DĖL LIETUVOS KONVERGENCIJOS 2007 METŲ PROGRAMOS

DĖL LIETUVOS KONVERGENCIJOS 2007 METŲ PROGRAMOS Resolution no 1358 of 19 December 2007 ON THE CONVERGENCE PROGRAMME OF LITHUANIA OF 2007 Vilnius Acting pursuant to Article 7 of Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies (OJ, 2004, Special Edition, Chapter 10, Volume 1, p. 84), as last amended by Council Regulation (EC) No 1055/2005 of 27 June 2005 (OJ L 174, p. 1), which lays down a multilateral surveillance procedure of the European Union Member States carried out in the form of stability and convergence programmes, the Government of the Republic of Lithuania has resolved: 1. To approve the Convergence Programme of Lithuania of 2007 (as appended); 2. To charge the Ministry of Finance with the task of submitting the Convergence Programme of Lithuania of 2007 to the European Commission. Prime Minister                                                                                 Gediminas Kirkilas Minister of Finance                                                                         Rimantas Šadžius APPROVED by Resolution No 1358 of 19 December 2007 of the Government of the Republic of Lithuania CONVERGENCE PROGRAMME OF LITHUANIA of 2007 I. FINANCIAL POLICY OVERVIEW 1. Lithuania’s economic policy serves the goal of ensuring a rapid and sustainable real convergence, i.e. approximation to the high level of productivity and income within the Economic and Monetary Union. The Convergence Programme of Lithuania of 2007 (hereinafter referred to as the Programme) gives projections of the economic policy outlined in the 2008 Law on Approval of Financial Indicators of the State Budget and Municipal Budgets (Valstybės žinios (Official Gazette) No. 132-5356, 2007). 2. The entire Programme is geared towards the development of measures aimed at achieving the above-mentioned goal over the medium term. These measures include: 2.1. a rapid and sustainable real convergence and a stable macroeconomic environment; 2.2. favourable conditions for business development and a successful implementation of structural reforms; 2.3. a transparent public administration and a political consensus regarding the reforms to be carried out; 2.4. improvement of fiscal discipline norms that ensure long-term sustainability of general government finances and stable economic development, implementation of education, health and tax reforms; 2.5. preparation of the proposals on the measures capable to ensure that potential economic growth necessary for low inflation and high employment is utilised and that implementation of them would not require fiscal deficit deterioration (in 2008). 3. Lithuania has committed in this Programme to pursue an economic policy that ensures the stability of prices and general government finances so that strong confidence in the continuity of the currency board arrangement in Lithuania is maintained and the perspective of long-term price stability is ensured. 4. This Programme gives an overview of recent economic developments in Lithuania, the planned medium-term economic policy, an assessment of risks factors, the quality of general government finances, and a description of Lithuania’s readiness to overcome the effects of an ageing population, as well as planned structural reforms which have a significant impact on general government finances. 5. This Programme examines and assesses the preconditions for the achievement of the economic policy goals. The economic development projections given are based on the assumption that the demand for loans will be based on thorough knowledge of economic perspectives, thus it is expected that the economy will reduce dependence on borrowed funds. The Programme has been based on assumptions on euro exchange rate, prices of oil and other raw materials used by the European Commission in the projections of economic indicators. Preconditions for the implementation of this Programme have been defined by the Law on Fiscal Discipline of the Republic of Lithuania (Valstybės žinios (Official Gazette) No 120-4881, 2007) that sets forth that in 2008 general government sector deficit must not exceed 0.5% of gross domestic product (hereinafter referred to as GDP), obligates over the medium term to pursue close-to-balanced or a surplus general government, and provides numerical and procedural rules for the achievement of that. 6. The national currency litas (hereinafter referred to as the litas) exchange rate pegged to the euro under the currency board arrangement ensures that the average multi-annual inflation will remain close to that in the euro area. After the acceleration of inflation in 2007-2008 and with the stabilisation of oil and natural gas prices in 2009 as well as with the harmonization of excises to the EU rates, inflation in Lithuania will, over time, again come close to inflation in the euro area. 7. The growth of exports and investment remains on a fast track in Lithuania, with unemployment going down at the highest pace among the EU states. Over the past six years (from the second quarter of 2001 to the second quarter of 2007), the number of the employed has grown by 12.4%. A rapid growth of investment will ensure Lithuania’s competitiveness in the long run and increase the import of investment goods and the current account deficit (hereinafter referred to as the CAD) of Lithuania's balance of payments in the short run. 8. Lithuania will make efforts to join the euro area. According to the available data, the best period for joining the euro area starts in 2010. 9. One of the fiscal policy objectives, to manage demand for mortgages through taxes, to allocate all additional revenues and saved expenditures to reduce fiscal deficit or to form surplus, to strive to balanced budget laid down in the Convergence Programme of Lithuania approved of by Resolution No 54 of 21 January 2005 of the Government of the Republic of Lithuania (Valstybės žinios (Official Gazette) No 11-341, 2005) will be pursued under this Programme, too. In future updates of this Programme, specific additional measures aimed at managing fiscal risks will be introduced. 10. The rapid growth of demand under the conditions of a fixed exchange rate for the litas increased imports and CAD. Thus, to ensure the continuity of foreign capital inflows, it is essential further improve the business and investment environment, give maximum support to investment that is promoted by laws, and create particularly favourable conditions for "green field" investment, as well as maintain market confidence in the continuity of the commitment of an early integration of Lithuania into the euro area. Given the need to implement structural reforms securing productivity and the long-term sustainability of government finances, and in the light of the rapid growth of GDP and the current low level of debt, the medium-term objective - to achieve structural deficit below 1% of GDP remains. For later periods, the MTO will be tightened to take into account the Commission’s latest estimates suggesting that general government debt will approach to 114% of GDP in 2050, unless fiscal policy is tightened. Therefore, once major structural reforms have been completed, in 2009-2010 the objective would be a structurally balanced or a surplus general government, depending on the economic cycle and following the Law on Fiscal Discipline of the Republic of Lithuania. 11. Currently, Lithuania’s possibilities to reduce fiscal deficit and general government deficit more than expected are restricted by temporary budgetary difficulties associated with tax reduction and necessity to save the present quality of education and health care. Fiscal discipline will be maintained by applying numerical and procedural Lithuania’s fiscal discipline rules set forth in the Law on Fiscal Discipline of the Republic of Lithuania, reducing GDP share that consists of government current expenditure and maintaining a higher share of social expenditure, close to 10% of GDP. The successful implementation of the pension reform will pave the way for the reduction of the national debt in the long run and will encourage private persons to save funds to supplement their old-age pension. Tax revenues to be allocated in 2008 for the pension reform will account for about 1% of GDP. The reduction of the rate of personal income tax which determines a balance between labour and capital taxation will contribute to the successful implementation of the objectives of the National Lisbon Strategy Implementation Programme, approved by Resolution No. 1270 of 22 November 2005 (Valstybės žinios (Official Gazette) No 139-5019, 2005), in the labour market, to increase employment and potential GDP, and to mitigate the effects of an ageing population for government finances. In the long-tem Lithuania will pursue the expansion of housing renovation that would contribute to the efficient use of heat and reduction of economy’s dependence on growing prices of natural gas. Health and education reforms ensuring higher quality and enabling attraction of additional means from private sources will be implemented. 12. The fiscal policy pursued in compliance with the strict regulations of the Stability and Growth Pact (Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies (OJ, 2004, Special Edition, Chapter 10, Volume 1, p. 84 and Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure (OJ, 2004, Special Edition, Chapter 10, Volume 1, p. 89) will make it possible to consistently reduce government debt until government finances become capable of ensuring a sustainable implementation of commitments under the Maastricht Treaty (OJ 1992 July 29 C 191), while maintaining reliable social guarantees, regardless of the projected significant growth in the number of pensioners and the decreasing number of employed people in the third decade as a result of the low birth-rate and high emigration. II. economic outlook Assumptions 13. The projections for Lithuania’s economic indicators are based on recent economic development trends and assumptions about economic growth. Economic projections are based on the assumption that the Seimas of the Republic of Lithuania, when passing legal acts regulating general government expenditures and tax rates, will take into account the principal provisions of the Stability and Growth Pact and will further collaborate with the Government of the Republic of Lithuania in  implementing measures aimed at stabilising inflation at below 3%. Law on Fiscal Discipline of the Republic of Lithuania and political agreement on the implementation of education reform provisions reinforces confidence of financial markets in long-term sustainability of general government finances, and contributes to ensuring price stability in long-term perspective. The key assumptions about the external economic environment in implementing the EU fiscal monitoring procedure and in seeking to ensure the comparability of economic forecasts correspond to the external environment assumptions published by the European Commission. Table 1. Key assumptions Indicator 2006 2007 2008 2009 2010 Short-term interest rates 3.7 5 4.6 4 4.9 Long-term interest rates 4.1 4.7 4.7 4.8 5 USD/€ exchange rate (euro area and exchange-rate mechanism II (hereinafter referred to as ERM II countries) 1.25 1.35 1.4 1.4 1.4 Nominal effective exchange rate -1 0 0 0 0 (for countries not in euro area or ERM II) exchange rate vis-à-vis the € (annual average) n.a. n.a. n.a. n.a. n.a. World excluding EU, GDP growth 6 5.6 5.3 5.4 5.4 EU GDP growth, % 3 2.9 2.4 2.4 2.4 Growth of relevant foreign markets 3 2.9 2.4 2.4 2.4 World import volumes, excluding EU growth, % 8 7.8 7.1 7.7 7.7 Oil prices (Brent, USD/barrel) 66.2 70.6 78.8 75.5 76 Sources: Ministry of Finance, European Commission GDP growth projections are particularly dependent on frequently and radically changing credit increase projections made by commercial banks. As recent year experience shows that commercial bank credit increase forecast used to be surpassed and credit increase in the first three quarters of 2007 was 5.1 percentage point of GDP higher than a year ago; credit increase in the fourth quarter of 2007 is also probable. Euro area interest rates increased by the European Central Bank (hereinafter referred to as ECB) in the first half of 2007 provided liquidity sufficient for economy stimulation, and the credit lending process of the second half of the year is predetermined by previously concluded contracts. International financial market turbulences in August strengthened assumptions made in early 2007 that a higher deceleration of credit increase is assumed to start in 2008-2009, marking the start of a natural cyclical slow-down of GDP growth. Globalisation-driven competition and possible changes in real estate prices will have no effect on real production volumes only if labour force is flexible enough and manage to shift among different sectors of the economy. Labour market flexibility may be achieved at the expense of wages: in the medium term, competition intensified by globalisation and a credit change cycle in certain sectors may prompt not only a slow-down of the growth of wages but also their reduction. The assumption about labour market flexibility ensures that the rapid growth of average wages is balanced with potential development divergences among sectors of the economy of Lithuania. If the assumption of labour force flexibility proves false, employment will be lower and real GDP growth will be slower. A medium-term growth of economy is particularly dependant on the assumption that business community will manage to meet financial markets expectations for a rapid and sustainable approximation of Lithuania’s productivity to the EU-average and to generate profits even with a rapid growth of wages and interest rates. After credit increase more than 15% of GDP in 2006, assumptions about the volume of absorption of EU financial support will become peripheral. In the period 2007-2010, absorption of the EU structural funds and other financial assistance from the EU will have a smaller effect on the growth of demand than changes in credit increase volumes. A different-than-planned absorption of EU support would only slightly affect the growth of GDP in the corresponding year. Growth of Lithuania’s economy in the medium term will slightly slower than in the recent years, though it still will be rather fast.       Growth in 2007 will not basically close gap between the inflationary GDP and GDP potential. It is assumed that ECB anti-inflationary policy of raising interest rates will eventually affect not only euro area but also Lithuania, therefore, the gap between the inflationary GDP and the potential will start decreasing in 2008-2009. GDP growth will account for 5.3% in 2008, 4.5% in 2009, and 5.2% in 2010. An early and manageable correction of GDP growth rates would ensure a rapid and sustainable average growth of 6% in later years. Sticking to fiscal discipline standards may also manage interest risk spreads and create conditions for even and fast economy development. In case economic environment deviates from assumptions, projections of economic indicators for 2007–2010 or projection outlook would be adjusted accordingly. Monetary and exchange rate policy 14. Lithuania pursues monetary policy under the conditions of a fixed exchange rate for the litas. Such exchange rate regime increases confidence in Lithuania’s economic policy and together with competitive economic environment allows pursuing relative long-term price stability. Openness of the economy, relative flexibility of prices and wages, litas exchange rate importance for the price stability are those features of Lithuania’s economy that contribute to the successful application of the fixed exchange rate strategy. By becoming a EU Member State Lithuania has undertaken to replace the litas with the EU currency euro (hereinafter referred to as the euro). Lithuania has been participating in the ERM II since 28 June 2004, by implementing a unilateral commitment to maintain a fixed exchange rate regime and a fixed national currency exchange rate vis-à-vis the euro. 15. Lithuania’s monetary and exchange rate policy goals remain unchanged. Lithuania will further maintain a strictly fixed litas exchange rate vis-à-vis the euro, and will seek to join the euro area as soon as economic convergence criteria are met. Lithuania’s resolution to adopt the euro is supported by: 15.1. successful application of the fixed exchange rate and ability to withstand a shock without changes of nominal exchange rate of the litas; 15.2. Lithuania has pegged the litas to the euro but it has not been gaining full advantage of single currency: economic entities suffer currency exchange losses; the litas interest rates are higher than the euro interest rates; 15.3. euro adoption in Lithuania will accelerate real convergence of Lithuania’s economy with other EU Member States, make Lithuania more attractive for investors, speed up trade and finance integration into the EU. 16. Estimates and assessment carried out considering Lithuania’s obligations undertaken when joining the EU to raise tobacco and fuel excise to the EU minimal level and growing prices of energy resources indicate that the most favourable tome for Lithuania to adopt the euro starts with 2010. At the same, the Bank of Lithuania maintains the level of institutional preparation which under favourable macroeconomic conditions ensures smooth and rapid currency replacement. Economic cycle and a medium-term macroeconomic scenario Goods and services markets 17. Lithuania’s economy has been growing at a very high pace: Over 2006, real GDP has grown by 7.7%, followed by a growth of as much as over 9% in three quarters of 2007. Domestic demand remains the main driver of economic development, stimulated by intensive borrowing and rapidly growing nominal income. Results of the first three quarters of 2007 confirm that the slowdown in the economic development in the second half of 2006 was not related to the cooling of the economy or return to the balanced growth. The negative impact of net exports on the economic growth has intensified although clear signs of decreasing competitiveness are not visible. Considering negative impact of high activity in oil refining, very high activity in construction and construction maintenance, the economy growth in the recent quarters has mostly depended on the growth of closed sectors. A positive gap between the actual and potential GDP raises certain concerns related to a growing tension in the labour market and an increasingly high impact of domestic demand on prices and the current account deficit of the balance of payments of Lithuania. It is expected, however, that a very rapid growth of domestic demand will slow down as the rate of growth of bank loans (which seems to be quite inert) become more responsive to the continued tightening of monetary policies by the ECB and uncertainty in the real estate market. GDP growth was driven mainly by the growth of household consumption expenditure. The empiric analysis confirms that private consumption in the country depends not only on the current quarter but also on the income of approximately twelve months. In the recent four quarters nominal wages have been rapidly growing (on the average 20% per year), while growth of net wages was even more rapid after income tax rate was reduced in July 2006; employment has also been reasonably growing, which rather increased household disposable income. Figure 1. Contributions to real GDP growth (expenditure approach) Sources: Statistics Department under the Government of the Republic of Lithuania (hereinafter referred to as Statistics Lithuania) and estimates by the Bank of Lithuania The still relatively favourable conditions of external financing of enterprises, high profitability of investment projects and good financial situation of enterprises, EU financial support to infrastructure and commercial projects determined that in the first half of 2007 the growth of investment has risen considerably. In the first half year of 2007, the trend of rapid growth in the investment into transport vehicles has emerged. In the environment of high domestic demand and shortage of labour force, investments play a particularly important role in promoting sustainable economic growth: they are expected to ensure a growth of the economic potential and to avert the danger of economic “overheating”. Effective investments will be promoted by allocating EU structural funds support. Real import growth exceeding export growth resulted in the increased negative impact of export on GDP. The still increasingly growing import is mostly associated with much stronger domestic demand, while disruption of oil refining activity had a temporary negative impact on export. Relatively fast nominal export growth shows that a potential drop of competitiveness of Lithuanian producers is still maintained irrespective of growing prices of raw materials and rising labour demand in the market. As a result of a negative impact of oil refining activity, manufacturing industry has been slowly growing but the level of private sector economic activity stimulated by other types of domestic demand kept rapidly raising. Construction has become the most important sector of the economy growth, as due to very favourable weather conditions in early 2007 and an insignificant impact of growing interest rates in 2007 its development was very fast. Figure 2. Contributions to real GDP growth (production approach) Sources: Statistics Lithuania, estimates by the Bank of Lithuania Future capacity of producers to satisfy the high domestic demand will largely depend on sufficiency of labour force as one of the most important factors of production. In the past quarters, labour market has been very dynamic, with the overall situation in the market being very tense. An increasing number of vacant jobs and rising wages that outpaced efficiency gains evidence the lack of labour. On the other hand, economically inactive population that enters into the labour market due to rapidly growing wages and high pressure in the labour market in the second half of 2007 will be an stimulus of the economy growth. The gap in the growth of wages between the private and public sectors has become very wide. Owning to shortage of employees and declining share of illegal wages, wages in the private sector have been growing well faster than in the public sector. Sticking to the Lithuania's fiscal discipline rules set forth in the Law on Fiscal Discipline of the Republic of Lithuania would in the medium-term mitigate risks related to internal and external differences and would allow even development of the economy using relatively low interest. The medium term economic growth will depend on the country’s capacity to get prepared for natural economic cycles in time and rationally. It is advisable to assessment of financial liquidity and solvency indicators of both private and public sector ground not only on nominal values but also on the temporary nature of the cyclical income spike. Table 2. Macroeconomic prospects ESA Code 2006 2006 2007 2008 2009 2010 Level rate of change rate of change rate of change rate of change rate of change 1. Real GDP B1*g 71649,1 7,7 9,8 5,3 4,5 5,2 2. Nominal GDP B1*g 81905,2 14,7 16,4 12,3 7,9 7,7 Components of real GDP 3. Private consumption expenditure P.3 50599,1 11,9 12,4 6,7 6,2 5,4 4. Government consumption expenditure P.3 12423,6 5,5 4,9 8,7 2,6 4,4 5. Gross fixed capital formation P.51 18499,4 17,4 26,5 3,4 5,2 7,9 6. Changes in inventories and net acquisition of valuables (% of GDP) P.52 + P.53 0,9 3,2 -0,1 0 0 0 7. Exports of goods and services P.6 43669,8 12,2 8,6 12,2 2,4 8 8. Imports of goods and services P.7 54661,4 13,8 16 12,3 4,1 8,4 Contributions to real GDP growth 9. Final domestic demand – 9,6 15,8 7 6,1 6,8 10. Changes in inventories and net acquisition of valuables P.52 + P.53 – -3 0 0 0 0 11. External balance of goods and services B.11 – -2 -6 -1,7 -1,6 -1,6 Stability of prices 18. In 2007, prices in Lithuania were increasing at a faster pace. In the first ten months of 2007, the average annual inflation measured on the basis of the Harmonised Index of Consumer Prices (hereinafter referred to as HICP) reached 5.2%. Headline inflation accelerated mainly due to increasing growth rates of prices on processed foodstuffs and services. With the prevalence of imported manufactured goods in the consumer’s basket, the impact of the increasing Lithuanian producer prices on headline inflation remained limited. In the first ten months of 2007, increased prices on food products accounted for nearly two thirds of headline annual inflation. In the middle of 2007, prices on foodstuffs and beverages were on average about 10% higher than a year before. During all this period, there was a marked increase in prices on bread and cereal products, while in the second half of 2007, the prices on milk and meat products saw a faster rise. Cigarette prices also went up as a result of increased excises on cigarettes. Figure 3. Annual HICP inflation and contributions* Sources: Department of Statistics, Bank of Lithuania estimates *HIPC excl. food, fuels and lubricants, and administered prices The rise in processed food prices is attributable to increasing prices on agricultural products, rising wage costs as well as the growing profits of food producing and trading enterprises. In the context of the growing prices on agricultural products abroad and the ongoing convergence of these prices in Lithuania with West European prices, the prices of agricultural products in Lithuania went up by several dozen per cent. As wage costs constituted an almost fixed part in producer prices, food prices were steadily increasing. The growing wage costs were also included in producer prices. It is believed that a more significant increase of unit labour costs in the food production sector started in 2007, which had an additional impact on food prices. Moreover, as production costs increased and food producers maintained nearly stable profit margins, the absolute value of their profit was also growing. This boosted food producer prices. An analogous situation was also observed in the food trading sector, however, here, unlike in the food production sector, the increase in consumer prices was largely driven by unit labour costs, which had been rising already since the beginning of 2006. The increase in consumer prices was also caused by growing trader profits. The impact of administered prices on headline inflation in 2007 changed slightly. The largest contribution to the growth in headline annual inflation came from raising heating prices since autumn 2006 and electricity prices since the beginning of 2007. The rise in heating prices in July-August 2007 in Vilnius and some other Lithuanian cities also caused a slight increase in headline inflation. In August 2007, there was a small increase in headline inflation due to higher prices on public transport services (in Kaunas and Panevėžys). Fig. 4. Impact of administered prices on headline annual inflation Sources: Department of Statistics and Bank of Lithuania estimates In view of increased geopolitical uncertainty in August 2007, as well as the unscheduled suspension of operation of some oil companies, US dollar-denominated oil prices were approaching the price level of the respective period of the previous year and eventually exceeded it. This resulted in a decreasing negative annual change in fuel prices and their impact on headline annual inflation in the first eight months of 2007, and later this impact changed to positive. The impact of prices of manufactured goods on headline inflation also remained negligible. Such price developments are mainly determined by changes in prices on imported goods, rather than rising prices of Lithuanian producers. The price rise of manufactured goods of Lithuanian producers is due to increasing prices on imported gas, other raw materials (e.g. timber) and wage growth exceeding labour productivity growth; however, with the prevalence of imported goods (excluding food products and liquid fuels) in the consumer’s basket, there was no increase in consumer prices of manufactured goods. In the first ten months of 2007, the impact of prices of services on headline inflation was steadily increasing from 1.3 percentage points to 2 percentage points, which showed the increasing effect of aggregate demand on price change. The prices of market services have been for some time greatly influenced by growing wage costs. Though labour productivity growth in the market services has been increasing, the increase in the value added per employee has been substantially lower than wage growth. In the market services sector, the greatest impact on headline inflation in 2007 was caused by the rising prices of restaurant, café and canteen services. The price increase of these services is determined not only by high demand and growing wage costs, but also by higher food prices. The average monthly gross earnings in the country have continued to grow rapidly as a result of labour market tensions and other factors (administrative decisions, presumably declining share of illegal earnings). The annual wage and salary growth in the third quarter of 2007 was 17.9% (19.9% in the third quarter of 2006). Fig. 5. Change of wages and productivity in the market services sector Sources: Department of Statistics and Bank of Lithuania estimates Table 3. Price indicators Indicator ESA code Level in 2006 Rate of change, % 2006 2007 2008 2009 2010 1. GDP deflator 114.3 6.6 6.1 6.7 3.2 2.3 2. Private consumption deflator 105.7 2.9 5.2 5.5 2.5 2.2 3. HICP (average annual change) 103.8 3.8 5.8 6.5 5.1 3.6 4. Public consumption deflator 119 14.5 9.3 9.4 4.9 3.9 5. Investment deflator 109.7 6 6.5 6.5 5 3.3 6. Export price deflator (goods and services) 112 5.2 4.9 4.1 2 2.2 7. Import price deflator (goods and services) 105 8 3.1 4.2 2.5 2.5 Sources: Statistics Lithuania, Ministry of Finance In the medium term, the price increase for services will have a crucial impact on underlying inflation, as increasingly expensive labour will account for an increasingly large share of the cost of services, and the global competition and rapid development of production will continue to push the prices of clothes, footwear and household appliances down. The increased natural gas prices for regulated consumers and heat supplying enterprises may cause an upsurge in inflation by 1.5 percentage points. The exchange rate of the litas against the euro, fixed under the currency board arrangement, ensures that the average multi-annual inflation will remain close to that in the euro area. Following the acceleration of inflation in 2006–2008, and with the stabilization of oil and gas prices, harmonisation of excises to the EU rates, and along with the increase in interest rates and a deceleration of credit increase, inflation in Lithuania will again move closer to the inflation rates observed in the euro area. Labour market 19. Confidence in macroeconomic stability has promoted private investment and consumption; therefore, over the period from the second quarter of 2001 to the second quarter of 2007, the number of the employed has grown by 12.4%: 14.9% in urban areas and 6.9% in rural areas. Unemployment has shrunk by 12.7 percentage points. Labour force has shrunk by 2.5%; to a certain extent, this shrinkage could have been caused by emigration. In rural areas, labour force shrank one and a half times as fast as in urban areas: by 2% in urban areas and by 3.5% in rural areas. Lithuania’s labour market increasingly integrates into the EU single market, which makes it possible to expect that labour market developments will be beneficial for employees. Table 4. Labour market indicators Indicator ESA code Level in 2006 Rate of change, % 2006 2007 2008 2009 2010 1. Employment, persons (thou) 1499 1.7 2.3 0.3 0.1 0 2. Employment, hours worked 2757133 0.9 3. Unemployment rate (%) 5.6 4.5 5.2 6 5.9 4. Productivity (real GDP per person employed) 47798 5.9 7.3 5 4.4 5.2 5. Labour productivity (real GDP per hour worked), LTL 26.8 6.6 6. Compensation of employees, LTL million D.1 34966.8 18.9 23.2 19 7.6 7.2 7. Compensation per employee 23326.7 16.9 20.4 18.7 7.6 7.2 Sources: Statistics Lithuania, Ministry of Finance * Value of indicator is shown. Projections of the unemployment level for 2008–2010 are based on the assumption that increasingly higher wages may enhance the activity of labour force and change migration flows; if the activity of labour force and migration changed, unemployment, according to the recent trends, would stand at some 4.8% in 2008, and 4.9% in 2009–2010. It is assumed that emigration will not slow down the growth of employment in Lithuania and will continue to improve the current account of the balance of payments of Lithuania. Growing demand for labour force, increasing productivity, growing minimal monthly wages, improving market expectations and price convergence after accession to the EU will bring changes in wages. Trends that started in 2004 are projected to continue, meaning a further growth of average monthly wages in 2008–2010. The average monthly gross wages are projected to increase from LTL 1495.7 in 2006 to LTL 2388.2 in 2010. Growth of wages will make it possible to reward gradually the employed population for the high labour productivity growth achieved in the previous year. Unemployment has been decreasing very rapidly recently. In the second quarter of 2007, the level of unemployment dropped to its record lows of 4.1% (compared to 5.6% in the same period a year ago and 8.5% in 2005). The labour market also underwent certain structural changes, such as a shift of labour force from less productive sectors of the economy to those which are currently very active yet are affected by larger cyclical fluctuations (e.g. construction, real estate, trade). Re-training and re-allocation of labour from low productivity sectors to higher productivity sectors will become an important GDP growth factor capable of preventing a shortfall of labour in the medium term. Balance of Payments 20. In 2007, the trend of a widening current account deficit of Lithuania’s balance of payments continued: in the first quarter it went up to 13.2% of GDP, while in the second quarter up to 16.1% of GDP. According to the data for the second quarter, the four-quarter moving sum of the CAD rose to 13.4% of GDP. Such development of external accounts essentially means that the net financial flows from foreign trade and other current transfers are negative, large and tend to increase, which in turn results in a rapid increase in foreign debt. The balance of savings and investment shows that the growth of the CAD over the past two years was also determined by growing investment, the annual moving sum of which went up to 28.3% of GDP (cf. 26.6% a year ago) as well as a decline in savings, the annual moving sum of which fell to 14.9% of GDP (from 18.1% a year ago). The development of the current account of the balance of payments of Lithuania greatly depends on the lending policies of foreign banks. As foreign banks are being more cautious about the economic prospects of the Baltic countries, the CAD is likely to fall, thus affecting GDP growth. Fig. 6. Components of the current account balance Sources: Department of Statistics, Bank of Lithuania and Bank of Lithuania estimates The recent widening of the CAD has been mostly inspired by the increasing deficit of the balance of goods, which, in the first half of 2007, was 45.3% above the figure for the corresponding period in 2006. About a third of the annual growth of the balance of goods in the first half of 2007 as compared to the same period of 2006 is associated with the developments in oil refining activities – the interruption of oil supplies via the pipeline from Russia in July 2006 and the severe fire in the oil refinery of AB “Mažeikių nafta“ in October 2006 had a hugely detrimental impact on the development of foreign trade. This impact is still felt today, though the situation in the sector is gradually stabilizing. The total exports of petroleum products in the first half of 2007 were 47.3% below the figure a year ago, while imports were 26.1% down. It is notable, that Lithuania is a net importer of oil and the profit of foreign investors controlling AB “Mažeikių nafta” is essentially treated as foreign direct investment (hereinafter referred to as FDI) inflows in Lithuania. Thus, oil prices or the growth of earnings of AB “Mažeikių nafta” contribute to the increase in the CAD. In the second quarter of 2007, the average oil price in litas was some 9% below the figure a year ago, which had a positive effect on the development of the current account. In the first half of 2007, the positive balance of services was decreasing and fell by 29.7% as compared to the same period in 2006. This decline was mainly due to the decreased volume of exports of intermediation services and worsened travel balance. The positive balance of transport services, which is the main component of the services balance, declined only slightly. Over the year, a substantial decrease in the import of pipeline transport services was partially offset by the rise in import of sea transport services. Given a rapid growth of foreign trade, a significant increase in the volume of rail and road transport (in both import and export of these services) was recorded. The income balance was deteriorating during the first half of 2007 and stood 45% below the figure a year ago. Although there was a moderate improvement of the balance of labour income, negative flows of investment income experienced a faster growth. This rise, as earlier, was largely determined by increasing growth of the profit of foreign investors in Lithuania and growing income of foreign investors from other investment, which mostly consists of higher interest paid to foreign banks as the debt of the economy increases. The increase in income deficit was slowed down by growing foreign investment portfolio income of residents. In the first half of 2007, the development of the current account of the balance of payments of Lithuania was positively affected by a 17.5% increase of net current transfers. Their increase was determined by a fast growth of private transfers, which was especially strong in the first quarter, but fairly slow in the second quarter. Over the recent period, the developments of debt-neutral capital flows, which are used to finance the CAD, were benign. Capital transfers (support of EU cohesion funds) increased over the year and, in the first half of 2007, covered 8.8% of the CAD. This was related to a faster use of EU financial support. Lithuania’s FDI flows, after an especially active fourth quarter of 2006, when the stocks of AB “Mažeikių nafta” were sold to a foreign investor, continued into the first quarter of 2007, with investment in oil refining and other industries being intense, while in the second quarter the FDI processes saw a slow down. Apart from the sale of the stocks of AB “Mažeikių nafta”, the reinvestment of profit earned by companies usually constituted the largest part of investment. In the first half of the year, the FDI in Lithuania financed 42.2% of the CAD. Fig. 7. FDI trends in Lithuania Fig. 8. FDI financing sources Bank of Lithuania Bank of Lithuania The net foreign borrowing of commercial banks remained the most important and stable source of CAD financing: the net financial inflows to the commercial banking sector covered 62.5% of the CAD in the first half of the year. Such large injections of financial resources into the country’s economy greatly encourage economic development; moreover, as these resources boost domestic demand, import of consumer and investment goods as well as the CAD increase accordingly. In the first half of 2007, portfolio investment flows remained negative and accounted for 24.4% of the CAD. A further increase in foreign portfolio investment (which is mostly private sector investment in foreign equities) was nearly offset by non-resident investment in debt securities of banks. The increasing foreign financial investment flows are in part associated with the emergence and promotion of new financial savings instruments and active growth of investment and pension funds. At the end of the second quarter of 2007, as the debt of the economy increased, the total foreign debt was 40.4% above the figure a year before and accounted for LTL 58.2% billion, or 66.1% of GDP. Almost a half of the year-on-year increase of foreign debt was determined by foreign borrowing of banks (mainly in the form of long-term liabilities). Nearly one third of the increase is attributable to the growth of long-term liabilities of other financial enterprises (non-banking institutions). In the second quarter, the total foreign debt administration costs amounted to LTL 7.6 billion, or 32.2% of the second-quarter GDP, of which repayment of loans made up LTL 473.2 billion, or 2% of GDP. These repayments of loans are direct economic costs incurred by the country’s economy for the possibility to finance the current economic development with foreign funds. To achieve stability in the administration of foreign debt, it is necessary to ensure continuous refinancing flows from foreign banks whose strategic aim to enter Lithuania’s financial market directly or through their subsidiaries is an important risk-reducing factor. In the first half of 2007 foreign trade grew rapidly. When compared to the same period of the last year, the nominal export of goods has increased by 7,2 % and import – by 15,6 %. Nominal export of goods excluding trade in oil and oil products has increased by 33,4 % and import – by 30,3 %. Demand in raw materials backed by high activity of manufacturing industry encourages to import intermediate goods of industry. In the first half of 2007 this resulted in the growth of nominal import by 12,8 % or more than half of the total nominal import (excluding oil and oil products). Since the year 2006 the direct impact of imported vehicles on the nominal import has significantly increased, which accordingly was strengthened by increase in prices of imported vehicles. Rapid growth of export (excluding oil and oil products) is to the great extent related to the intensive export of chemical industry as well as plastics industry products. Rate of vehicle export growth is also very high, however, the impact on total export growth in 2007 has declined. Due to differences between prices in Lithuania and in main export markets the export of production of animal origin – live animals, meat and milk – is rapidly increasing: during ten months in 2007 such export increased by 43 %. When Russia and Belarus, the main exporters of wood, increased custom duties on exported produce, the demand for wood in other EU countries has increased. This resulted in increased prices of wood and made positive impact on the nominal export of Lithuanian wood, part of wood being exported to the EU countries. Fig. 9 Factors of change in import excluding mineral products Fig. 10 Factors of change in export excluding mineral products Sources: Department of Statistics, Bank of Lithuania, calculations of the Bank of Lithuania Sources: Department of Statistics, Bank of Lithuania, calculations of the Bank of Lithuania In the end of the 2nd quarter of 2007 the real effective exchange rate of the litas was higher by 1,3 % than a year ago. The real effective exchange rate of the litas increased vis-à-vis trade partners of the euro zone and the Commonwealth of Independent States, but declined vis-à-vis the new EU Member States (mainly because of higher inflation in the neighbouring Baltic states). The effective exchange rate of the litas based on deflationary factor of export prices has increased by 2,1 % during the year. Up until now the increased prices of production under exportation has no vivid negative impact on a real export growth rate and competitiveness. It is expected that the fundamental export development will meet changes in foreign demand, and in the end of 2007 export growth will increase due to the recovery of oil refining capacity. This should smooth the increase of CAD in the 4th quarter of 2007. It is expected that in 2007 the CAD may count for 14 % of GDP. Due to rapid increase in internal demand CAD will further increase in 2008 and may count for more that 15 % of GDP. Table 5. Sectoral balances Indicator ESA code % of GDP 2006 2007 2008 2009 2010 1. Net lending/borrowing vis-à-vis the rest of the world B.9N -9,5 -12,5 -12,7 -14,5 -15,4 of which: - balance of goods and services -10,4 -13,5 -14,2 -15,4 -16,3 - balance of primary incomes and transfers* -0,3 -0,5 -0,1 -0,6 -0,6 - capital account* 1,2 1,5 1,6 1,5 1,5 2. Net lending/borrowing of the private sector -8,9 -11,6 -12,2 -14,7 -16,2 3. Net lending/borrowing of the general government B.9N -0,6 -0,9 -0,5 0,2 0,8 4. Statistical discrepancy 0 0 0 0 0 Sources: Ministry of Finance, *Bank of Lithuania Risk related factors of economic development 21. In the medium and long-term the risk stems from the imbalances existing in the real estate market of the country, potential correction of asset prices and a significant slowdown in the growth of the national economy. The potential GDP growth will remain close to 6 %, however, the existing risk factors may unnaturally retard economic growth in the medium-term and the future of the economic sectors which have recently experienced a boom will depend on their flexibility with regard to changes in real estate prices. The risk remains, especially in 2008, that the return of real estate prices back to economically justified levels might slow down the GDP growth by several percentage points. The presence of such a risk is supported by the start in the USA of the correction of the real estate market that still is going on. The correction of the real estate market would allow to determine the extent to which the decisions of borrowers that are not always rational made in recent years could influence the medium-term perspectives. 22. Cyclical impact of credit increase on the demand has reached such a level that in the light of a change of an economic cycle and a faster slowdown of credit increase, the upward impact of EU support on the demand would be capable of compensating these cyclical slowdowns only in part. Therefore consistent implementation of fiscal objectives of general government and compliance with fiscal discipline would help for economic risk management. 23. The issues of “overheating” and two correction scenarios, “soft lending” and “hard lending”, which discussed in macroeconomic overviews by commercial banks, show that mid-term economic risks depend on the country’s capacity to get prepared for natural economic cycles in time and efficiently. 24. Inflation may increase in the mid-term due to a faster growth of wages prompted by the “heating” of the economy. Persistence of expectations of market participants for a strong rise of prices and a faster growth of wages could change consumer behaviour and increase nominal GDP growth and the CAD by several percentage points. Growth of wages and nominal GDP could also be several percentage points higher if credit growth went up rather than down. 25. If because of concerns about the state of regional economy the commercial banks will change their credit supply policies too quickly, Lithuania’s economic growth in the years of correction would be several percentage points slower, but would subsequently come equal to the high potential GDP growth. 26. Due to repair works at the Mažeikiai oil refinery in 2007 the Lithuania’s total exports experienced a sudden slowdown, but export of products of Lithuanian origin maintained its recent stable nominal growth of 6-9 %. In case the supply of raw materials for the refinery will be restored to the previous capacity, Lithuania’s general export may significantly increase in 2008. III. PUBLIC FINANCES Strategy of financial policy 27. The medium-term objective is the reduction, by ensuring the implementation of economic policy priorities, of the structural deficit down to 1 % GDP or below after 2008 and further down in later years up to a structurally balanced deficit or structural surplus. Stricter fiscal policy goals have been set in the light of faster-than-projected trends of nominal GDP growth and committed limitation of expenditure growth as set by the Fiscal Discipline Law of the Republic of Lithuania. 28. The medium-term fiscal policy (macroeconomic policy) will be geared towards the implementation of the following priorities: 28.1 to match the fiscal policy with the priorities of social policy; 28.2 to continue the tax reform aimed at balancing labour and capital taxation; 28.3 to promote further reforms in energy and agriculture sectors; 28.4 to continue the pension reform ensuring a long-term sustainability of general government finances; 28.5 to create favourable conditions for the improvement of labour efficiency, improve competitiveness of the economy, attract more FDI, and successfully implement EU cohesion policies; 28.6 during 2008 to prepare proposals on measures capable of ensuring continuous usage of potential economic growth necessary for low inflation and high employment and ensuring deterioration of fiscal deficit. Partnership of public and private sectors, the efficiency of which is evidenced by the participation of private sector due to profitability of joint project, should be applied to investments that do not increase fiscal deficit for the state; 28.7 to improve long-term sustainability of finances of general government and fiscal discipline norms that ensure long-term economy development as well as implement education and health care reforms; 28.8 to apply quasi-monetary measures, such as tax subsidies influencing demand of credits, for the implementation of active monetary policy aiming to ensure stability of prices and acceptable level of employment; 28.9 to rise confidence in sustainability of long-term finances of the general government and improve the planning framework for the state budget of the Republic of Lithuania for a mid-term period. 29. Seeking to maintain confidence in the currency board arrangement, Lithuania will, as part of its fiscal policy, further create favourable conditions for improving labour efficiency, improve tax administration, encourage investment, create favourable business environment and ensure rational use of public funds allocated for investment. Any additional general government revenue and unspent expenditure allocations will be used for the achievement of the fiscal deficit objectives and for measures aimed at ensuring long-term sustainability of government finances. Actions planned for 2008 to 2010 aimed for the implementation of fiscal deficit objectives 30. Once personal income tax reform has been implemented, i. e. a better balance is achieved between capital and labour taxation, there will be better conditions to develop human capital intensive industries and to implement Lisbon strategy goals in the labour market by promoting job creation. Efforts will be made to ensure that the balance between labour and capital taxation is achieved without increasing the fiscal deficit and that it creates conditions to enhance business competitiveness. In 2005–2007, Lithuania successfully mitigated negative effects of the shadow economy on general government finances. In the mid-term, tax collection will continue to be further improved; therefore, the structural revenue is expected to increase by more than 1,5 % of GDP in 2008; any extra revenues will be used to achieve fiscal deficit targets. Taking account of present possibilities efforts are made to increase the share of GDP for health care and education. Compliance with the Fiscal Discipline Law of the Republic of Lithuania in a medium -term would create conditions for limiting the increase of structural expenses and for ensuring the implementation of fiscal deficit targets. In order to implement the targets of the fiscal deficit planned for 2008, the sum impact of structural measures in 2008 should account for 1,8 %. The implementation of structural measures in 2008 would allow to enjoy surplus budget in 2009 and 2010. The implementation of the targets of the fiscal deficit of 2009 and 2010 will greatly depend on the ability of municipalities to implement the provisions of the Organic Budget Law of the Republic of Lithuania (Valstybės žinios, (Official Gazette) 1990, Nr. 24-596; 2004 Nr. 4-47) concerning the balanced budgets and to implement commitments concerning national financing when implementing projects financed form the EU resources. Risk management measures of fiscal deficit target implementation in the year 2008 are discussed in point 57 of this Programme. 31. The following measures are foreseen for the implementation of the targets of the Lithuania’s finance policy: 31.1 measures for the implementation of fiscal deficit targets in the period of 2008–2010: 31.1.1 making further efforts to mitigate the adverse impact of the shadow economy on general government finances and seeking to ensure that the planed increase of structural revenue by more than 1,5 % of GDP in 2008 is outperformed at least by 0,3 % of GDP.; 31.1.2 seeking to ensure rational spending of general government expenditure; 31.1.3 using unspent expenditure allocations for the achievement of fiscal deficit target; 31.1.4 present to the Seimas of the Republic of Lithuania draft laws on the approval of financial indicators of the state budget and municipal budgets of 2009–2011 implementing the norms of Fiscal Discipline Law of the Republic of Lithuania that require to limit the increase of expenditure to such an extent that fiscal deficit when compared with the pervious year improves at least by 1 % of GDP or the expenditure increase of the state budget of the Republic of Lithuania expressed in per cents is not higher than half of revenue increase during the previous five years expressed in per cents; 31.1.5 solving the issue on the risk concerning the increase of fiscal deficit stemming from renovation of residential houses by means of public and private sectors partnership or targeted financing of international institutions; reducing the risk of fiscal deficit to the risk of temporary debt increase; 31.1.6 reconsidering the principles for financing the health care system, determining (after evaluation of purposefulness) independent source of financing that is independent of population income tax; 31.1.7 preparing by the end of 2008 and presenting if necessary to the Seimas of the Republic of Lithuania relevant proposals following the evaluation by the Government of the Republic of Lithuania of the analysis of purposefulness of tax exemptions; 31.2 with a view to achieve long-term stability of prices in 2008, consider the possibilities to develop measures of quasi-monetary policy based on the impact of real estate related taxes and subsidies on credit demand, that would allow to ensure price stability in the short-term and policy that guarantees acceptable level of employment; aiming to make influence on public expectations and place obstacles for over-consumption in the future; 31.3 preparing measures during the year 2008 that would ensure consistent use of potential economic growth necessary for low inflation and high employment and without increasing of general government deficit. If necessary these measures would allow to aim at real stability of the sector and tax bases. Application of public and private partnership, the productivity of which is ensured by the participation of the private sector seeking for profit of the common project, for investment that does not increase state fiscal deficit would allow to avoid the growth slowdown deeper that the natural cyclic growth and would ensure the collection of planned state budget revenues; 31.4 increasing confidence in sustainability of long-term finances of the general government by improving the state budget medium-term planning framework. Strengthening of fiscal discipline by improving the state budget medium-term planning framework of the Republic of Lithuania Overview 32. The Constitution of the Republic of Lithuania, the Organic Budget Law of the Republic of Lithuania, the Law on State Debt of the Republic of Lithuania (Valstybės žinios, (Official Gazette) 1996, Nr. 86-2045; 2005, Nr. 83-3041), the Law on State Control of the Republic of Lithuania (Valstybės žinios, (Official Gazette) 1995, Nr. 51-1243; 2001, Nr. 112-4070), Treaty establishing the EU, regulations of the Stability and Growth Pact, opinions of the Economic and Financial Affairs Council of the EU and conclusions of the European Council as well as the Law on Fiscal Discipline of the Republic of Lithuania help to ensure fiscal discipline in Lithuania. The Law on Fiscal Discipline of the Republic of Lithuania supplemented the planning framework for the state budget of the Republic of Lithuania by commitments that will allow to use sound general government finances as means for strengthening conditions for price stability and sustainable growth that are favourable for employment growth. The fact that fiscal discipline is enshrined in the law strengthens confidence in effect of fixed rate of litas on long-term price stability. Strict compliance with budget discipline (aiming at structurally balanced or surplus general government finances) will allow the economy of Lithuania to overcome cyclic fluctuations and to preserve deficit of the general government not exceeding 3 % of GDP. The Law on Fiscal Discipline of the Republic of Lithuania lays down algorithm of fiscal discipline that was formed taking account of the results of econometric study presented in the report on public finance by the European Commission in 2007 (in English: EUROPEAN ECONOMY. No 3. 2007. Office for Official Publications of the EC. Luxembourg. 330 pp). The empirical study has indicated that there are two practical approaches for strengthening the finances – ‘gradual’ and ‘cold shower’. The ‘gradual’ approach for strengthening finances is applied over rapid growth periods by limiting increase of expenditure, while the ‘cold shower’ approach is applied in case of risk of economic crisis by reducing expenditures. The algorithm of fiscal discipline of Lithuania puts a commitment to strengthen government finances by applying the ‘gradual’ approach during rapid growth periods. The algorithm of fiscal discipline is based on the combination of three fundamental stability rules. The first rule lays down a common guideline: the general government is managed in such a way that ensures it being in surplus or balanced, except in case of justifying circumstances that allow temporary app …