected 2006 budget deficit. Fiscal restraint would also help signal a commitment to early euro adoption.

Directors welcomed the steps taken by the authorities to contain vulnerabilities from aggressive lending practices. They took note of the Bank of Lithuania's efforts to increase coordination with foreign supervisors, publish a financial stability report, and provide guidance to banks on prudential lending. The implementation of the measures recommended in the 2001 FSAP has also been helpful. At this point, Directors did not see the need for administrative measures to slow the pace of credit growth. Instead, Directors encouraged the authorities to conduct forward-looking supervision. In particular, the authorities should ensure that banks' risk management systems keep pace with market developments. Directors urged the authorities to take measures to cool down the property market, encourage disclosure of bank fees, disseminate borrowing guidelines, and continue to report and regulate on the basis of the nonperforming loan ratio. Directors welcomed the planned FSAP update, which they considered would serve to strengthen financial sector surveillance and allow a more forward-looking approach to identifying vulnerabilities. In this context, a regional perspective and cooperation were seen as important.

Directors suggested that the risks from accumulating external short-term debt need close monitoring. Nevertheless, they agreed that there are important mitigating factors. In particular, they noted that the short-term debt mainly comprises trade credits and lending from reputable foreign banks to their Lithuanian subsidiaries.

Directors called for measures to address the growing medium-term fiscal pressures. They observed that the planned personal income tax cuts will weaken the revenue base from 2008 onward. These cuts would put at risk the medium-term target of a structural deficit of 1 percent of GDP. Several Directors underscored that the tax base could be increased by eliminating exemptions related to mortgages, by introducing a more far-reaching property tax and a vehicle tax, and by strengthening tax administration.

Directors encouraged the authorities to aim for greater expenditure efficiency, including in the social sector. In the health sector, the introduction of co-payments would formalize the existing system of informal payments and strengthen patient responsibility. Increased competition would help contain the cost and improve the quality of health care delivery. In the area of social assistance, consolidation and improved targeting of the currently fragmented system would reduce incentives to move into long-term unemployment.

Directors noted that these measures needed to be embedded in a more fully fledged medium-term expenditure framework (MTEF). In this context, Directors called for stricter scrutiny of expenditures by line ministries and municipalities. Directors encouraged integration of the MTEF into a Fiscal Responsibility Act that could help fiscal discipline.

Directors noted that export growth would face new challenges. The real exchange rate appears broadly in line with fundamentals. However, price competition for labor-intensive goods is intensifying, while rising domestic wages are adding to cost pressures. Directors stressed that EU funds could help enhance competitiveness and, therefore, need to be harnessed carefully. Maintaining centralized management of these funds in the Ministry of Finance would support their effective use. Directors encouraged the authorities to ensure transparency of contract awards and to integrate the allocation of EU funds with structural reforms, for example in the social sector.

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.