IMF Finalizes 2023 Article IV Review with Lithuania

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation^[1]with the Republic of Lithuania on August 28, 2023.

Lithuania weathered a series of unprecedented external shocks, owing to resilient macroeconomic fundamentals and a decisive policy response. Recently, however, high inflation and rising interest rates have affected disposable incomes which, combined with weak external demand, resulted in an economic contraction in the last quarter of 2022 and early 2023. At the same time, the labor market has remained broadly resilient with high wage growth, albeit negative in real terms, and has supported domestic demand for a year until July.

Headline inflation increased at an annual average of 19 percent in 2022—one of the highest in the eurozone, along with Estonia and Latvia. While the rate of inflation is falling rapidly due to lower energy prices and base effects to around 10 percent in May from a peak of 23 percent in September last year, it remains significantly above the eurozone average. Core inflation, excluding energy and unprocessed food, remains very high, reflecting supply bottlenecks, higher commodity prices, and the robust recovery of demand after the pandemic, pointing to still fairly broad-based price pressures.

The economy is expected to recover later this year and next supported by domestic and external demand. On balance, risks are tilted to the downside with persistently higher inflation than the Euro Area as the biggest risk. On the domestic front, current deviations of wages from productivity can be accommodated given large past competitiveness gains provided they are transitory. However, if inflation remains high for longer, inflation expectations might adjust upwards, perpetuating high rates of price and wage growth that would eventually erode competitiveness. On the external front, an escalation of Russia's war in Ukraine could trigger higher energy and food prices leading to an increase in inflation. In this scenario, the authorities' response should not interfere with price signals and provide targeted support to the most vulnerable. On the upside, the economy could prove more resilient than projected given the strength of private sector balance sheets, strong underlying fundamentals and an external demand that could recover quicker than projected.

Executive Board Assessment2

In concluding the 2023 Article IV consultation with the Republic of Estonia, Executive Directors endorsed staff's appraisal, as follows:

Executive Directors welcomed the authorities' policies that have contributed to the resilience of the economy. However, while Lithuania continues to benefit from strong fundamentals, Directors pointed out that high inflation and rising interest rates weakened disposable income which, combined with weak external demand, resulted in a temporary contraction of economic activity.

They encouraged the authorities to mitigate the risk of high and persistent inflation by tightening the fiscal stance while preserving public investment. To this end, the reactivation of the domestic fiscal rule will help contain inflation risks and gradually rebuild fiscal buffers. Directors also acknowledged that accommodating new and pre-existing spending pressures will likely require new revenues under the existing fiscal rule that can be simplified and adjusted to accommodate permanently higher defense spending.

They noted that a weakening economy and higher interest rates impose risks to the financial sector, but banks are in a position to manage these risks given high liquidity, capitalization, and profitability. While macroprudential measures could be eased in the event of a sharp downturn, a number of Directors stressed the importance of building buffers further. Directors also encouraged the authorities to keep the levy on banks temporary to avoid being perceived as a levy on foreign investment and minimize the potential negative impact on efficiency. With a maturing Fintech sector, Directors emphasized the need to continue enhancing supervisory capacity and the AML/CFT framework.

They highlighted the importance of preserving the flexibility of the economy and advancing long-overdue structural reforms, including through full and timely implementation of the country´s Recovery and Resilience Plan. They welcomed the recent civil service reform and underscored the need to accelerate reforms in the healthcare and education sectors that will be critical to support further productivity gains and higher living standards. Furthermore, Directors agreed that developing renewable sources of energy and improving energy efficiency are necessary for climate change mitigation and energy security. To this end, Directors encouraged the authorities the application of a carbon tax in sectors not covered by the EU's Emission Trading System (ETS).