On June 30, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Republic of Lithuania, and considered and endorsed the staff appraisal without a meeting. [2]

The economy has been gathering momentum, following sluggish performance in 2015 and most of 2016. Real GDP expanded by 3.9 percent in the first quarter of 2017 after rising by 2.3 percent in 2016. Strong private consumption, on the back of robust wage growth and low inflation that supported purchasing power, has long been a main driver of growth. More recently, exports have also been growing, as the external environment improves and the adverse effects from retaliatory Russian trade sanctions and depreciation of the Russian ruble wane. But gross fixed capital formation has remained weak so far, reflecting the still subdued absorption of European funds.

Building on recent momentum, economic growth should be strong this year rising to 3.2 percent. Improving external conditions and a turnaround in European funds absorption, as well as high capacity utilization, should spur exports and investment. Private consumption will likely remain robust, although some moderation is to be expected as real wages decelerate. Strong domestic demand will pull in imports, leading to a modest deterioration of the trade balance despite improving export prospects. Annual average HICP inflation is set to spike to 3.4 percent this year, because of higher global energy prices and excise tax hikes earlier this year.

The main policy challenge is to reinvigorate income convergence with Western Europe. For it to be sustainable, Lithuania needs to narrow its productivity gap. Further structural reforms are the main lever to make progress, while macroeconomic and financial stability need to be maintained.

Executive Board Assessment

In concluding the 2017 Article IV consultation with the Republic of Lithuania, Executive Directors endorsed staff’s appraisal, as follows:

The emerging cyclical upswing of the economy is welcome, but Lithuania’s productivity gap with Western Europe stopped narrowing in the last three years, raising questions about the sustainability of income convergence. To alleviate downside risks to the medium-term growth outlook, it will not only be important to maintain the sound macroeconomic and financial management of the past. Identifying priority structural reforms that promote growth and help realize the government’s income equality objective and then pushing ahead with their implementation is now key.

Public finances are vastly improved. A commendable multi-year consolidation effort culminated in the first ever fiscal surplus last year. The public debt ratio declined from its peak in 2015 to some 40 percent. A package of social measures will push the fiscal balance into a deficit in 2017, but balance would still be achieved in structural terms. To avoid a sharp and unwarranted fiscal consolidation in subsequent years, Lithuania should revisit its fiscal rules, which are unnecessarily stringent relative to EU and euro area requirements.

A medium-term target of 0.5 percent of GDP for the structural fiscal deficit is appropriate for Lithuania. Its achievement would rebuild the fiscal buffers essential for a small open economy. Room under this target is available to finance fiscal structural reforms. One-off costs of structural reforms should be accommodated in addition. In the longer run, public finances are set to come under pressure from rising age-related spending and declining EU funds. Rather than cutting benefits or scaling back investment, Lithuania should boost its low tax revenues, primarily through tax administration improvements, but also through selected tax policy measures.

Fiscal structural reforms should focus on pro-growth and pro-equity measures. The government could consider lowering social contributions for low-wage earners, broadening active labor market programs, and making unemployment benefits more generous. The government’s intention to improve the quality of public spending through performance-based budgeting is welcome, although payoffs may materialize only over time.

In the financial sector, there are no immediate risks to stability, but Nordic-Baltic cooperation should be strengthened further. Strong soundness indicators and stress tests attest to the resiliency of the sector. Spillovers from vulnerabilities in parent banks are a potential risk going forward. Nordic-Baltic cooperation should hence be strengthened, including through the planned crisis simulation exercise, in which ECB supervisors should participate. The revival of credit growth is generally welcome and its pace appears to remain prudent, but this should be monitored. The strength of some small non-systemic financial institutions also needs continued attention. Credit union reform is on track and should be completed in line with current plans.

Lithuania’s external balance is broadly consistent with medium-term fundamentals. External stability and exchange rate alignment are not immediate concerns, but the persistent increase of unit labor costs, together with signs of sliding export shares, require close monitoring.

Amongst structural reforms, overhauling the education system should be at the top of the priority list. Addressing poor educational outcomes requires improving the management of educational institutions, stepping up standard setting and enforcement, tackling rapidly rising overcapacities due to declining school-age populations, and ensuring better pay for a smaller teaching staff. Reform needs permeate all levels of education, from higher education, to still underdeveloped vocational training and general education.

Innovation promotion policy is another critical area. Efforts to date have achieved relatively little compared to the allocated public resources. To overcome the high fragmentation of the system, the number of implementing, advisory, and decision making institutions needs to be reduced through mergers. There should be fewer promotion instruments that can be used more flexibly for a broader range of innovation activities. Instead of ever more programs that are underused by businesses, direct financial support for innovation-related outlays by businesses should be stepped up.

The recent adoption of a modern Labor Code has further strengthened Lithuania’s generally favorable business environment. Although not perfect in every respect, the new Labor Code is a big step forward and any potential deficiencies should be addressed at a later stage, once some experience has been gathered with how the new legislation works in practice. Ongoing reform of the governance framework for state-owned enterprises is welcome.