Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1] with the Republic of Lithuania and endorsed the staff appraisal on a lapse-of-time basis without a meeting.
After a short and shallow recession, the Lithuanian economy has started to recover 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 in 2023 and is now below the euro area average. The strong disinflationary momentum continued in early-2024 and reflects lower commodity prices, tighter monetary conditions, and a contractionary fiscal stance. Core inflation, however, remains elevated due to high energy pass-through, services inflation and nominal wage growth. The labor market has remained tight with declining labor productivity as firms held on to workers during the downturn. The banking system continues to be well capitalized and highly profitable while the real estate market has partially corrected imbalances built in the post-covid, pre-war period.
The economy is expected to continue the recovery path supported by high real wage growth and public investment while external demand is expected to gain momentum throughout the year. Headline inflation will remain close to 1 percent this year before converging to above 2 percent, but core inflation will experience larger persistence due to the tight labor market and strong real wage growth. However, global fragmentation, long-term spending pressures, eroded corporate profitability, and pre-existing structural challenges in education, healthcare and the labor market continue weighing on productivity and the medium-term growth outlook.
Risks to the short-term outlook have become more balanced as inflation risks have dissipated and a quicker pickup in external demand or higher investment could increase the speed of the recovery. Geopolitical risks, in contrast, could harm growth, as could slow progress in implementing politically difficult but needed structural reforms in pensions, education, and healthcare.
Executive Board Assessment2
In concluding the 2024 Article IV Consultation with the Republic of Lithuania, Executive Directors endorsed staff's appraisal, as follows:
The Lithuanian economy is recovering from a shallow recession and high inflation. Inflation more than halved last year supported by lower energy prices and is now below the eurozone 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 reflects lower commodity prices, tighter monetary conditions, and a contractionary fiscal stance. Risks have become more balanced.
After a strong performance last year, the fiscal position is expected to become moderately expansionary this year but less than the budget would imply. Remarkably, the structural fiscal position has barely deteriorated compared to the pre-pandemic period. Given that 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.
Lithuania is facing large spending pressures from defense and higher borrowing costs that add to long-term pressures from aging and climate. These pressures could add between 5 and 10 percent of GDP to spending. Addressing these pressures will require a comprehensive strategy with the aim to avoid introducing distortions that would worsen the growth potential; preserve fiscal sustainability; and maintain a pro-active fiscal policy. There are four elements to this strategy: (i) pension reform; (ii) education and healthcare reforms; (iii) revenue mobilization; and (iv) resetting the fiscal targets around current levels preserving a strong fiscal position.
Despite declining interest margins, banks' profitability will remain elevated. With deposit rates gradually increasing and policy rates expected to continue decreasing, net interest income is easing from very high levels. The banking system remains liquid and well capitalized providing large buffers to absorb potential losses arising from unexpected shocks. Balance sheet risks associated with higher interest rates have not materialized so far. 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.
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. Thus, the authorities have adopted an appropriate neutral macroprudential stance. 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.
The levy on banks should be phased out. Given its careful design, the levy has had little disincentive effects. However, the decision to extend the levy one more year raises questions about the future taxation of the sector that is already subject to higher tax rates. Thus, the levy should be let expire, 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.
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: (i) deepening their understanding of the country's non-resident ML/TF risks; (ii) increasing BoL's AML/CFT supervisory resources; (iii) updating ML/FT risk assessment methodology; (iv) strengthening VASPs market entry controls; and (v) strengthening AML/CFT controls to access CENTROlink. The BoL 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.
Lithuania's external position was broadly in line with fundamentals in 2023. It entered the recent shock in 2021 with an undervalued REER, which helped absorb permanently higher input costs from high inflation.
Solid fundamentals have allowed Lithuania to absorb the recent competitiveness shock without a significant impact on its growth potential. The recent loss in market shares for goods was largely driven by sanctions on Russia and Belarus, while exports of services have continued to grow strongly. With negative inflation differentials with 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 and the education system should be addressed. Active labor market policies need to be more responsive to cyclical conditions while employment subsidies should concentrate on the most disadvantaged. Education reforms are necessary to foster vocational training, but funding is locked in a 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.
Table 1. Lithuania: Selected Economic Indicators, 2020–291
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[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.
2 The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.
